Market Sector Update

• The market got its wish for some help from the Federal Reserve (Fed) as policymakers reduced interest rates twice in the quarter. The federal funds target range is now 1.75-2.0%. Inflation expectations softened, and growth projections barely budged. This raised concern that conventional policies from the Fed may be less effective this time around.
• Economic headwinds going into the fourth quarter are led by the global trade war and subsequent uncertainty as global supply chains are disrupted. On the bright side, lower rates are boosting housing, the employment picture is solid, and consumer spending has remained resilient.
• The same can’t be said for business, where the outlook darkened in the quarter as uncertainty dampened investment. Global manufacturing hit the skids, with both the U.S. and eurozone toying with a contraction. Global trade slowed and more tariffs are slated for the fourth quarter, which will hit consumers for the first time. Analysts now expect a decline in year-over-year corporate earnings for the third quarter in a row. We don’t see an easy fix and expect continued pressure for the remainder of the year.
• Amid the economic and political uncertainty, real estate stocks have been stalwart performers. The FTSE NAREIT Equity REITs Index, the Portfolio’s benchmark, was up nearly 8% for the quarter and has delivered a year-to-date total return of 27%, widely outpacing the broader S&P 500 Index.
• 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 latter part of the year. If weaker conditions do materialize, we still anticipate solid 2020 earnings growth for real estate investment trusts (REITs) as landlords enjoy the benefit of contractual lease obligations from their tenants and today’s ultra-low interest rate environment is providing a refinancing boost to the expense structure.

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 favorable stock selection and sector allocation across several property types, including office, net lease, regional malls, multifamily and hotel owners. Generally speaking, we have remained tilted toward “defensive” positions within the portfolio given our belief that expectations for a “Goldilocks” environment are too optimistic. We also believe an economic slowdown could manifest itself in corporate earnings declines and continued low Treasury yields. In response, we have increased the Portfolio’s holdings in net lease and health care while reducing exposure to hotel and retail.
• Stock selection in the office space was the leading positive contributor to the Portfolio’s relative performance. We have avoided exposure to owners of New York City office given weak operating fundamentals. The recent struggles with failed IPOs only heighten our nervousness about further erosion in that market. The Portfolio’s positioning in office is primarily tilted to those focused on bio-medical facilities and West Coast owners.
• Net lease owners also contributed positively to the Portfolio’s relative performance. Net lease REITs are among the most “bond like” real estate property types due to their very long lease commitments and limited rental escalations. Our strategy focuses on the companies we believe have the highest achievable growth potential and it was finally rewarded. We have recently added to the Portfolio’s weighting in net lease owners given our nervousness surrounding economic growth and it now is overweight relative to the benchmark.
• Retail REITs showed mixed results for the period. Mall REITs lagged the benchmark and were positive contributors to relative performance. Sector weakness was driven by continued concerns about tenant health as well as increased concerns over high leverage at several companies. Shopping center REITs were a detractor from portfolio performance as the group outperformed the index on better than expected results, driven by quicker than expected lease-up of recently vacated space. The portfolio remains underweight both of these sectors with the belief that store closings and leasing costs will remain elevated, thereby muting returns for the space.
• Hotel REITs represent one of the more economically sensitive subsectors. They underperformed the broader REITs group and contributed to relative returns because of the Fund's underweight position. While valuation in the space is starting to look more compelling, we expect new supply, higher labor costs and continued economic headwinds will limit earnings power for the next several quarters and we remain underweight this group.
• The Portfolio’s overweight position to Datacenter REITs aided performance, but unfavorable stock selection meant the group was an overall detractor on a relative basis. Demand for space remains strong, with the continued enterprise migration, edge and cloud computing, and artificial intelligence expected to provide tailwinds to the group for the foreseeable future. We continue to see the space as attractively valued when considering its growth prospects, and the portfolio remains overweight to this sector.

Outlook

• While the Fed has joined other major central banks in easing monetary conditions, investors are increasingly concerned that the Fed’s toolkit won’t be sufficient when the cycle finally turns. We expect much more discussion about the effectiveness of policy tools. Debate about the merits of fiscal stimulus vs. quantitative easing, negative interest rates and yield curve targeting will keep investors on their toes. Rhetoric going into the 2020 elections also is likely to heighten risk.
• 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.
• As we have stated repeatedly to our investors, short-term REIT price movements have been tightly tethered to changes in the 10-Year U.S. Treasury yield for the past six years. While acquiescing to the new normal, we continue to believe that longer-term share price performance will be heavily influenced by macro conditions and individual company portfolio decisions. Share price support will come from continued low interest rates, further employment gains, avoiding a textbook recession, and further vigilance in lending standards. Higher borrowing costs, such as a rising 10-year U.S. Treasury yield, or a steepening yield curve could offer resistance.

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 Sept. 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. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. 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.