Despite central bankers’ best efforts and consumers’ wishes, inflation risk is unlikely to go away and stay away. This year’s rapid repricing of inflation expectations is a fresh reminder of both the limitations of inflation forecasting and the risks that unanticipated inflation can pose for investors who do not address inflation risk in their long-term, strategic asset allocations.
Inflation-hedging assets such as commodities and natural resource stocks have strongly outperformed in the first half of 2022, but some investors are now left wondering what role real assets can play going forward if inflation begins to gravitate lower. We strongly believe that, in addition to their inflation-hedging role, real assets exhibit desirable characteristics that support their inclusion as a long-term core component of a diversified and balanced portfolio.
Real assets can be a valuable source of diversification when combined with broad equities and nominal bonds. Many real assets are also income-producing, offering attractive returns when inflation is stable. When expected returns for stocks and bonds are low, real assets can serve as a potential source of total return. And while skilled investors can certainly benefit from tactical decisions to overweight or underweight inflation-sensitive assets to reflect shorter-term inflation expectations, we believe the broad characteristics of this asset class argue for a diversified core strategic allocation that can help meet investors’ risk and return objectives.
Understanding how asset classes perform across different inflation regimes can help investors to build an appropriate hedge into their strategic asset allocation. Figure 1 displays the quarterly returns of US equities and fixed income, a common balanced asset allocation approach, standalone real estate via US Real Estate Investment Trusts (REITs), global infrastructure equities, and a diversified custom real asset composite the comprises commodities, global natural resource and infrastructure equities, US REITs, and US intermediate-term Treasury Inflation Protected Securities (TIPS). Returns are shown for four discrete inflation regimes: inflation, reflation, disinflation and deflation.
Source: FactSet, US Bureau of Labor Statistics, SSGA. As of 03/31/2022. “Inflation” is an inflation rate greater than 3% when the year-over-year (YOY) consumer price index (CPI) is rising, “Reflation” is an inflation rate of 0-3% when the YOY CPI is rising, “Deflation” is an inflation rate of 0-2% when the YOY CPI is declining, and “Disinflation” is an inflation rate of 2-10% when the YOY CPI is declining. The “Real Asset Composite” comprises 25% Bloomberg Roll Select Commodity Index, 25% S&P® Global LargeMidCap Commodity and Resources Index, 20% S&P® Global Infrastructure Index, 20% Bloomberg US Government Inflation-Linked 1–10 Year Bond Index, and 10% Dow Jones US Select REIT Index. The “Traditional 60% US Equity-40% US FI Mix” comprises 60% S&P® 500 and 40% Bloomberg US Aggregate Bond Index. Quarterly data. No inflation rates greater than 10% were seen in the time frame analyzed. Please refer to the Glossary for proxy indices used for the remaining asset classes shown.
As Figure 1 shows, during periods of high and rising inflation real assets have historically demonstrated their most competitive returns relative to both traditional equities and fixed income. In addition, during these inflation regimes a diversified real assets allocation did improve returns relative to a standalone allocation to US REITs, global infrastructures equities, and TIPS.
Early business cycle expansion, which is often characterized by reflation, has historically been supportive for a range of real asset classes and for equities, but has traditionally been more challenging for fixed income assets. Disinflation environments, characterised by inflation declining while remaining above 2% YoY, have favored all asset categories with positive returns to varying degrees.
Periods of low and declining inflation defined here as deflation have historically served as a headwind for real assets. It is also in these inflation regimes that traditional equities and nominal bonds have produced some of their strongest returns and were most likely to outperform real assets. This latter point supports the concept that, while real assets can serve as an insurance policy against some of the more negative inflationary outcomes, this insurance policy may represent an opportunity cost in some of the more favorable environments for broad equities and nominal bonds.
Fast forward to mid-2022. Those investors who have experienced a year-to-date outperformance of real asset returns over traditional equities and nominal bonds may be wondering if inflation-hedging assets still have a role to play in their portfolio, if and when inflation levels begin to gravitate lower.
A quick reversion to pre-pandemic inflation levels cannot not be assumed – one never knows if and when a “new normal” is being established. Central banks have limited influence on the supply-side constraints that are currently boosting inflation, and questions remain as to whether traditional secular drivers of low inflation (e.g., globalization, technology, and wage stability) may be lastingly altered by the emergence of new thematics such as energy transition, reshoring, and labor shortages. We would therefore argue that a prudent long-term, strategic portfolio positioning should account for a full range of inflation outcomes.
Looking back at Figure 1, we can see that for those quarters of elevated (above 2%) but declining inflation (i.e., disinflation), the Real Asset Composite produced returns that were, on average, roughly equivalent to those of a traditional 60/40 portfolio. And while past performance is certainly not a guarantee of future results, investors might take some comfort in historical examples which demonstrate that declining inflation isn’t necessarily synonymous with negative returns for real assets. In sum, as long as the inflation regime did not dip into deflation territory, maintaining a measure of inflation protection in a balanced portfolio did not materially detract from returns in either the disinflation or reflation regimes during the time frame analyzed.
