Real Assets Insights: Q3 2023 Inflation Stuck with Labor and Energy Pressures

Real Assets strategy showcased a mixed performance in Q3, with the quarter starting out on a positive note but retreating in the last two months. Commodities posted the best performance during the period, driven by higher energy prices, and global natural resource equities followed. Our outlook for energy commodities, gold and global natural resource equities continues to remain positive, while valuations for commercial and industrial real estate continue to get more attractive from a historical perspective.

Global economic growth remained lackluster in the quarter, with manufacturing activities contracting for the fourth month running and services sector slowing down. Business activity in the United States (US) rose at a weaker pace, signaling broad stagnation in output amid muted demand conditions. Eurozone activities rebounded a bit in September but remained in contractionary territory. Core inflation numbers in the US showed a disinflationary trend, while the labor market continued to be relatively robust across key developed economies. Risk assets ended the third quarter down amid higher interest rates and prospects for financial instability in China. Bond markets struggled over the period as yields rose, with the 10-year US Treasury touching 4.57%, its highest level since 2007, and the 2-year Treasury hovering over 5%. The US dollar strengthened steadily, and commodities rose on the back of higher energy prices.

Quarter in Review

In the US, inflation remained elevated throughout the third quarter, albeit showing a slight moderation, which was not sufficient to alter the Federal Reserve's hawkish monetary policy. The August US Consumer Price Index (CPI) rose by +0.6% compared to +0.2% in July and June, inching up to 3.7% over the past year. Both commodities and natural resources, which show a higher sensitivity to inflation, proved resilient as raw materials edged up off their lows for the year. Infrastructure and real estate continued to be pressured by moderate growth expectations, higher interest rates and prospects for the peak in rates being pushed out further into 2024. Inflation-linked bonds were dragged down by a sharp rise in real rates.

The Real Assets strategy started out on a positive note but retreated over the last two months of the quarter and closed down by -0.6% with a modest outperformance relative to its composite benchmark. The year-to-date performance remained negative, but strong longer-term 3 and 5-year returns are still in place. Since its inception in 2005, the strategy has continued to maintain its lead over the composite benchmark by about 25 basis points (bps) annually and has provided an annual return of close to 4.0%.

Commodities rose during the quarter, outperforming both equities and bond markets, driven by higher energy prices. The energy sector posted robust gains of about 20%, followed by industrial metals, while both precious metals and agriculture declined. Supported by OPEC+, crude oil production cuts led by Saudi Arabia and Russia began to squeeze global supply and lower inventories in the US, resulting in a resurgence in crude oil prices. Industrial metals were positive with support from zinc and aluminum. However, copper languished due to a slowdown in global manufacturing activity, while increasing real rates and a strong US dollar weighed on gold. Agriculture declined on lower grain prices, led by higher production forecasts and robust wheat stockpiles.

Global natural resource companies followed commodities, with leadership coming from energy related industries such as integrated oils, exploration and production and other consumable fuels. Diversified metals & mining, agricultural fertilizer, chemicals as well as food products names were muted to negative.

Global infrastructure languished as utilities as well as industrials subsectors such as road and rail, airport services and marine logistics struggled, with competition coming from increasingly higher income options, rising energy costs and a decline in global exports.

US real estate investment trusts (REITs) continued to underperform broader markets for the quarter and the year as interest rates rose and valuation concerns lingered. All property sectors were negative performers, led by self-storage and residential real estate.

US Treasury Inflation Linked Securities (TIPS) declined as real rates increased by over 40 bps. for the 5-year and by nearly 65 bps. for the 10-year security. Market-based inflation expectations for the US, measured by five-year break-evens, increased slightly during the quarter to 2.25% as the US economy continued to show signs of strength.

Investment Outlook

The forecast for a deficit in global crude oil balance through the end of the year and a rise in geopolitical tensions may push the price of energy commodities further, even after the rise in the past quarter. The energy sector is being driven by crude oil with robust global demand coming from both the US and China. Paired with continued production discipline from OPEC+, led by Saudi Arabia and Russia, and US production near pre-pandemic levels that are forecasted to leave the world undersupplied. Agriculture has retreated on better projected grain harvests in the northern hemisphere and continued exports from Ukraine despite the expiration of the Black Sea Grain Deal and the continued ongoing conflict with Russia.

Gold retreated in response to the recent surge in real rates but has held its ground over the past three years despite nominal rates increasing by 4.5%, 10-year real rates by 3.8%, Fed Funds rate by 5.5% and the US dollar appreciating by 20%. Investor holdings of gold have declined this year and expectations for price movement are low, as measured by implied volatility, but the metal remains supported by continued central bank purchases and robust demand for jewelry from Asia. Further, protracted conflicts in the Middle East on top of other geopolitical tensions may lead investors to seek safety by holding gold.

