Eurozone inflation recently hit a record 5%. European Central Bank policymakers, like central bankers everywhere, are divided on whether the recent spike in prices will persist or if it is a passing phenomenon. Indeed, everyone seems to have an opinion about inflation these days.
But the mere threat of a sustained higher inflation regime is inspiring many investors to reconsider the potential implications for their asset allocations – as they should.
Our analysis of available US data extending back to the late 1970s shows that real (inflation-adjusted) returns for stocks and bonds have skewed heavily in favour of periods of low inflation, implying that traditional asset allocations have likely benefitted disproportionately from the historically low inflation rates experienced in recent years.
And today, with real interest rates in deeply negative territory and equity valuations rivalled only by those seen during the tech bubble of the early 2000s, we believe most stock/bond allocations offer little margin of safety to defend against a prolonged, adverse inflation environment.
Turning to real assets
The need for inflation protection and diversification has taken on added significance amid a potential turning point in long-term economic trends, driven by historic fiscal spending on a global scale and central banks conditioned to let bouts of high inflation persist longer than under prior frameworks.
Add to this mix tight labour markets that are driving wage inflation higher and a turn toward more disciplined capital management in natural resource industries that appears likely to drive a new bullish commodities cycle. For many institutional investors, this has led to a greater focus on real assets.
This growing category – once limited primarily to real estate and precious metals – now represents a sizeable allocation in many institutional portfolios, spanning infrastructure, commodities and natural resources, held privately and through listed markets.
In contrast with inflation hedges such as CPI swaps, the appeal of real assets is rooted in their potential to help defend against inflation while also offering prospects for attractive long-term returns.
One factor common to all real assets is their positive sensitivity to inflation surprises. The reason for this is simple: inflation often affects both asset prices and revenues of real assets, either directly through contractual inflation linkages or indirectly through fundamental economic drivers.
This ability of real assets to counter inflation offers potential benefits to portfolios in the short term, as prices climb, and in the longer term, should inflation rates continue to surprise to the upside.
The result of these inflation relationships has historically been strong returns in environments of rising and unexpected inflation, whether looking at individual real assets categories or a diversified real assets blend.
Diversification potential
The goal of portfolio diversification is to own asset classes that tend to experience their above- and below-average returns in different economic and market environments.
This desynchronisation of payoffs creates opportunities to build portfolios designed to perform well in a variety of scenarios. Real assets’ distinct economic sensitivities tend to differentiate them from stocks and bonds, most notably in relation to inflation and growth regimes.
When looking at historical inflation-adjusted performance of a number of asset classes, real assets have typically performed well in reflationary conditions (unsurprisingly), as well as in stagflation – historically a challenging environment for both stocks and bonds.
Additionally, commodities and resource equities are generally the most sensitive to upside inflation surprises, regardless of the growth backdrop. Real estate has been somewhat less geared to inflation trends and more tied to economic growth than commodity-linked real assets, while infrastructure has been fairly consistent across all regimes, including greater resilience in stagnation than other equity categories.
Strong total returns
Real assets have historically generated strong returns over full market cycles, with all but commodities delivering performance in line with or better than global stocks over the past 50 years.
The long-term average for commodities has been depressed by a decade-long bear market from 2008 to 2018, driven by the downshift in China demand and an oversupply cycle.
However, commodities have since experienced substantial improvements in supply/demand fundamentals and a more supportive macroeconomic backdrop, providing potential catalysts for a sustained multi-year recovery.
Furthermore, combining multiple real assets within a single portfolio may offer additional benefits. A diversified real assets blend has historically delivered competitive returns with significantly less volatility than global stocks or standalone real assets, capitalising on diversification benefits available within and among the different real assets categories.
Investors’ approach to real assets depends on their objectives
Historically, no single real asset has excelled across each of the criteria of inflation sensitivity, diversification potential and total returns.
Some real assets have historically performed better on certain dimensions than others, requiring investors to consider various strengths and trade-offs according to the specific role of real assets in their portfolio.
Strategic inflation defence at attractive relative value
As investors consider how to best protect against the risk of higher inflation, history shows that including real assets in a portfolio may provide key benefits.
Moreover, the repeated and unprecedented disinflation surprises of the 2010s weighed on real assets returns while the broader market surged to ever-higher levels. This has resulted in historically attractive real assets valuations relative to equities, even after the group’s strong returns in 2021.
We believe this combination of potential inflation benefits, diversification and relative value represents a compelling opportunity to realign portfolios to take advantage of what real assets can offer.
Vince Childers is head of real assets multi-strategy at Cohen & Steers. The views expressed above are his own and should not be taken as investment advice.