Getting Real
by P.E. Kelley
Mr. Kelley is managing editor of this magazine. Connect with him at pkelley@lifehealth.com.
As investors grapple with a historic low interest climate, reverberations from stifling Covid-19 protocols and newly emerging economic volatility, prospects for asset growth are, to say the least, a little hazy. One area of growing interest is the prospects for real assets, defined as real estate, infrastructure and natural resources.
Real assets represent physical assets that are often linked to inflation—a favorable characteristic as potential demand rises in periods of economic expansion. At the same time, the increasing demand for the goods and services that real assets provide may be relatively predictable and inelastic (insensitive to changes in price or income), which can be helpful in periods of economic uncertainty.
Chris Huemmer is senior investment strategist at FlexShares ETFs, managed by Northern Trust Asset Management. He spoke with us about the cash-flow stability that real assets have typically delivered, while offering an effective way to enhance portfolio diversification beyond traditional stock and bond allocations.
PEK: Has the demand for real assets, typically real estate, infrastructure and natural resources, increased significantly amid recent economic volatility?
CH: In short, yes there has been an increase in demand for real assets and for good reason. One of the key drivers behind the recent market volatility is the concern around inflation and how the Federal Reserve will shift monetary policy to combat purchasing power erosion. Going back to last November, the Fed Funds futures curve – a way of measuring the market’s view of potential interest rate hikes – was pricing in two hikes by the end of 2022.
But with year-over-year inflation numbers coming in higher than expected and comments by Fed Chairman Powell and other Fed officials signaling the need to raise rates sooner than later to combat inflation, the market is currently expecting between six and seven rate hikes this year. This dramatic shift in policy expectations has been felt across all markets. In addition, market expectations have led to the flattening of the yield curve, which can be another source of volatility in markets.
With inflation being the primary catalyst behind this volatility, it makes sense for investors to gravitate to asset classes that can help mitigate inflation. Historically, all three of the real asset categories you mentioned – natural resource equities, infrastructure and real estate – have demonstrated strong correlations to inflation over an intermediate time horizon. We view all three asset classes as compelling tools to combat inflation.
In addition to offering inflation protection, natural resource equities have generated a lot of interest as supply chain bottlenecks and increases in global demand for raw materials have driven commodity prices higher. Year-to-date global natural resources is one of the few asset classes with positive performance.
PEK: As inflation fears rise, do real assets actually perform well during periods of expansion and contraction?
CH: One of the advantages of blending this combination of asset classes together is that each tends to perform well at different points of the economic cycle in addition to protecting against inflation. Typically real estate tends to perform well early in an economic expansion as interest rates are low and the anticipation of growth leads to increased demand in the asset class. Natural resources and commodities tend to do well at the peak of the economic cycle where demand and production output is traditionally at its highest point.
Finally, infrastructure tends to do well late in the economic cycle where high cash flow, defensive businesses benefit from inelastic demand for their mission critical services, as well as from a falling interest rate environment.
By investing in a combination of this trio of real asset types, investors can look to combat inflation irrespective of the point in the economic cycle we are currently in or at any point in time.
PEK: How do real assets enhance portfolio diversification, beyond traditional stock and bond allocations?
CH: Our research shows that when real assets are integrated into a traditional stock and bond portfolio, such as a 60/40 approach, the blended allocation with real assets has the potential to enhance diversification and improve risk-adjusted returns.
Real assets are unique because each asset class has different sensitivities to macroeconomic factors beyond equity market exposure. For example, similar to how a bond reacts, global infrastructure is sensitive to changes in interest rates, commonly called term exposure. The returns of global real estate can be predominately explained by global equity markets and changes in interest rates, as well as by changes in credit spreads; as credit spreads tighten, global real estate tends to benefit.
Finally natural resource equities are sensitive to changes in commodity prices as well as emerging market growth expectations. Overall, these different sensitivities to macroeconomic factors contribute to real assets having a return stream distinct from either global equities or fixed income, which can lead to increased diversification across the entire portfolio.
PEK: How do current ’supply chain’ issues impact the viability of certain types of real estate assets?
CH: Anyone who has taken a trip to their local Home Depot over the last two years can see the impact that supply chain issues has had on the price of lumber. Though down from the peak we saw last year, lumber prices are still four times what they were at the beginning of the pandemic. In addition to the cost of raw materials increasing, supply chain bottlenecks, higher transportation costs and other COVID related issues, such as labor shortages due to illness, have created delays in the completion of new real estate projects. In residential real estate, this has hampered new supply and set prices for existing single family and multi-family properties higher.