After a breather at the end of the summer and global growth concerns in September, natural resource equities have regained their footing on the back of a rally in energy commodities. The companies are still attractive based on valuation metrics, capital expenditure discipline that have led to improved earnings and positive cash flow, and investor payouts via dividends and buybacks. The environment has also turned attractive in the energy complex for merger and acquisition activity.

The rise in interest rates and competition for yield have taken a toll on global infrastructure equities with utilities bearing the brunt of that impact. The debate over hard versus soft landing for the global economy, the continued call for a recession in 2024 and a trend towards de-globalization have made investors cautious about industries tied to the flow of goods. The defensive nature and quality of the group of companies could prove beneficial if a broad equity pull back emerges and inflation remains elevated in the longer term.

Commercial and industrial real estate continues to be challenged this year, but with valuations this low the group appears attractive from a historical perspective. However, earnings are moderating and the possibility of one or more hikes in US interest rates by the US Federal Reserve coupled with continued uncertainty in the global economy weigh heavily on the asset group. The office sector may be nearing a bottom, but elevated capitalization rates and resetting valuations warrant caution. The outlook for select sectors, such as industrials, lodging/gaming, single family residential and strip centers, is improving.

Inflation-linked bonds were hit by another leg up in real rates over the past quarter. As interest rates reset to higher levels and the US Fed stands firm on its goal of bringing inflation lower, inflation-linked bonds will remain under pressure. Current US inflation measures have ticked up in recent months and market-based expectations have inched up as “sticky” inflation components have taken hold.

Inflation and Real Assets

In the US disinflation is afoot, but at a gradual and less widespread pace than hoped. Headline CPI in the US has inched higher over the past quarter mainly due to energy, but the core reading has surprised to the upside in August and is unchanged in September, with core goods experiencing less deflation than anticipated and core services continuing to move higher. Based on the Fed’s preferred inflation gauge, the core PCE services excluding shelter, “sticky” inflation persists. This measure has been rangebound between 4 and 5 percent and is highly sensitive to the labor market and wages.

Ultimately, for inflation to lessen, there should be a pickup in unemployment and a reduction in wages. While measures for labor and wages have cooled, they continue to point to tight employment that supports elevated wages. Job openings relative to the unemployment rate continue to suggest that excess demand for workers remains high, while unemployment claims, both continued and initial, have only trended lower recently. Further, a combination of tight labor market, impact from the CHIPS and Science Act and the Inflation Reduction Act and general deglobalization appear to have ignited a demand for better wages and working conditions (union activities related to UPS-Teamsters, SAG-AFTRA and WGA and UAW-automakers). Lost production from strikes coupled with rising real wages could press labor costs higher without an increase in productivity, which could lead to further inflationary pressures.

Additionally, there is a forthcoming change from the US Bureau of Labor Statistics to the methodology employed for calculating health insurance costs in the US CPI to capture actual expenses more accurately. Since the pandemic, the health insurance component within the US CPI has declined and most recently by 3%-4% month over month. But economists project that health insurance cost will rise by 1% beginning this October. This means, for core CPI, health insurance will change from a 0.2% benefit to a 0.1% increase. This will have a meaningful impact on the core services excluding housing metric, with the three-month average rising to 0.5% over the next six months before slowing to 0.3% by April 2024.

One of the most easily observed and more volatile components of inflation is energy costs. Resurgent global demand paired with production cuts by OPEC+ countries and additional voluntary cuts by Saudi Arabia and Russia have sent crude oil prices up 30% to 8-month highs in less than three months, pushing headline inflation higher. The near-term outlook from both the EIA and IEA is for inventory deficits in the last quarter of the year due to a combination of stronger-than-expected global growth, modest Chinese stimulus, low stockpiles, and the voluntary OPEC+ output cuts.

There may be some relief in 2024 if slower economic growth emerges and OPEC+ reverts to previous production levels, but the risks are to the upside for prices. Countries with spare capacity are incentivized to maintain higher energy prices, US SPR levels are at 40-year lows, energy companies have exhibited more financial discipline regarding capital expenditures, and in the US shale production is near 2019 highs while drilling rig counts have been declining in 2023. The result supports the current and potentially higher inflation levels.

Real Assets Strategy

At State Street Global Advisors, we have a seasoned, diversified multi-asset strategy that combines exposure to a broad array of liquid real asset securities that are expected to perform during periods of rising or elevated inflation.

The asset allocation is strategic and utilizes indexed underlying funds. It is being used by a variety of clients as a core real asset holding or as a liquidity vehicle in conjunction with private real asset exposures. The strategy is meant to be a complement to traditional equity and bond assets, providing further diversification, attractive returns, and a meaningful source of income in the current environment.