By Vince Childers, head of real assets multi-strategy at Cohen & Steers
Allocating to listed real assets may help investors better manage inflation risks—while also enhancing diversification potential and risk-adjusted returns
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.
Here, we examine the role of listed real assets in helping investors build portfolios that may offer 1) enhanced risk-adjusted return potential and 2) resiliency in a variety of economic and market environments.
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.
Exhibit 1: Real assets have historically outperformed in inflationary environments
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 desynchronization 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.