This timely Q&A with Senior Portfolio Manager Rob Guiliano explores the value of real assets in the current inflationary environment as well as their use as a long-term, strategic portfolio allocation.
The sharp rise in inflation this year has been a by-product of global central bank injections of liquidity, a willingness by central bankers to allow inflation to run “hot” in the short term, consumer spending increases, economies re-opening, and workforce employment rebounding. In addition, rising demand trends have run headfirst into supply-chain snarls as well as production and capacity constraints for suppliers and manufacturers. Lastly, the Russian invasion of Ukraine and its global impact on commodity prices has helped push inflation to highs we haven’t seen for decades.
Interest in real assets has spiked as inflation prints have risen, and for a good reason. Inflation-hedging assets have generally performed significantly better than traditional equity and bond assets. Year-to-date in 2022, commodities are up 18%, natural resources equities are modestly positive at over 2%, and infrastructure equities are slightly negative. And while they have outperformed broad equities, US REITs have declined by over 20% and US TIPS have suffered from the rise in real yields – off close to 8%1. These returns reinforce the importance of using a diversified approach to investing in real assets.
State Street’s “all weather” multi-asset Real Asset Strategy has strongly outperformed in 2022. The Strategy carries exposures to commodities, global natural resource and infrastructure stocks, publicly listed real estate via REITs, and intermediate US inflation-linked bonds.2
Our near-term outlook for real assets continues to be constructive, even after this year’s large moves for the asset class, as inflation has proven to be much stickier than originally anticipated. Central banks are clearly willing to create some level of demand destruction, and the combination of slowing growth and higher inflation may ultimately lead to a period of stagflation – which has been a historically tough environment for equities and bonds.
Within the commodities sector, the energy complex is most attractive to us, as demand for crude oil is near pre-pandemic levels and supply constraints are causing a decline in inventories. Prices are being pressured higher, which impacts all aspects of the economy and can be easily tracked at the gas pump. The Russia-Ukraine war has also expanded the impact on the energy complex to include natural gas, sending prices to extreme levels in Europe and the Pacific.
Further, both Russia and Ukraine play a significant role in supplying base metals and in feeding the world – the latter raises the possibility of a resulting global food crisis. None of these issues can be addressed quickly, and as such we expect commodities to remain elevated in the near term. We also expect that those companies which are involved in the extraction, production, and processing of raw materials will be resilient and will outperform.
We believe that inflation will come down but will settle at a higher level than is generally anticipated and take longer than anticipated to arrive at the central banks’ targets. The case for using real assets as a potential hedge against rising realized and unexpected inflation remains compelling.
That said, real assets can also play a strategic, long-term role in a portfolio. The asset class will continue to act as a diversifier to traditional equity and bond investments. The improved risk characteristics and improved risk-adjusted returns that real assets can bring to a total portfolio have been clearly demonstrated during the last year. Further, real assets can be a meaningful source of income via dividend yields (now close to 3%),3 and they have historically produced an attractive absolute return. We consider the inclusion of real assets to a portfolio to be a thoughtful strategic decision.
Participants in retirement plans are exposed to the negative effects of inflation within their traditional equity and bond holdings. But those same participants may have limited (or no) inflation-hedging options – such as US Treasury Inflation-Protected Securities (TIPS) or real estate investment trusts (REITs) – in their plans’ investment offerings. A diversified, multi-strategy approach to real assets, combining exposures to commodities, global natural resource and infrastructure equities, real estate, and inflation-protected securities, can be a valuable addition to the core menu. Many target-date offerings address inflation concerns only through the use of TIPS, but we feel that the TIPS offering can be greatly enhanced with the inclusion of a more diverse set of real assets.
The recent spike in inflation has increased awareness, and plan sponsors along with participants are realizing the vital role that real assets can play in providing diversification and acting as a complement to traditional equities and bonds. Target-date funds can effectively incorporate real assets into their glide path in a thoughtful manner, and continued awareness and education by plan sponsors may also help increase the addition of real assets by plan participants into their portfolios.
Real assets play a role that complements the role of traditional equity and bond offerings in a DC plan. Real assets perform differently in various inflationary environments and, for this reason, their inclusion should be a strategic decision. The performance of real assets can act as a diversifier during rising or high inflationary environments, as we are experiencing today. During stable, more normal periods, real assets have performed similarly to a typical balanced portfolio. It is only during low or negative inflationary periods that real assets lag, but that is the exact timing when equities and nominal bonds in a portfolio typically shine. Utilizing a diversified, multi-strategy approach to real assets may also help to mitigate the volatility of individual real assets over the business cycle.
1 Source: FactSet.
2 We have been managing this strategy for 18 years and have approximately $8.2 billion in assets under management, as of June 30, 2022.
3 Source: SSGA and FactSet.
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