Inflation protection in portfolio allocation

A deep dive into real assets and their value in protecting your portfolio against inflation

Growing numbers of investors have steadily increased their real asset allocations. Many investors have discovered the benefits of real assets in potentially providing long-term total returns, inflation protection and the difference in historical correlation with equity and fixed-income invest¬ments. We believe investors are looking for what real assets can offer: the potential for income, diversification and assets linked to inflation in an unclear global environment. 

At the same time, investors continue to benefit from innovation within a variety of investment vehicles that focus on real assets. Furthermore, strong demand for real assets is being met with an unprecedented supply of opportunities for investment, and we believe trends indicate that it will continue to grow. The Real Assets classification (e.g., timber, water, infrastructure, natural resources, etc.) is continually evolving, influenced not only by new asset types, but also regulatory and issuance changes.

DEFINING THE ASSET CLASS AND ITS BENEFIT POTENTIAL

Real assets—which we define as real estate, infrastructure and natural resources— form the pillars of the global economy. As such, these classifications are inherently tied to global developments, inflation and other macroeconomic trends. Notably, the cash flows that historically have been produced by real assets can be valuable in times of both economic expansion and contraction. 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.

While cash-flow stability has historically been characteristic of real asset investments, the fundamentals that drive the cash flows are distinct. As such, real assets can provide an effective way to enhance portfolio diversification beyond traditional stock and bond allocations. The chart below highlights potential benefits such as income, capital appreciation, higher risk-adjusted returns and inflation protection.

p2_RealAssetsScenerioPlanning_Potential Benefits Chart

PORTFOLIO DIVERSIFICATION

Real assets tend to have low correlations with traditional stock and bond allocations. Correlations are also low among the sectors comprising individual real asset categories.

Real asset returns have historically had low correlations to traditional equity and fixed-income investments, which our findings suggest they can provide an effective way to enhance the diversification of a traditional stock and bond portfolio. Individual real asset categories have historically displayed correlations with each other that may provide investors with an opportunity to diversify their holdings into more than one real asset class in order to enhance overall diversification within their portfolio.

As highlighted in the chart below, the correlations of real estate with infrastructure and natural resources are 0.91 and 0.74, respectively. The return streams of two assets having a correlation of 1.00 would be perfectly correlated. These measures are relatively moderate because the drivers behind the returns of these categories are distinct. Consider natural resource pricing, which for some assets like timber are highly dependent on short-term factors such as climate, temperature and water supply. In contrast, the cash flows from some infrastructure assets, such as toll roads, tend to rise with an expanding economy, while those derived from more essential services, such as utilities, tend to be more highly regulated, and consequently during times of economic weakness tend to have more locked in levels of usage pricing.

p3_RealAssetsScenerioPlanning_LowCorrelationTable

CAPITAL APPRECIATION POTENTIAL

Our research has shown that both income return and capital appreciation represented a meaningful amount of the historical total returns generated by real assets below. Historically, many of these hard assets tend to be long term and increase in value over time, as replacement costs may rise and operational efficiencies can be achieved. For many investors, this scenario may be visualized within their own daily experience as they see leasing of vacant space, steady climb of toll road fees, rising usage of energy or climbing wood prices. We believe that income from real-asset-related investments may help protect value on the downside, while operational efficiencies may enhance value on the upside.

p3_RealAssetsScenerioPlanning_10yt Capital Apprec chart

POTENTIALLY HIGHER RISK-ADJUSTED RETURNS

Adding real assets may also enhance the risk-adjusted returns of a mixed-asset portfolio. The chart below shows the various historical Sharpe Ratios of the three real asset categories in comparison to equities and bonds. The Sharpe Ratio is a measure of return per unit of risk, which indicates whether an investment’s return sufficiently rewarded investors for the level of risk assumed (the higher the Sharpe Ratio, the greater the level of risk-adjusted performance). For example, the 10-year Sharpe Ratio for Infrastructure as defined in the chart below is .570 which means that an investor should have a greater risk-adjusted return in comparison to an investment in a Treasury bond which has a Sharpe Ratio of zero. Only when an investor compares one investment’s Sharpe Ratio with that of another investment can the investor get a feel for the return versus the relative amount of risk they can expect to take to achieve that return.