Likewise, construction costs and delays have impacted commercial real estate. Additionally as businesses look to protect themselves from good shortages by increasing inventories closer to major sales hubs, demand for warehouses and industrial real estate has been very strong.
PEK: What are the variables to consider for capital appreciation with real assets, particularly when the income from those assets are used as a hedge against downside values?
CH: The income component from real assets should not be overlooked. One of the additional benefits we find in the current low rate environment is the ability of these asset classes to deliver a dependable income stream. It is one of the reasons we prefer natural resource equities over futures-based commodity strategies: the upstream natural resources companies pay compelling dividends to their shareholders. Likewise our research shows that over the past ten years, 45% of the total return of global real estate and 52% of global infrastructure has come from dividend income. Those dividend payments can act as a stabilizer in periods of equity market volatility.
Regarding capital appreciation, even after dividend income is accounted for, around half of the total return performance over the past ten years has come from stock price increases in these asset classes. The drivers of capital appreciation beyond macroeconomic variables such as global growth expectations, equity market performance and inflation expectations are asset class specific. As I mentioned, interest rate expectations, credit spreads, commodity prices and growth in emerging economies will influence one or more of the asset classes that make up real assets.
PEK: Is it true that real assets do not exhibit wide swings in either direction, up or down, and does this provide meaningful stability within an entire investment portfolio?
CH: Real assets as a whole are made up of three different asset classes and the volatility of each of these assets classes is unique. Both natural resources and real estate historically have indeed had periods of great volatility, albeit often at different times. Of the three real asset buckets, infrastructure most closely fits that description.
Infrastructure is unique because typically these assets are location-specific with high barriers of entry and large upfront costs. They often operate in pseudo-monopolistic environments and are highly regulated. And they typically operate businesses with inelastic demand, meaning that they are less susceptible to changes in the economic cycle than a cyclical business is. All of these factors, as well as the long life of these assets, leads to fairly predictable cash flows and maintenance costs. Of the different types of real assets, infrastructure is the most likely to provide that stability to an overall asset allocation.
However, infrastructure is not without its own risks, as changes in regulatory environments and governments can lead to a more conducive or restrictive operating environment for single infrastructure projects. This is why we advocate for a broadly diversified approach to infrastructure investing that covers as many different types of infrastructure assets as feasible.
PEK: How do real assets affect an investor’s risk tolerance preferences?
CH: One of the benefits of real assets is that the mix of asset classes have diverse risk and return profiles so in aggregate, the asset allocation can be very agile and tailored to suit a client’s specific needs. Those seeking to capture higher growth and willing to tolerate more risk can build an asset allocation in real assets that heavier weights global real estate and natural resource equities. Those looking to blend a real asset mix with historically less price variance can tilt their allocation towards global infrastructure instead.
PEK: How do today’s market variables, such as US debt, a declining dollar and a rising consumer price index, play into a real asset strategy?
CH: Of the variables mentioned, a rising consumer price index (CPI) is the one that is most directly related to real assets. All three of the asset classes we have discussed have demonstrated a historical correlation to CPI over both rolling five- and ten-year time horizons. So if historical relationships are maintained, one would expect that a rising CPI would be the result of several of the real asset categories moving higher.
As we advocate for taking a global approach to real assets, a declining dollar would actually favor U.S. investors, as the portion of the portfolio that invests internationally would see incremental positive returns after earnings in local foreign currencies are translated to US dollars.
One additional variable that has had strong impact on real assets of late has been the rise of commodity prices. That has led to the strong performance we have seen from global upstream natural resources companies this year.
PEK: How do advisors begin to incorporate, for their clients, real assets into otherwise traditional allocation strategies?
CH: When creating a new real asset allocation, typically we have seen clients either source funding proportionally from equity and fixed income or allocate 100% of the exposure from equities.
Another way that advisors can look to allocate to real assets would be to fund the position based on the specific asset class sensitivities. For example, since global real estate exhibits risk exposures to global equity markets, interest rate term exposure and credit spreads, funding the allocation from equities and corporate credit might offer a similar exposure to those factors. Likewise, global infrastructure could be funded from equities and a combination of government and corporate credit. For natural resources, funding can come from global equities or replace commodity exposure.
