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Real Assets Insights: Q2 2023 Playing Defense as Inflation and Growth Moderate

Commodities can potentially move forward in the near term with energy fundamentals coming to a head and agriculture facing weather-related volatility. Gold holds its ground and a confluence of factors should continue to provide support for the yellow metal. Global natural resource equities continue to reflect attractive valuations. Similarly, global infrastructure equities are well positioned with defensive quality names in the utility, transportation, and energy sectors. While real estate has been impacted by rising borrowing costs, US REITs are a diversified group and look for continued leadership in select subsectors to provide support. Inflation-linked bonds, however, have struggled in the face of real rates that have broken out to the upside.

Senior Portfolio Manager
Portfolio Analyst

The global economy expanded in the quarter, but momentum slowed as the June business surveys softened for most countries. While inflation appears to have peaked globally, it remains above central banks’ target levels, considering a tight job market and low unemployment rates. This has led central banks on multiple paths: those with elevated inflation prints made meaningful interest rate hikes, some others resumed raising rates, and the US Federal Reserve (Fed) signaled the potential for two more subsequent increases. Risk assets rallied as global equities advanced for both developed and emerging markets, global bond prices declined with rising yields, the US dollar appreciated and commodities receded.

Quarter in Review

The impact on assets most sensitive to inflation, such as commodities and natural resources, was heavy. While rising real rates were a drag on inflation-linked bonds, real estate and global infrastructure held up the best. The Real Assets strategy was volatile over the three months and closed the quarter down by -1.9%. The year-to-date performance turned negative, but the longer-term 3- and 5-year strong returns remained in place. Since its inception in 2005, the strategy has provided an annual return close to 4.0%.

US real estate investment trusts (REITs) followed the broader surge in equities amid prospects for a soft landing in the US. For the quarter, returns were divergent across sectors with residential, health care, and data centers contributing and diversified, self storage, and specialty REITs lagging. The office subsector within the commercial real estate sector continued to suffer from above average vacancies, poor valuations, and increased refinance risk. Infrastructure focused equities were flat. Large utility companies in the US had to confront the technology-led rally and the elevated interest rates, while airport services and marine ports/services outside of the US struggled with the unfolding global economic slowdown.

Natural resource equities and commodities turned negative as mounting concerns about a global recession continued to exert downward pressure on prices. Higher rates and a strengthening US dollar also dented demand. Performance of all major commodity sectors was tepid, led by industrial metals retreating due to China’s disappointing post-lockdown recovery. Gold was not immune to these circumstances either. Despite oil production cuts from OPEC+, the energy sector fell modestly as higher natural gas prices partially offset declines in crude oil.

Real rates broke out of their range mid-May and yields climbed to highs that exceeded levels observed over the past year as well as going back to 2008. Market-based inflation expectations for the US as measured by five-year break-evens decreased, resulting in a decline for US TIPS, despite the Fed emphasizing its concern around current inflation levels.

Investment Outlook

Commodities can potentially move forward in the near term. The energy sector has additional crude oil supply constraints imposed by OPEC+ that are projected to cause inventory draws by the fourth quarter as global demand remains strong. Agriculture pricing remains elevated on increased demand, the tenuous Black Sea Grain Deal between Russia and Ukraine, and global weather-related challenges.

Gold has held its ground in the face of rising real rates and a resurgent US dollar. Going forward, continued net buying by official institutions, late stages of the hiking cycle, reversals in USD strength, and fears of a global economic recession may provide more opportunities for the yellow metal to shine.

Global natural resource equities are intrinsically tied to commodities and continue to provide attractive valuations relative to more growth-oriented equity sectors. A sustained slowness in economic growth may prove to be a sweet spot for these assets if demand surprises on the upside and inflation remains above central bank target levels.

With inflation normalization and a low-to-moderate growth environment, global infrastructure equities are well positioned with defensive quality names in the utility, transportation, and energy sectors. This group may prove more resilient due to pricing power from concessions or regulation and monopolistic market structures, further supporting the meaningful dividend yields from these securities.

Real estate has been heavily impacted by rising borrowing costs, the result of a sharp and unexpected rise in real rates, that has led to cap rates increasing. Commercial real estate in the Office space continues to warrant caution, but US REITs are a more diversified group and continued leadership in industrials, manufactured housing, triple net, and strip center subsectors may help provide support.

Inflation-linked bonds have struggled in the face of real rates that broke out in May and climbed to highs that exceeded levels observed over the past year and going back to 2008. Market-based expectations for US inflation continued to decline and the US Fed appears determined to exert pressure over the coming months to reign it to target levels.

Figure 4: Short and Medium-Term Directional Outlooks

Real Assets Insights Q2

Inflation and Real Assets

The normalization of supply constraints, lesser fiscal support, lower energy prices and monetary tightening have successfully brought US inflation down to more moderate levels from the multi-decade highs experienced in 2022. The recent US CPI release surprised to the downside and the disinflation trend remains intact. However, the next step towards target levels may prove more challenging. Goods disinflation may not have fully run its course, as it still hovers above pre-COVID levels and used car prices are only just declining. Rent is likely the next big mover with the easing of rent prices being reflected in the CPI over the second half of 2023.

While energy prices have been rangebound, demand continues to run above expectations and a combination of supply constraint by OPEC+ members and a decline in US output could push prices higher on declining inventories. Housing prices have adjusted down, but a severe lack of inventory and a strong job market could buttress prices. The knock-on effect from these may keep inflation higher for longer. Longer-term structural factors including energy transition, ESG considerations, demographics and ongoing de-globalization introduce upside risks to inflation not seen in the past decade.

Having peaked in mid-2022, near-term inflation expectations have dropped meaningfully, but remain above recent levels (Figure 4). Consumer survey measures, both from the Federal Reserve Bank of New York and from the University of Michigan, anticipate inflation exceeding 3% one year from now. While the Survey of Professional Forecasters is a bit more optimistic at 2.8%. Another rate hike in July from the US Fed could bring expectations down further, but we could be nearing the bottom.

While declining inflation and slowing growth can be a headwind for some real assets, others have performed well in this environment. Since 2004 when inflation is headed down for the calendar year, global infrastructure equities and US real estate, via REITs, have historically provided positive average returns of 0.7% and 3.2%, respectively, compared to a broad global equity index like MSCI ACWI that posted -0.7%. Further, if inflation were to remain in the 2%-4% range, similar to the current anticipated environment, infrastructure and real estate have historically, provided strong absolute average returns and outpaced global equities.

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.