The classic balanced portfolio of equities and bonds has been through difficult terrain lately, thanks to rising inflation, rising interest rates, and falling growth expectations. Assets that many investors hope will play a defensive role in times of uncertainty — namely, bonds — have failed to do so, even as assets that have traditionally performed well in better times — stocks — have suffered. Yet, one asset class has bucked the trend — real assets, which include commodities, infrastructure, and real estate, traditionally thought of as inflation hedges.
Much is uncertain about the outlook. Will central banks be able to control inflation? Will their efforts cause a recession? Has the COVID-19 pandemic led to structural changes in the economy and in the trajectory of inflation and interest rates? As these questions have weighed on investors, real assets have provided a much-needed source of diversification.
Inflation surges globally
Inflation has risen dramatically since late 2020, and this rise has been pervasive, hitting decades-long highs in many countries: in the United States its highest level since the early 1980s; in Japan and the United Kingdom, since the early 1990s; in the euro area, since its founding. Australia has fared relatively better, but it continues to trend higher well above the RBA’s target level. Globally, the International Monetary Fund (IMF) expects consumer price inflation (CPI) to reach levels last seen in the 1990s.
A variety of factors have contributed to this surge, including a dramatic increase in commodity prices, constraints on supply and changing consumption patterns due to the pandemic, and cyclical pressures from the broader economic recovery aided by generous policy support. In the United States, demand for labor has exceeded supply, putting upward pressure on wages, particularly in reopening industries.
Looking ahead, there are clear risks that could exacerbate already-tight conditions. Russia’s invasion of Ukraine threatens to constrain the global supply of a number of important commodities, including wheat, natural gas, and oil. And the pandemic continues to threaten further disruptions to production and supply chains, particularly in China, where authorities remain committed to “zero COVID” despite the emergence of highly infectious new variants of COVID-19.
In response to rising inflation, central banks have raised interest rates and tightened financial conditions as it became clear that they could no longer afford to patiently wait for pandemic-related factors to subside. In a number of emerging markets, policymakers came to this conclusion sooner and began raising interest rates in 2021. Many of their developed markets peers have pivoted to less accommodative policy since, including the US Federal Reserve (late 2022), the European Central Bank, and Australia’s RBA all in 2022.
In theory, inflationary pressure linked to the strength of the economic recovery ought to subside as higher interest rates and tighter financial conditions slow economic activity. But high commodity prices and other pandemic-related pressures may prove harder to tame, raising concerns both that central banks may cause a recession — on purpose or by accident — and that expectations for higher future inflation could become embedded, leading to an environment of slow growth and high inflation that is difficult to dislodge.
Another key uncertainty about the outlook is whether structural changes in the economy, some accelerated by the pandemic and others longer running, may have more permanently changed the economic and market environment. For example, stretched global supply chains and new geopolitical realities are leading many multinational corporations to reconsider their outsourcing of manufacturing to low-cost areas and their reliance on just-in-time manufacturing in favour of “reshoring” and greater redundancy in production. Furthermore, while the macroeconomic impacts are difficult to untangle, climate change may put upward pressure on inflation and interest rates because it will require massive investment in the coming years to reduce greenhouse gas emissions, to build greater resilience to its many impacts, and to respond to climate disasters that are increasing in their severity and frequency.
What works when a balanced portfolio doesn’t?
High inflation, rising interest rates, and falling growth expectations have proven to be a particularly difficult recipe for balanced portfolios, as both equities and bonds have suffered.
One asset class has stood out during this period: real assets — which derive their value from something tangible in the real world, such as real estate, commodities, or infrastructure. As equities and bonds have struggled, real assets have outperformed, as one would expect based on history.
All three broad categories — real estate, infrastructure, and commodities — are well suited to inflationary periods but have differing characteristics that can make one more or less attractive than the others depending on the economic and market environment. For example, commodities might be most attractive in an environment of accelerating economic growth and rising demand for production and investment, while infrastructure tends to have more stable revenue streams that might be more defensive in an environment of slowing growth.
The way forward
We are in an especially difficult period for investors, as both equities and bonds have sold off in response to high inflation, rising interest rates, and falling growth expectations. Real assets like commodities, real estate, and infrastructure have outperformed during this period and provided valuable hedges against uncertainty. It may be that central banks will quickly bring inflation to heel, and that they will be able to do so without triggering a recession: a rare “soft landing.” However, after so many unexpected and unusual developments over the past two years and with so many challenges ahead for the global economy, we think there is a compelling case for real assets as a diversifying component of a well-balanced portfolio and a safeguard against the unexpected.
Jai Jacob, portfolio manager/analyst, Lazard Real Assets Team