Real Assets Insights: Q2 2024 Gold Shines Amid Inflation Uncertainty

Real assets strategy posted a positive quarter as underlying assets responded to anticipated global rate cutting cycle and escalating global tensions. While real estate begins its road to recovery, the riskiest assets look to benefit from any global economic improvement.

Global growth remains moderate but steady, with broadening signs of a bottoming in manufacturing, improvement in Europe, and deceleration in the United States (US). China’s economic growth stabilized but remained constrained, with weak consumer sentiment and ongoing challenges in the property sector. Business activity, which had seen solid momentum in April and May, slowed down in June.

In the US, inflation continued to ease over the period after running hotter than expected earlier in the year. Political and geopolitical risks loomed large with elections in Mexico, India, and the European Union providing surprising outcomes.

Quarter in Review

The quarter saw favorable performance from risk assets driven by solid earnings with developed market equities delivering positive returns and emerging markets being supported by strength in Asian markets. Treasuries were weaker across the curve, with the 10-year US Treasury yield rising over the period as market expectations for multiple 2024 rate cuts eased. The US dollar was up, showing strength against the yen. Commodities posted modest returns.

Real assets started the quarter with fears that the decline in US inflation may have stalled and that the “last mile” to achieving the US Federal Reserve’s (Fed) inflation target may prove more difficult. However, by June the Fed acknowledged that the economy appeared to be slowing and price pressures were easing.

Commodities and natural resource equities built upon the momentum started in the previous quarter but reversed course in the final month. As rates pivoted in April and declined, infrastructure and real estate rebounded before stalling. Real rates oscillated and ended modestly higher, more so for short and intermediate-term inflation-linked bonds.

Real assets strategy advanced for the first two months before retreating. It closed the quarter with a gain of 1.5%, lagging its composite benchmark due to the whipsawing of returns from underlying assets. The longer-term returns remain solid and since its inception in 2005 the strategy continues to maintain its lead over the composite benchmark by over 20 basis points annually and has provided an annual return of 4.0%.

Commodities rose for the second consecutive period despite a stronger dollar, supply-demand dynamics, and lingering geopolitical risks. Industrial and precious metals led the gains, while energy experienced a tempering of crude oil and rebound in natural gas. Agriculture faced losses due to weak grain performance. A resilient global economy and the energy transition drove zinc, which surged on supply disruptions in major global mines, and copper advanced on higher demand combined with tighter inventories.

Gold responded to continued robust central bank purchases and looming geopolitical risks. The decision in June by the OPEC+ alliance to gradually unwind a complex array of production cuts along with subdued demand weighed on oil. Natural gas began to recover from significant losses earlier in 2024 amid forecasts of growing demand for power generation, specifically in Asia, reduced US production supply, and disruptions in Norway.

Global natural resources trailed commodities, led by the metals and mining companies that gained on improved metals prices. However, the energy group was held back by the exploration and production companies and agriculture suffered from declines in the fertilizer, food, and forest products names.

For infrastructure equities, utilities experienced increased demand and an improved interest rate environment and was joined by energy storage and transportation.

US Real Estate Investment Trusts (REITs) reacted to the shift in interest rates, starting with a steep decline and clawing back much of that over the next two months. The lodging and resorts sector was the largest detractor, followed by the industrial and office sectors. A bright spot was the health care group.

US Treasury Inflation Linked Securities (TIPS) peaked at the end of April before descending by the quarter end with an increase of 15 bp for the 5-year and of 10 bp for the 10-year security. Market-based inflation expectations for the US, measured by five-year break-evens, eased significantly by just over 15 bp to 2.28% in June. While elements of inflation remained sticky, the trajectory has been downward.

Investment Outlook

As global economic growth continues at a moderate pace, commodities appear poised for further upside in the second half of the year and into 2025. Seasonal demand for energy is robust as reflected in jet fuel and gasoline, as summer travelers take to the sky. However, China’s oil imports have been sluggish, and refinery run rates remain low. Crude oil supply production from OPEC+ appears to be tightening on improving compliance and reduced Russian oil exports as the third quarter begins. This suggests that forthcoming global inventory withdrawals along with the ever present elevated geopolitical risks put upward pressure on oil prices. Natural gas has paused after a significant rally in the previous quarter and is absorbing increased production, but a bullish opportunity exists longer term as power generation demand expands.

Declines in manufacturing activity in the US and China have impacted demand for industrials metals. Copper supply concerns are balanced against lackluster demand from China, while aluminum pricing is being squeezed in the short term as Chinese supply increases and demand slows.

Precious metals, such as gold, continue to be supported by anticipation of US Federal Reserve (Fed) rate cuts by end of the year as weaking US economic data and cooling inflation support the argument for monetary policy easing. With the US dollar trending lower, continued significant central bank purchases, increased investor flows, and geopolitical tensions, the yellow metal may test record highs before year end.

The agricultural sector may see increased US export demand as drought within the Black Sea breadbasket affects global grain supplies and South America’s struggles with disease reduces corn harvests. Further, softs such as cocoa, coffee, and sugar have suffered from disease, El Nino-induced extreme drought, and stagnant supply due to underinvestment relative to demand growth, respectively.

Natural resource equities are beginning to attract more attention as commodity forecasts reset higher and the beginning of a rotation into value-oriented equities shows signs of taking hold. Assuming global economic growth progresses at a moderate pace as the prospects for a recession diminish further, natural resources should see improved fundamental results even as capital expenditures show some expansion to address expected commodity supply constraints.

