Inflation may be persistent

Inflation has surged to near 40-year highs, and evidence is mounting that the spike in prices is more than temporary. A major shift in the drivers of this business cycle vs. prior expansions points to enduring inflation and a prolonged environment favorable for real assets.

In the last economic cycle, the slow and shallow recovery following the global financial crisis was characterized by deflationary globalization forces and insufficient aggregate demand (due to deleveraging in the private sector). Consequently, Organisation for Economic Co-Operation and Development (OECD) core inflation averaged just 1.8% annually between 2010 and 2020.

In stark contrast, the economy’s rapid recovery from the Covid pandemic has been characterized by inflationary forces (wage/price pressures) and insufficient aggregate supply to keep up with an over-stimulated private sector. This convergence of supply and demand pressures is jointly driving inflation higher (Exhibit 1). Moreover, the longer the Russia–Ukraine war continues, the higher the likelihood that supply disruptions will endure.

Inflation is therefore likely to stay well above the previous cycle average, in our view.
As today’s strong demand and impaired supply point to persistent inflation forces, investors may want to consider real assets, which often have built-in inflation escalators or may benefit directly from rising commodity prices. It is key for investors to consult their financial professional concerning their
investment objectives, financial position and risk tolerance before making any investment decision.

EXHIBIT 1

Inflation is high and broad-based

OECD consumer prices (y/y % change)
January 1970–March 2022

At March 31, 2022. Source: Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. Core inflation is a measure of inflation that excludes certain items that face volatile price movements because in finding out the legitimate long run inflation, short-term price volatility and transitory changes in price must be removed. Core inflation is most often calculated using the consumer price index (CPI), which eliminates products—usually those in the energy and food sectors—that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation. Headline inflation reflects the long-term trend in a particular price level, but does not exclude any items that face volatile price movements. See page 8 for additional disclosures.

Positioning portfolios for long-term inflation risk

Listed real assets can help defend against inflation. At Cohen & Steers, we define listed real assets as four core asset classes: real estate, infrastructure, commodities and resource equities. What unifies real assets more than any other attribute is that their returns have historically benefited from inflation surprises. In other words, this means real assets have tended to outperform during periods of rising and unexpected inflation, contrasting with the modest or negative inflation sensitivity of stocks and bonds (Exhibit 2).

The economic drivers of real assets are often directly or indirectly tied to inflationary trends; this linkage historically has resulted in outsized returns when inflation exceeds expectations. An allocation to real assets may therefore help to preserve future purchasing power, potentially offsetting the vulnerability to unexpected inflation that is historically common to traditional portfolios of stocks and bonds.

EXHIBIT 2

Real assets have historically outperformed in inflationary environments

Average annual real returns in periods of rising and unexpected inflation June 1991–March 2022

At March 31, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. Inflation measured as the year-over-year change in the Consumer Price Index for all urban consumers, published by the U.S. Bureau of Labor Statistics. Rising inflation is measured as a positive year-over-year increase in the 12-month inflation rate. Unexpected inflation measured as a positive difference between the year-over-year realized inflation rate and lagged 1-year-ahead expected inflation, as measured by the University of Michigan survey of 1-year-ahead inflation expectations. The real assets blend is not representative of an actual portfolio and is for illustrative purposes only. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See page 8 for index associations, definitions and additional disclosures.

Why real assets

Three potential benefits

Real assets are the structures and raw materials that economies rely on to function and be productive. That includes the properties where we live, work and shop; the infrastructure

that provides power and water and enables transportation and communications; and the basic natural resources, such as food and energy, that sustain societies. Products that invest in publicly traded (listed) markets offer a convenient way to access the global opportunity set of real assets, capturing the underlying economics of these investments with the added benefit of liquidity.

A diversified blend of real assets—including real estate securities, listed infrastructure, commodities and natural resource equities— may help enhance a portfolio in three key ways:

1. Positive inflation sensitivity to help mitigate the potentially damaging effects of accelerating inflation.
2. Diversification potential from distinct performance drivers that typically result in low correlations, both among real assets categories and vs. stocks and bonds.
3. Attractive return potential over full market cycles, with a history of attractive risk-adjusted performance.

Inflation sensitivity

The economic drivers of real assets are often directly or indirectly tied to inflationary trends, historically resulting in outsized returns when inflation exceeds expectations (and relative underperformance when inflation is low). For example, the release of pent-up consumer demand, which is one of the drivers

of inflation today, stands to benefit assets that struggled the most early in the pandemic such as commodities, natural resource equities, real estate and infrastructure.

An allocation to a blend of real assets may help preserve future purchasing power, potentially offsetting the weak or even negative inflation sensitivity of traditional portfolios concentrated in stocks and bonds. The ability of real assets to counter inflation may have an impact on portfolios both today, as prices climb, and longer-term if elevated inflation persists.

How real assets are tied to inflation

Real estate

• Property values tend to rise with the overall price environment due to rising costs of labor, land and materials.
• Real estate companies typically have high operating margins and low labor costs.
• Some commercial leases have explicit rent escalators tied to inflation.
• Sectors with shorter lease durations can take advantage of reflationary rents relatively quickly.

Infrastructure

• Cash flows and asset values may have direct or indirect links to inflation.
• For example, with regulated utilities, inflation is typically factored in when determining consumer rates and included in utility project costs that can affect a utility’s rate base.
• With marine ports, contracted rates typically include escalators if inflation exceeds a specified level.

