Real Asset Returns Should Lead Inflation’s Rise

Timing matters when it comes to protecting portfolios from the negative effects of inflation. While the Fed intends to stay behind the curve as inflation rises, investors should consider an allocation to real assets, whose returns have historically been boosted by rising inflation expectations and, ultimately, by realized inflation observed in the US Consumer Price Index (CPI). The current accommodative fiscal and monetary policies in the US and globally, coupled with pent-up consumer demand, have the potential to usher in a period of increasing price pressures that have not been seen for decades.

Senior Portfolio Manager
Senior Portfolio Manager

Breakevens versus CPI

Returns of inflation-hedging assets typically lead inflation, while other more traditional assets may lag. This can be observed by measuring the strength and magnitude of the relationship via the correlation and beta between the asset and inflation, both realized and market expectations.

Most real assets have historically shown their strongest correlation to US CPI in the quarter preceding publication of the CPI data. (See Figure 1.) This demonstrates how real assets, particularly commodities and natural resource equities, quickly respond to economic conditions and experience positive returns ahead of realized inflation. Infrastructure equities and real estate maintain a more modest positive correlation, both prior to and after CPI data prints, due perhaps to pass-through effects from contractual fee or lease rental arrangements that do not allow for immediate adjustments.

Figure 1: Asset Class Correlation to CPI

4/1/2005 – 12/31/2020

However, CPI is a lagging indicator based on surveys, and markets are more sensitive to immediate indicators of future inflation sentiment. This can be observed through the breakeven inflation rate, which is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. Using 5-year inflation breakevens, which provide an intermediate view and avoid shorter-term factors that increase uncertainty, a more immediate and stronger relationship with real assets can be seen. (See Figure 2.) With the exception of real estate, all real assets peak at the current period, rather than leading as with CPI. In addition, they also display a stronger correlation.

Figure 2: Asset Class Correlations to 5-Year Breakevens

4/1/2005 – 12/31/2020

Not all inflation hedges are created equal. Some assets are more sensitive to inflationary changes, and the magnitude can be measured with beta. The inflation beta shows the degree to which an asset class will move up or down per a 1% change in inflation. Real assets, particularly commodities and natural resources, have consistently exhibited positive, sizable inflation betas, and even a small portfolio allocation can be used advantageously to provide protection from inflation shocks. (See Figures 3 and 4.)

Figure 3 : Beta Relative to CPI

4/1/2005 – 12/31/2020

Figure 4 : Beta Relative to 5-Year Inflation Breakevens

4/1/2005 – 12/31/2020

Perfect inflation hedges do not exist, but real assets historically have displayed a strong correlation and beta to inflation and often are considered the most effective assets for hedging inflation. Real assets have historically led moves in CPI, and their ability to keep pace with breakevens is a proof point for their ability to hedge inflation. Looking outside of real assets, equities have historically provided a modest hedge against rising inflation but have performed poorly in times of unexpected inflation. Given their current lofty valuations and a rising rate environment, equities could prove vulnerable to a rise in inflation. As expected, fixed income and long-duration government bonds, in particular, have performed poorly during periods of higher trending inflation and are an ineffective inflation hedge.

Closing Thoughts

The recent market focus on inflation represents a more complex inflationary backdrop than investors have had to navigate for decades. Inflation gauges are likely to receive a boost in the coming months from the rolling-off of the negative base effects from the depths of the pandemic in 2020, coupled with accommodative central bank policies and mounting pricing pressures. Real assets have proven to lead inflationary economic data and perform positively with inflation expectations. The timing may be right for investors to reevaluate the use of real assets in their portfolios as inflation trends higher.

About the State Street Real Asset Strategy

State Street offers investors a seasoned, diversified multi-asset strategy that combines exposure to a broad array of liquid real asset securities. (See Figure 5) The Real Asset Strategy is expected to perform best during periods of increasing inflation or rising unexpected inflation. The Strategy is meant to be a complement to traditional equity and bond assets, providing further diversification, attractive returns, and a source of income in a low-yielding environment. For complete information, please contact your State Street representative.

Figure 5 : State Street Real Asset Strategy

Illustrative Asset Allocation