Alternative assets, such as transport, timber and private core infrastructure can provide genuine inflation protection, at times when there are few places to hide.

There are four ways in which the world is changing that, in our view, challenge the risk-adjusted returns investors might achieve by allocating solely to public market assets. These changes are modestly higher unanticipated inflation, bouts of cost-push inflation, the changing structure of capital markets and the energy transition.

Protecting against inflation

The first two themes relate to the outlook for inflation.

On average we expect inflation to be moderately higher than it was pre-pandemic. Demand is expected to be modestly firmer, with austerity being less of a prominent political narrative, while trade fragmentation and re-shoring are likely to result in modest goods inflation, in contrast to the 20-plus years of goods disinflation that western economies enjoyed before the pandemic.

We would generally classify modestly higher inflation caused by firmer demand as “good inflation”, and corporate earnings would be a beneficiary. However, any inflation that is unanticipated erodes the real return on bonds. By contrast, real assets, such as real estate, have tended to provide long-term protection from modestly higher inflation.

Economies may also be subject, however, to more bouts of “bad inflation” (cost shocks) as a result of a more fragmented geopolitical, trade and energy system. As 2022 taught us, neither bonds nor stocks like cost-push inflation. Alternative assets, such as transport, timber and private core infrastructure can provide genuine inflation protection, at times when there are few places to hide. While core bonds will still insulate a portfolio from growth shocks, these alternative assets can help insulate a portfolio from cost shocks.

Changing capital markets and an infrastructure overhaul

The next way in which the world is changing relates less to the macroeconomic backdrop, and more to the structure of capital markets. More companies are either choosing to stay private, or are entering the public markets at a much more mature age. Investors in the small cap equity space are therefore missing out on some of the early stage returns that they might once have enjoyed, which makes private equity and private credit important allocation decisions. Many of the exciting new developments in artificial intelligence and healthcare, for example, are gestating in private markets.

Finally, while climate ambitions were already going to necessitate a dramatic overhaul of our domestic infrastructure, the current focus on energy security has injected a new sense of urgency to the energy transition. As many governments have limited fiscal space, there is likely to be plenty of regulation and subsidies to support private solutions, presenting numerous opportunities for investment in core infrastructure. 

There is no doubt that alternative asset classes come with additional complexity and illiquidity. But in our view, alternatives are essential when building portfolios that are fit for this changing world. 

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