Market Sector Update

• Late-cycle concerns have emerged, putting downward pressure on second quarter economic forecasts. Gross domestic product (GDP) growth estimates for the period have fallen to 1.7% as cost pressures, trade tensions, and global uncertainty take their toll. These factors are pressuring corporate earnings, making a year-over-year decline likely for the second consecutive quarter. On a brighter note, the labor picture remains exceptionally strong, with the unemployment rate at 3.6% its lowest level in nearly 50 years.
• While the U.S. Federal Reserve’s (Fed) base case calls for growth trending to a slower but more sustainable level, rate cuts are likely if the U.S. economy softens more than expected. Interest rates – here and abroad – are signaling that investors are worried about a slowdown. Investors believe the Fed is entering an easing cycle, at futures have priced multiple cuts over the next year. It’s unusual to see such strong market conviction about the need for easier policy while the Fed continues to temper expectations, guiding to only modest easing this year.
• Despite the pro-cyclical bias of the equity market, the 10-year U.S. Treasury yield declined 11 basis points (bps) to 2.57%. The yield curve continued to flatten with the spread relationship between the 2-year and 10-year U.S. Treasuries ending the quarter at 14 bps, down from 19 bps at the start of the year.
• All asset classes have performed well to date in 2019 despite slowing growth and fears of a downturn. Ironically, the catalyst for the second quarter rally was growing conviction the Fed will reduce rates in the near term, which would prolong the expansion. Real estate stocks once again delivered positive returns, including the FTSE NAREIT Equity REITs Index, the Portfolio's benchmark.
• Macroeconomic and interest rate conditions remain favorable for real estate operators, although we are paying careful attention to indicators that suggest a slowdown and possible earnings recession in the second half of the year. Tailwinds from U.S. tax reform, business expansion and positive consumer sentiment have created a solid demand backdrop, allowing real estate investment trusts (REITs) to improve occupancies and command higher rental rate.

Portfolio Strategy

• The Portfolio delivered a positive return for the quarter, but underperformed its benchmark.
• The Portfolio's overall performance for the period is attributed to a more defensive positioning. We have held a larger than typical exposure to net lease and health care properties throughout 2019 given our belief that expectations for a “Goldilocks” environment are too optimistic. Net lease and health care companies tend to outperform while interest rates are falling, and underperform when rates climb. Our conviction is heightened by the sharp run-up in equity prices into what we believe will be an “earnings recession” this year.
• Warehouse REITS also proved to be a detractor to relative performance, although modestly. The burgeoning ecommerce activity has produced strong demand for warehouse space, but new supply has begun to outstrip that demand, leading to reduced rental rate and net income growth for the companies. Typically, that combination has resulted in sub-par performance for the equity and we believe a correction is due. We reduced our exposure to warehouse owners after a period of strong performance left these companies with what we believe are unsustainably inflated valuation levels – particularly if the previously mentioned “earnings recession” unfolds across corporate America.
• Single family rentals (SFR) REITs were the top performing sector in the benchmark for the quarter on a total return basis. Given the Portfolio’s overweight, it was also the top positive contributor for the quarter. The expense hiccups from previous quarters for now have stabilized, resulting in a robust same store net operating income growth average of 6.4% for the quarter. With greater comfort with their maturing operational controls, SFR holdings were increased during the quarter, as we feel there continues to be a long runway for growth; both from a steady stream of millennial and retiree demand, and from demonstrated outreach for affordable housing.
• Datacenter REITs outperformed the broader index for the quarter and contributed to the Portfolio’s performance. Demand for the space remains strong, driven most notably by cloud computing, enterprise outsourcing, artificial intelligence and the continued growth of edge computing. We anticipate these tailwinds to produce better than industry earnings growth in the near future and, with the sector valuation remaining compelling, we are overweight the sectors.
• Also contributing to performance in the quarter were retail REITs. The Portfolio was underweight to both shopping centers and malls in the quarter and both sectors lagged the broader universe. The Portfolio remains underweight to the traditional retail group with the belief that store closings and leasing costs will remain elevated and mute returns for the space.
• Self-storage REITs remain under new supply pressure, causing significant deceleration in revenue growth. Despite the drag on quarterly performance, we remain underweight the sector. Among the REITs that provide 2019 guidance, the implication is that revenue growth will continue to decelerate as the overhang from new supply erodes pricing power for this subsector. We believe this will be a continued strain on operations into 2020.
• Negative stock selection among hotel REITS detracted from the Portfolio’s relative performance. We remain underweight the group on concerns that increasing labor costs and continued new supply will pressure earnings, while increasing economic headwinds will pressure sentiment towards the spacer.

Outlook

• Equity markets remained rock solid for the period, but risks are in play. Geopolitical risks remain high. Increasing labor costs and slowing growth have reset earnings expectations at a lower level. However, we think a strong backdrop for the consumer and favorable Fed policies are enough to keep the economy out of a textbook recession.
• However, we a being quite vigilant for signs of further macroeconomic data deterioration along with a corporate “earnings recession.” Continued dovish Fed policy should prove favorable for risk assets so long as the date doesn’t deteriorate materially throughout the remainder of the year.
• With regard to the current commercial real estate cycle, we continue to see stable operating conditions across the sector with few material concerns on the horizon. Bank lending, commercial construction, equity allocations and overall pricing metrics remain much healthier than was often the case in previous cycle peaks. Simply moving into the later stages of this recovery does not mean sector fundamentals will turn negative.

The opinions expressed are those of the Portfolio's managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 30, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The FTSE NAREIT Equity REITs Index is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. The FTSE NAREIT Equity REITs index contains all Equity REITs not designated as Timber REITs or Infrastructure REITs. It is not possible to invest directly in an index.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. Because the Fund invests more than 25% of its total assets in the real estate industry, the Fund may be more susceptible to a single economic, regulatory, or technical occurrence than a fund that does not concentrate its investments in this industry. These and other risks are more fully described in the fund's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.