We can see in Figure 2 that an allocation to a diversified portfolio of real assets (represented by the Real Asset Composite) can also meaningfully enhance a balanced portfolio’s sensitivity to inflation, as measured by the beta to US CPI.
Figure 2 Asset Class Sensitivity to Inflation
Beta to US CPI
Benefits Beyond Hedging
While conversations about real assets are typically – and justifiably – centered on their inflation-hedging benefits, attributes including expected risk/return characteristics, diversification, liquidity, and yield also support the inclusion of real assets in a strategic asset allocation.
Risk/Return. Using State Street’s Long-Term Asset Class Forecasts as a basis of comparison, Figure 3 shows that a diversified portfolio of real assets is expected to generate a level of risk only slightly below that of Long US Treasuries with a better long-term expected return than both nominal and inflation-protected US bonds.
Figure 3 Risk and Return Forecasts, by Asset Class
SGA Long-Term (10+ Years) Asset Class Return Forecast
US Large Cap
Global Equities (ACWI)
US Government Bond
US Investment Grade Bond
US Long Government Bond
US TIPS Bond
Global Real Estate (REITs)
Real Asset Composite Constituents
Global Natural Resources (25%)
Commodities (Bloomberg Roll Select Index) (25%)
US Intermediate TIPS Bond (20%)
US Real Estate (REITs) (10%)
Real Asset Composite
Source: SSGA Long Term Asset Class Forecast Q2, 2022. The forecast returns are annual arithmetic averages based on State Street Global Advisors’ Investment Solutions Group March 31, 2022, forecast returns and long-term standard deviations. The forecast performance data is reported on a gross of fees basis. Additional fees, such as the advisory fee, would reduce the return. For example, if an annualized gross return of 10% was achieved over a five-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 53%. The performance includes the reinvestment of dividends and other corporate earnings and is calculated in the local (or regional) currency presented. It does not take into consideration currency effects. The forecast performance is not necessarily indicative of future performance, which could differ substantially. Note: Forecasts apply to the listed primary benchmarks and other asset class benchmarks as long as they are substantially similar. Neither Global Natural Resources nor US Long Government Bond are included in the SSGA LTACF data. They are part of the broader forecast used in the firm’s Strategic Asset Allocation framework. “Real Asset Composite” comprises 25% Bloomberg Roll Select Commodity Index, 25% S&P® Global LargeMidCap Commodity and Resources Index, 20% S&P® Global Infrastructure Index, 20% Bloomberg US Government Inflation-Linked 1–10 Year Bond Index, and 10% Dow Jones US Select REIT Index. Please refer to the Glossary for proxy indices used for the remaining asset classes shown.
Yield. Beyond their inflation sensitivity and correlation, real assets can also help investors offset the long-term impact of inflation through the regular income yield produced by real assets such as global natural resource and infrastructure equities, as well as REITs – see Figure 4. These securities can also help offset lower yields offered by commodities and inflation-linked bonds, in the context of a diversified real asset allocation.
Figure 4 Historical Yields of Real Asset Components and Benchmarks
Liquidity. So far we have limited our discussion to the more liquid publicly traded real assets. These can also serve in a completion role, providing complementary liquidity to other less liquid direct or private real asset investments and assist in rebalancing or in managing ongoing cash flows. They may also be used in conjunction with other inflation-hedging assets such as gold or MLPs,1 providing further diversification benefits in a multi-asset-class portfolio.
A generation of long-term investors that has experienced no meaningful inflation for decades is now fully cognizant of the challenges that inflation brings. That same group is also awakening to the strategic, long-term value of a real asset portfolio allocation.
It’s clear that inflation should be a consideration in investors’ long-term asset allocation decisions going forward, and it’s equally clear that a core allocation to real assets should be part of that consideration – the core can of course be overweighted or underweighted based on shorter-term expectations. In addition to inflation hedging, real assets provide diversification, yield, and risk benefits that exist outside of an inflationary environment.
Inflation is hard to forecast and harder to control. A strategic exposure to real assets can provide a portfolio with a long-term insurance policy against elevated inflation that also carries ancillary benefits to the policy holder. At a time when it is important to mitigate the tail risk that inflation can represent to portfolios, real assets matter.
1Master limited partnerships.
Inflation. An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. In this article, “Inflation” is an inflation rate greater than 3% when the year-over-year (YOY) consumer price index (CPI) is rising, “Reflation” is an inflation rate of 0-3% when the YOY CPI is rising, “Deflation” is an inflation rate of 0-2% when the YOY CPI is declining, and “Disinflation” is an inflation rate of 2-10% when the YOY CPI is declining.
Proxy indexes used for asset classes shown in Figures:
Commodities = Bloomberg Roll Select Commodity Index.
Infrastructure = S&P Global Infrastructure Index.
Global Natural Resource = S&P Global LargeMidCap Natural Resources Index Strategy.
REITs = Dow Jones US Select REIT Index.
TIPS = Bloomberg US Government Inflation-Linked 1–10 Year Bond Index.
US Equities = S&P 500.
US Fixed Income = Bloomberg US Aggregate Bond Index.
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