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Real Assets Insights: Q4 2023 New Inflation Wave and Resilient Gold

Real assets got a lift in the final quarter of 2023 on prospects of easing monetary policy in the coming year. The outlook is improved for infrastructure and real estate, while commodities and natural resources may take longer to shine.

Senior Portfolio Manager
Portfolio Analyst

A volatile 2023 ended on a cautiously positive note, as developed market central banks appeared to have reached the end of their tightening cycle and signaled that some relief on rates was not too far off. Global economic activity edged higher towards end of 2023. Service sector activity rose while manufacturing remained in decline. Inflation continued to retreat during the quarter. Over 2023, global growth slowed at divergent rates across key economies – growth in the United States (US) outpaced expectations but growth disappointed elsewhere.

Quarter in Review

In the quarter, risk assets climbed in value on growing anticipation of a potential policy easing. Developed market equities registered double-digit gains and outperformed their emerging markets peers. Bond prices rose as yields fell dramatically. US Treasuries rallied sharply across the curve with the yield on the 2-year note declining by more than 75 bp to 4.25% and the yield on the 10-year note retreating by 70 bp to 3.88%. The US dollar index was off 4.5%, its biggest quarterly loss in a year, while commodities fell due to lower energy prices.

Real assets stumbled in the waning months of the summer, then regained their footing by year end as inflation hovered above 3% and investors debated the potential peak in the Federal funds rate and the US Federal Reserve’s next steps. The November 2023 US Consumer Price Index (CPI) had come down to 3.14% and calls for a global recession, hard or soft, had been pushed out to 2024. Concerns over slowing demand in 2024 impacted commodities, especially the energy sector, and natural resource equities.

The more defensive assets, such as infrastructure and real estate, benefited from the move in interest rates and better-than-expected economic growth. Inflation-linked bonds gained from a decline in real rates from October highs. The Real Assets strategy started the period with a continuation of previous quarter’s negative trend, then reversed course over the last two months. It ended the quarter with a gain of 3.7%, keeping pace with its composite benchmark. The annual performance for 2023 was a positive 1.2%, with longer-term 3 and 5-year returns of over 8%. Since its inception in 2005, the strategy has continued to maintain its lead over the composite benchmark by over 20 basis points annually and has provided an annual return of 4.0%.

Commodities were down for the quarter and finished 2023 in negative territory – a sharp contrast to the previous year, with everything from oil and gas to base metals and grains recording declines. The energy sector fell significantly in the final months, off close to 20%, as concerns around a potential slowdown in global demand weighed on oil and higher inventory combined with mild temperatures put pressure on natural gas. The industrial metals complex posted flat performance for the quarter as higher copper prices offset losses from nickel, while for the year the metals were pressured by global economic headwinds and uncertainty over China’s growth outlook. The agricultural sector was slightly negative for the quarter, stemming double-digit declines experienced by grains, partially offset by gain by softs. Precious metals was the sole sector that had a positive return.

Global natural resources held up better – metals and mining companies showed strength, with gold and diversified miners leading the way. Energy was held down by the integrated oils and gas securities and agriculture succumbed to lower prices for the fertilizer and chemicals names. Global infrastructure was supported by a late rally by the industrial and utilities sectors, led by highways and rail tracks and electric and gas utilities.

Real estate staged a comeback with US real estate investment trusts (REITs) surging in the final two months, outperforming the broader market. All sectors posted positive returns for the quarter with retail/malls, specialized (self-storage and data centers) and office REITs being the largest contributors. For 2023, REITs were led by specialized, hotels/resorts and industrials.

US Treasury Inflation Linked Securities (TIPS) advanced as real rates declined by over 65 bp for the 5-year and by near 50 bp for the 10-year security. Market-based inflation expectations for the US, measured by five-year break-evens, fell by 9 bp during the quarter to 2.15% as US CPI based headline and core inflation prints came in lower than expected.

Investment Outlook

The global economy is projected to slowdown in 2024, which is having an impact on commodity prices. The energy sector, crude oils and natural gas, is under pressure due the potential for reduced demand and a milder-than-expected winter relative to current supplies. The Organization of the Petroleum Exporting Countries (OPEC) along with ten other oil-producing countries (OPEC+) reiterated their commitment to reduced quotas and voluntary output cuts, yet Saudi Arabia has been willing to adjust prices downward for February and potentially future months. However, geopolitical risks have increased in the Middle East with the prospects for the Israel-Hamas conflict to expand and draw in other regional and western countries.

Industrial metals appear rangebound with slowing China’s economy and balanced short-term supplies. Agricultural grains may temper the pace of their downtrend this year as corn supply is plentiful, wheat looks at robust Chinese imports and soybean recovery and currency devaluation in Argentina add to increased exports.