Risk-adjusted return refines an investment’s return by measuring how much risk is involved in producing that return.

p4_RealAssetsScenerioPlanning_10Year Sharpe Ration Table

While real assets tend to retain value during economic downturns and contribute to value creation during economic upturns, performance generally lacks drastic movements in either direction. This potential performance stability may provide investors with portfolio benefits in a variety of market environments.

p4_RealAssetsScenerioPlanning_Avg Annual Returns Table

INFLATION PROTECTION

Against a backdrop of increasing levels of U.S. indebtedness, declining U.S. dollar, and higher overall prices as measured by the Consumer Price Index (CPI), Treasury Inflation-Protected Securities (TIPS) breakeven spreads (BES) have been on the rise since mid-March 2020, reversing the trend seen through most of 2019.1 BES measure the difference in yield between similar maturity Treasury yields and the current yields on comparable TIPS.

p5_RealAssetsScenerioPlanning_Breakeven Inflation Chart

Rising BES is one indicator that investors have historically used to measure expectations for higher inflation. We believe that there are two drivers of inflation — demand-driven and supply-driven inflation. Many economists believe that demand-driven inflation can be labeled as “good inflation” because often times it reflects overall economic growth, such as an increase in average hourly earnings, and stimulates the supply of goods and services. Supply-driven inflation can be labeled as “bad inflation” because it may reflect non-economic drivers, such as the price of oil, which can have a negative impact on both the supply chain and labor markets and tends to cut demand.

As recently demonstrated in the Consumer Price Index (CPI), investors have recently begun to see increasing levels of annual inflation when the CPI rose 6.8 percent YOY (November 2020 to November 2021), the largest 12-month increase since the period ending June 1982. Energy prices rose 33.3 percent over the last year, and food prices increased 6.1 percent.

p6_RealAssetsScenerioPlanning_Inflation Upward Track Chart

Whether you believe that inflation is a threat to your investment portfolios will depend on many factors. As investors continue to expect higher inflation, reflected by either the BES or CPI, those who think inflation will trend even higher may benefit from considering an investment that offers potential inflation protection.

p6_RealAssetsScenerioPlanning_Three Step Approach

Building a real asset portfolio is a process that requires multiple considerations in terms of reviewing your expectations for inflation. Real assets can play a fundamental role in a portfolio, depending on an investor’s objectives and given the current low-yield environment along with the potential diversification that real assets have historically provided, we believe that investors should consider them in order to create a well-diversified portfolio.


DEFINITIONS

FTSE EPRA/Nareit Global Real Estate Index (FTSE EPRA/NAREIT Global Index) is an index designed to track the performance of listed real estate companies in both developed and emerging countries worldwide.

S&P Global Infrastructure Index (S&P Global Infrastructure Index) is designed to track 75 companies from around the world chosen to represent the listed infrastructure industry while maintaining liquidity and tradability.

Standard & Poor’s Global Natural Resources Index (S&P Global Natural Resources Index) includes 90 of the largest publicly-traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors diversified and investable equity exposure across 3 primary commodity-related sectors: agribusiness, energy, and metals & mining.

MSCI World Index a market cap weighted stock market index of companies throughout the world and is used as a common benchmark for ‘world’ or ‘global’ stock funds intended to represent a broad cross-section of global markets.

Bloomberg US Aggregate Bond Index (Bloomberg Aggregate Index) is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.

Cash flow refers to the net balance of cash moving into and out of a business at a specific point in time. Cash flow can be positive or negative.


FOOTNOTE

1 Federal Reserve Bank of St. Louis. In this analysis we are making a comparison between the differences between the 5-Year TIPS rates and the 5-Year nominal Treasury rates and the differences between the 10-Year TIPS rates and the 10-Year nominal Treasury rates in order to construct a U.S. Breakeven 5-Year rate and the U.S. Breakeven 10 Year rate using data available as of 11/30/2021.

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