Public infrastructure valuations appear well supported and the group should benefit from declining rates and the defensive characteristics from companies less exposed to changing GDP risk. Midstream energy operators, such as pipelines and storage facilities, stand to gain from elevated energy prices should they sustain. Utilities have been able to pass on rate increases via regulatory channels and are positioned to benefit from expectations of larger power generation needs from AI and data center demand.

Public real estate has been unloved for some time and was down nearly 10% earlier this year, but if nominal rates come down as anticipated, the group could embark on a sustained rally due to solid fundamentals driven by operational performance and disciplined balance sheets. The capitalization rate differential between public REITs and private real estate has continued to shrink and may lead to outperformance going forward.

Inflation-linked bonds have rolled over in the first half of the year, and as inflation expectations continue to ratchet down towards the Fed’s target, investors may look toward nominal bonds. Combined with low absolute current yields, the assets are set up to lag other real asset opportunities. However, any meaningful upside surprise in inflation would help.

Inflation and Real Assets

Over the past two months disinflationary pressures have resumed with both US CPI and US PCE inflation measures reflecting further easing in prices. Our near-term expectation is for further progress with the core PCE, falling close to the Fed’s target of 2% in 2025. However, this is not the only path forward and the specter of a second wave remains back of mind, even if it is not part of the immediate narrative.

The challenges today resemble what investors were confronted with during the inflationary period of the 1970’s. Fifty years ago geopolitical tensions were high with the Vietnam war, the Arab-Israeli Yom Kippur war, and the cold war with the Soviet Union. The Arab oil embargo drove the price of crude oil up significantly. At the same time the US faced multiple recessionary periods due to deficit spending that ballooned because of higher military spending and social programs to help fight poverty. The Fed, facing uncertainty on multiple fronts, adjusted policy frequently during the 1970’s and into the beginning of 1980’s, shifting the direction of rates higher and then lower on multiple occasions. Inflation during this time experienced multiple waves lasting into the mid-1980’s (Figure 4).

Fast forward to today, multiple wars are taking place, tensions with China and Russia are high, and deficits in the US are expected to rise significantly to elevated levels. The deglobalization trend has begun, and it is believed that it may exacerbate both deficits and inflation moving forward. The Fed appears close to reducing the policy rates by year end with inflation having fallen from its peak in 2022 and the labor market becoming more balanced.

Will the Fed’s rate cuts spur excess demand? Will tensions in the eastern Europe and Middle East escalate further and disrupt the supply of energy and other global commodities? Will the outcome of upcoming US and other global elections bring about a change in leadership and direction that will lead to an alteration of regional and country relationships, further economic isolationism, and increased government fiscal activity? Looking back, it is easy to see the similarities in political and economic conditions. Evaluating inflation breakevens, investors’ longer-term inflation expectations may be too low for an environment that does not revert to pre-pandemic levels.

In the US, one of the Fed’s mandates is to maximize employment and keep prices stable. Historically, rates are raised to curb inflation via higher borrowing costs. But if maintained for too long, higher rates can weaken economic activity, potentially leading to recession and increased unemployment. In reaction, the central bank lowers rates to stimulate economy. Currently the market is anticipating 50 bp worth of cuts to interest rates this year. This is not significant, but another 100 bp worth of expected cuts in 2025 could have a more meaningful impact. The increase in liquidity may lead to increased corporate activity and consumer credit growth, which may push inflation higher. Two areas of focus today are the potential re-acceleration in rent prices and a rollover in goods deflation that could push inflation higher.

Industrial Metals and Gold

Weaker global manufacturing indicators have posed a challenge for industrial metals, which surged in the first half of the year before retreating and investor positioning unwinding. However, China’s policy toward energy transition/decarbonization and the rise in expectations for a Fed rate cut should keep select base metals attractive. Copper has pulled back by more than 10% from 2024 highs, but this consolidation may turn bullish again as the global rate cut cycle begins to buttress sentiment in a broader sustained global growth and manufacturing recovery.

China’s policy support for decarbonization through power grid investment and renewables combined with any property measures or monetary easing would be supportive. Demand growth should be driven by electric vehicles, solar and wind power generation, and related infrastructure over the coming years. Further, copper will be the primary conduit to distribute power within and to data centers in the US and globally. Similarly, aluminum is weighed down by increased Chinese production capacity, but looking toward 2025, it would benefit from recovering developed market cyclical demand and its use as a substitute for copper in grid upgrades. Zinc is supported by a deficit in supply, but that may be worked out by 2025. Other metals such as nickel and tin suffer from surplus market conditions that change sentiment and pricing. Industrial metals’ longer-term outlook is still supportive, particularly for copper and aluminum.

Gold continues to be a favorite allocation within real assets as it tests all-time highs in 2024 and is forecast to be well supported into year end and potentially reach a range of US$2,700-3,000/oz during 2025. The largest demand has and continues to come from central banks and China, accounting for 85% of gold mine supply today, rising sharply from only 25% in late-2019 to mid-2022. This has superseded the impact from recently higher US real rates and the breakdown of that historical relationship.

Further, higher prices have dampened jewelry demand and have driven an increase in scrap supplies. The next move higher in price over the near term is anticipated to come from the normalization of US interest rates along with potential regional and national political uncertainty, escalations of geopolitical tensions or other inflationary shocks, such as proposed global tariff policies and fiscal spending from the US following the upcoming elections or a meaningful deterioration in the Middle East conflict.

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.