Gold surged to new highs by the end of last year and is supported by multiple tailwinds. Any downward pressure on the US dollar would be supportive and investor’s expectation for multiple cuts in interest rates by the US Fed over the course of the year could propel the yellow metal further. Futures positioning is bullish, central bank purchases robust, and increased geopolitical tensions may lead to further demand for the yellow metal.

Like their commodity brethren, natural resource equities lagged into year-end and may struggle in the coming quarter. The companies are still attractive on valuation metrics and capital expenditure discipline is still in place, but earnings have declined and cash flow is lower, offsetting dividends and buybacks.

The reversal of interest rates in the last quarter of 2023 and investor sentiment shifting to a softer economic landing were tailwinds for global infrastructure equities that were propelled by both industrial and utility names. Assets with a connection to inflation may see a modest decline in earnings as inflation levels retreat. However, with demand proving resilient, GDP growth forecasts higher than expected and lower rates on the horizon, infrastructure may be well supported in the coming year.

With the prospects of the Fed ending its tightening cycle sooner than expected, commercial and industrial real estate soared at the end of 2023 and appears poised to show improvement and emerge from its lows. Public real estate remains attractive and private transactions have begun to adjust valuations lower, leading to capitalization rates for the two groups to converge this year. The balance sheets of these companies are solid and provide an advantage towards future acquisition and merger activity.

Real rates have declined and have been a boost for inflation-linked bonds, which may trend in a range until the Fed begins reducing rates this year. Inflation expectations continue to trend lower, but short-term prints may move higher and limit any upside for inflation-linked bonds in the near term.

Figure 3: Short and Medium-Term Outlooks

Outlook Image Fig3

Inflation and Real Assets

Disinflation was a major thematic over the previous year and as we enter 2024, headline inflation has moderated considerably due to easing goods and energy prices and in comparison to the recent elevated levels. Disinflation should continue as the Fed rate hikes work through the economy and base effects push the US Consumer Price Index (CPI) and other measures of inflation lower. However, historically inflation has tended to exhibit a wave pattern (Figure 4).

The Fed is still guarded with regard to the prospects of inflation with Fed Chairman Jerome Powell suggesting that “declaring victory would be premature.” Other members of the Fed have warned that inflation is more stubborn and will continue to ease slowly and unevenly. Investors continue to be cautious with both short and medium-term inflation expectations from the University of Michigan survey easing recently but still staying elevated, while inflation uncertainty, as measured by the New York Federal Reserve’s survey of consumer expectations, remaining high.

There are numerous potential drivers for renewed upward pressure on prices. The biggest risk for another wave of inflation is premature rate cuts from the Fed before inflation is sufficiently contained. With financial conditions already easing, reducing rates at a time when wage growth is still elevated could create more demand, pushing prices for goods and services higher. After easing considerably in 2022, stress on supply chains, as measured by the NY Fed’s Global Supply Chain Pressure Index, increased in 2023 (Figure 6). NY Fed research from January 2022 noted that global supply factors are strongly associated with consumer price index goods inflation with recent trends suggesting an uptick could begin mid-2024.

Additionally, OPEC+ has pledged to support crude oil prices, and the latest conflicts in the Middle East, such as the attacks on commercial ships in the Red Sea, could add to the uncertainty, posing a threat to global trade and putting upward pressure on energy prices. Within the US, there is a potential for the shelter component of CPI inflation to rebound later in 2024 as home prices, measured by the S&P CoreLogic Case-Shiller US Home Price Index, move higher and other real time rent measures like the Zillow Observed Rent Index or Apartment List appear to have rolled over or found a bottom.

While the previous factors can be considered cyclical, structural forces may transition us to an environment that is more inflationary than the earlier cycle due to deglobalization. This decoupling shrinks global markets and fragments global labor markets, leading to higher costs for both labor and materials. Further, this produces a higher frequency of geopolitical crises and episodic shocks, either demand or supply driven, that exert inflationary pressures. All these influence the global transition to implementing green energy policies.

The desire of countries to become more self-sufficient and frequent supply limitations result in shortages and conflicts, putting upward pressure on prices. Collectively, the need for military spending to guard against foreign conflicts, onshoring expenses to shore up supply chains and energy transition costs suggest a need for more fiscal spending. This increased spending will likely be invested domestically or with other high cost “friendly” countries, which is inflationary. All these outcomes point in the same direction and while the magnitude of the change is uncertain, the global macro environment appears to be heading towards structurally higher inflation than what investors have witnessed over the past few decades.

After making advances in 2023, gold sits near record highs. The next major advance is likely to result from a shift in monetary policy when the Fed begins to cut rates in 2024. Overall, ongoing market volatility, slowing economic growth, geopolitical uncertainty, strong central bank demand and lower real yields are supportive of gold. Our gold strategy team in their recent 2024 Gold Outlook highlighted three macroeconomic themes: dovish monetary policy, declining US dollar, and increased investor sentiment, which could lead to increased demand and higher prices for gold in 2024.

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.

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