Defending against sustained inflation with real assets

Transcript

Real assets regained the limelight in 2022, a trend we believe will continue in 2023. But the investment merits of real assets span well beyond the next 12 to 18 months.

We believe we’re two years into a new, roughly decade-long regime best characterized as a period of secular stagflation, an environment of slow growth and elevated inflationary risks. And that’s even with inflation trending lower near-term.

It’s a market that warrants diversification and an allocation to assets that can mitigate the impact of inflation. It’s precisely the environment in which real assets can excel.

We think there are three areas to focus on in both the near-term and long-term case for real assets:

• First, valuations
• Second, elevated inflation that is likely to persist, despite being managed lower, and
• Third, the shift from the great disinflationary regime that characterized the prior decade to a regime of secular stagflation

Alright, to ground us, real assets are the raw materials and structures that help to facilitate global economic growth.

The core four asset classes that fall within this definition are:

• Global Real Estate Securities
• Commodities
• Global Resource Equities, and
• Global Listed Infrastructure

All are listed, liquid, global and very well-diversified at the sector and sub-sector levels. Combined, real assets form a foundational asset class.

A strategic allocation to real assets is important for three main reasons. Each of the core four, and especially when they are combined, can provide 1) equity-like returns, 2) diversification, and 3) and maybe most importantly, an opportunity to mitigate the impact of inflation, something that’s been very much needed over the last two years.

Our supportive outlook for real assets begins with valuations. We continue to see compelling valuations favoring real assets relative to broad equities. And that’s telling because despite real assets outperforming broad global equities in 2022, they’re still cheap. They’re inexpensive.

And why is that? It’s because valuations for real assets were historically discounted coming into 2022, which is not a surprise given we had over a decade of persistent disinflationary surprises. Resource equities and global listed infrastructure valuations both look very attractive compared to global equities. Global real estate has moved into the attractive zone given the weakness in 2022. Commodities is in the average territory compared to the previous 20 years. Put those core four together, and real assets continue to screen attractive compared to global equities. So that’s one.

Two, we think elevated inflation will persist. The Fed and Central Banks are working to manage inflation lower. Yet, inflation is likely to remain elevated through at least 2023, and we think well beyond, especially compared to the low inflation we saw, we experienced, in the prior decade when U.S. headline inflation hovered below the Fed’s target. We saw persistent disinflation surprises throughout that period.

Then Covid hit in 2020. We saw a spike in inflation in 2021, exacerbated by supply chain challenges, and then a war. Two black swan events in two years caused inflation to spike.

What’s interesting about this chart are the black dotted lines that show consensus forecasts for inflation and how wide off the mark those expectations were. The market expected inflation would normalize quickly. That was wrong.

While we believe we are now past peak in inflation and it will continue to fall, current expectations imply the Fed sticks the landing, which history tells us is very hard to do. We think inflation will again prove more stubborn than excepted despite being managed lower. We believe the secular inflationary forces that characterize this new regime remain under the surface.

Third, we believe we are two years into an environment that can best be characterized as secular stagflation. It’s pretty clear that there has been a shift in the global economy.

A period of Great Disinflation, as shown in this visual on the left, lasted from 2012 until 2020. That period witnessed highly accommodative monetary policy marked by low interest rates, low inflation, persistently oversupplied markets, relative geopolitical stability, and increased global trade. Those forces were all disinflationary. Those forces are also now in the rear-view mirror.

We’ve shifted to a regime that we define as Secular Stagflation, as shown on the right, in which growth remains slow or disappoints, and inflation risks remain elevated. To be clear, it does not mean we live in a prolonged period of consistent, unexpected inflation.

Rather, the risks that we experience bouts of inflationary shocks over the next decade have increased. And that’s the key, and it’s due to the inflationary forces in play.

This new period of Secular Stagflation will be marked by negative supply shocks that restrict supply, commodity underinvestment due to increased capital discipline, increased geopolitical uncertainty, and a move away from globalization to what can be termed friend-shoring or trade-partner selectivity. All of these are inflationary and point to a period of potential of scarcity.

In summary, we believe we have transitioned to a new regime. Despite inflation trending lower, we believe the secular inflationary forces that characterize this new regime remain under the surface and present a real risk. It’s an environment that we believe warrants diversification and inflation mitigation. And it’s precisely the role that we believe real assets can fulfill.