Real assets may be part of the solution for both creating income and hedging the risk of inflation.
Global Market Strategist
The outlook for inflation is perhaps the most important determinant of portfolio positioning at the current juncture in the economic recovery. The forces acting on inflation in both the short and medium term have been covered in previous On the minds of investors articles. But what are the options for investors looking reduce the impact of inflation on their portfolio?
Inflation pressures are building on the improving growth prospects, leading to rising bond yields as markets price for a brighter future and central banks to start tightening policy, first through the balance sheet then by raising rates. Our view is that inflation pressures will start to recede once the base effects from 2020 have passed and supply bottle necks fade away. However, the unknown nature of a recovery following a global pandemic and the implications of still huge amounts of fiscal stimulus being deployed at a time when private demand is accelerating creates a wide range of inflation outcomes. Crucially in contrast to prior years, there is now both risk of too much and too little inflation, rather than just too little.
For those wanting to protect portfolios against the upside risk of inflation, there are traditional assets which can help. Inflation is the traditional enemy of the bond investor, eroding the real value of the fixed-coupon payments. However, inflation-linked bonds are the clear exception given their coupon is linked to the rate of inflation.
Equities also offer up inflation protection as corporate earnings should rise with the rate of inflation. The logic is simple: strong economic growth lifts revenues and earnings as long as margins can be protected.
Commodities are another traditional go-to for inflation hedging given the strong historical relationship between commodity prices and the rate of inflation.
However, equities, commodities and inflation-linked bonds face their own challenges. Globally, equity valuations are well above long-run averages and have rebounded quickly from the lows of a year ago. There will also come a point where bond yields are high enough to impinge on the outlook for equity returns. Some commodity prices, such as copper, have reached multi-year highs and could come under pressure as China takes steps to curb credit growth and switches to a more sustainable path for economic growth. Meanwhile, inflation-linked bonds, such as Treasury Inflation-Protected Securities, come with a negative yield as a cost for adding that protection.
EXHIBIT 1: U.S. CORE REAL ESTATE VERSUS HEADLINE INFLATION
YEAR-OVER-YEAR RETURN, % CHANGE VS. PRIOR YEAR, SA
Real assets may be part of the solution for both creating income and hedging the risk of inflation. Our expectation is that government bond yields will rise over the course of this year, but even as they do, they will remain at low levels in historical terms. Real assets, such as infrastructure, real estate and transport can offer a yield that is similar to that found in credit markets but with the added benefit of moving with inflation rather than being reduced by it.
It is important to differentiate between core and non-core real assets. Core real assets are those that exhibit low levels of volatility, a greater share of the return comes from income rather than capital appreciation, and crucially come with predictable contracted cash flows. It is this last point that offers the offset to higher rates of inflation. The contracted cash flows from core real assets are often indexed to the level of inflation. Thus, while core real assets share the characteristics of yield and diversification to equities as core government bonds, they come with the added bonus of inflation protection.
Exhibit 1 illustrates that over time, core U.S. real estate has been a decent hedge against inflation, sporting a positive correlation with inflation and an annualized average return of almost 5% over the time period shown. While the relationship is not perfect, the hedging characteristics of core real estate does hold across the cycle.
The uncertain inflation outlook is unnerving to investors who are faced with the risk of too much inflation for the first time in many years. Some of the traditional inflation-hedging assets, such as index-linked bonds, commodities and equities, can help in easing the risks of run-away inflation. However, investors are all too aware of the return and income limitations associated with these assets. Core real assets can offer another option for those investors that are comfortable with owning less liquid assets. These types of assets have higher yield and cash flows that are often indexed to the rate of inflation.