Alternatives can provide important diversification against traditional equities and fixed income, Principal Asset Management has said.
However, the firm has established varying positions across the asset class as investors continue to weigh up geopolitical risks, high yields, and economic uncertainty.
Commodities
Principal noted that commodities handed in a mixed performance last quarter, with precious metals continuing their upward march while energy prices defied geopolitical tensions to sink lower.
As such, near-term dynamics for commodities look to be similarly scattered.
“Precious metals demand should remain robust given that only a mild global economic slowdown is expected,” the investment manager said.
“For energy, the demand prospects are equally positive. Indeed, while the broader market is pricing in a soft landing, the energy market is pricing in a recession, suggesting that a repricing is overdue in the commodity space.
“Supply dynamics are more mixed,” the firm added.
Namely, while various geopolitical tensions have not broadened out to impact energy, the threat is ever present and suggests some upside risks to oil prices.
“On the other hand, the unexpected increase in US oil output will likely continue to put downward pressure on oil prices. This makes for an uncertain near-term environment.
“The long-term outlook, however, remains more constructive. Global demand for fossil fuels is continuously rising and is unmatched by capital expenditure. This implies that commodities will likely remain in a long-term state of structural supply deficits that will support prices,” Principal continued.
As such, the firm has taken a neutral weighting of commodities and natural resources given the contrasting impacts from geopolitical risk and increased US oil supply.
Infrastructure
Defensive stocks have borne the brunt of market fears over higher-for-longer rates in 2023, and listed infrastructure has been no exception, according to the investment manager.
“Infrastructure now screens at historically cheap levels versus global equities,” Principal said.
“Typically, the most opportune environment for infrastructure is when inflation is sticky and rising.”
By contrast, it highlighted, infrastructure may struggle if inflation continues to soften.
“While this implies that infrastructure is unlikely to perform as strongly as in recent years, from a relative perspective and considering that the economy is likely to slow in 2024, infrastructure’s equity beta and the companies’ resilient fundamentals suggest that infrastructure may perform broadly in line with global equities, thereby deserving a neutral position.”
Even so, the firm warned that an inflation resurgence remains a continued threat, with infrastructure’s inflation mitigation properties still being required in a portfolio.
Principal added that infrastructure investments can also offer more stability within a well-diversified portfolio, typically having predictable cash flows associated with the long-lived assets.
“While the economic backdrop is no longer as constructive for infrastructure, its predictable cash flows will be important.
“They also provide exposure to the global theme of decarbonisation, which presents a multi-decade tailwind for utilities and renewable infrastructure companies.”
As such, the firm said its positioning for infrastructure remains neutral given the more resilient economic backdrop and continued disinflation trend.
REITs
It is within real estate investment trusts (REITs) that attractive valuations and fundamentals collide, according to Principal.
“After facing significant headwinds for the past two years, REITs are once again a compelling investment proposition.”
Historically, the peak in long-term real yields has been the catalyst for REITs outperformance, with the firm projecting that the significant bond market rally last quarter will create meaningful gains for global REITs.
These gains, the investment manager said, are likely to extend into 2024.
“Notably, the valuations of public REITs have corrected sharply since the Fed rate hike cycle started and look attractive compared to broader equity markets.
“Fundamentals are also looking more constructive. When macro conditions become more challenging, REITS are often beneficiaries of investor rotation into risk assets that feature long-duration, quality, and durable cash flows,” it continued.
With the global economy likely to slow somewhat in 2024, it is Principal’s belief that these defensive characteristics should drive strong REITs performance.
“Office REITs remain the weak spot. Yet, investors should note that traditional office space accounts for only 3 per cent of the overall US REIT market and 6 per cent of the global market.”
As such, Principal said that office exposure should not deter investors, and with REITs valuations having improved significantly and real yields having peaked, the firm made the case to shift REITs to overweight.