Commodities

• Commodities, such as grains, livestock and precious metals, frequently serve as direct inputs to inflation measures.
• Commodity prices tend to respond to economic forces, such as supply constraints and changes in global demand, that often drive the prices of other goods.

Resource equities

• Demand for essential resources such as food, energy and metals tends to be relatively inelastic (i.e., independent of rising or falling prices), which typically enables resource producers to pass through higher costs of labor, commodities and other inputs onto customers.
• As a result, prices for raw materials tend to rise with broader inflationary pressures, which may help increase cash flows and widen profit margins for producing companies.

Diversification potential

The goal of portfolio diversification is to own asset classes that tend to experience their above- and below-average returns in different economic and market environments—when one asset zigs, the expectation is that another will zag. Real assets’ distinct economic sensitivities tend to differentiate them from traditional risk assets such as stocks and bonds.

The historical benefits of having differentiated economic drivers can be seen in real assets’ “beta,” which is their sensitivity to the broad global equity market (Exhibit 3). A beta of more than 1 indicates that the asset class (over the timeframe being analyzed) exhibits more volatility than the broad equity market. A beta of less than 1 indicates that the asset class tends to behave
differently or be less volatile than the market. In this case, the low market beta of real assets suggests significant diversification potential, which may help to reduce portfolio volatility—and, we believe, improve risk-adjusted returns.

EXHIBIT 3

Low market beta suggests significant diversification potential

Beta to global equities
June 1991–March 2022

At March 31, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream and Cohen & Steers.
Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. Beta measures the relative volatility of an investment as compared to a standard market index. A market index will always be equal to 1.00. An investment with a higher/lower Beta, more/less than 1.00, is more/less volatile than the market index. See page 8 for index associations, definitions and additional disclosures.

Attractive risk-adjusted returns

Real assets have historically delivered attractive full-cycle returns that can potentially improve risk-adjusted portfolio returns without sacrificing growth potential. Over the last 30 years, a blend of real assets has exhibited returns competitive to those of global stocks, but with lower volatility (Exhibit 4).

EXHIBIT 4

A balanced approach

Since 1991, a real assets blend has exhibited favorable risk-adjusted return.

At March 31, 2022. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. Return reflects compound annualized return. Risk reflects annualized standard deviation of monthly returns. Standard deviation, also known as historical volatility, is a measure of the dispersion of a set of data from its mean and is used by investors as a gauge for the amount of expected volatility. Sharpe ratio is a measure of risk-adjusted return, calculated by subtracting the risk-free rate from a return and dividing that result by the standard deviation. The higher the Sharpe ratio, the higher the risk-adjusted return. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See page 8 for index associations, definitions and additional disclosures.

Benefits of the blend

A diversified blend of real assets may offer an effective way for investors to target common objectives of a real assets allocation—such as boosting inflation sensitivity, enhancing diversification and improving the risk-return profile— while potentially dampening the swings that investors may experience with separate allocations to individual asset classes (Exhibit 5).

EXHIBIT 5

Together

Matching real assets characteristics to portfolio objectives

At March 31, 2022. Based on Cohen & Steers analysis and expectations.
There is no guarantee that any market forecast set forth in this presentation will be realized. The views and opinions are as of the date of publication and are subject to change without notice. The mention of specific sectors is not a recommendation or solicitation to buy or hold securities in a particular sector and should not be relied upon as investment advice. The qualitative criteria in the above chart represent relative strengths across the real asset categories discussed in this presentation, based on realized historical data since June 1991 and Cohen & Steers’ expectations.

Why now

Priced at attractive relative discounts

Resilience in the face of inflation, portfolio diversification and historically attractive returns through an economic cycle are three reasons an allocation to real assets in a diversified portfolio may make sense in most economic regimes.

Potentially adding to the group’s appeal are attractive relative valuations.
The 2010s were characterized by repeated and unprecedented disinflation surprises, which weighed on real assets returns even as equities climbed ever higher. This has resulted in historically attractive real assets valuations relative to equities—even after the group’s strong returns since 2021 (Exhibit 6).

EXHIBIT 6

Real assets are generally trading near 20-year lows relative to stocks

Valuations vs. global equities
January 2000–March 2022

At March 31, 2022. Source: Bloomberg, S&P Xpressfeed, Cohen & Steers proprietary analysis.
Past performance is no guarantee of future results. Valuation scores represent composites of various metrics: global equities/infrastructure/resource equities: cashflow-to-price, dividend yield and book-to-price; real estate:
FFO-to-price, dividend yield and book-to-price; commodities: weighted real spot price. Real estate, infrastructure and resource equities based on proprietary Cohen & Steers data for respective stock universes, constructed from the S&P Global Xpressfeed database. Global equities represented by Datastream World Index. Commodities represented by Bloomberg Commodity Index. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. See end notes for index definitions and additional disclosures.

We believe today’s low relative prices are just one reason why the recovery in real assets may still have time to run. Potential catalysts for a longer period of outperformance include:

Macro backdrop may favor real assets

• Supply shortages across labor, product and commodity markets continue to impact inflation dynamics, with supply-side discipline in commodities production expected to persist.
• The combination of elevated public spending and peak globalization may sustain higher inflation over the coming decade, potentially weighing on stock and bond returns.
• Central banks have begun to tighten financial conditions to combat high inflation, but they risk tightening so much that economic growth slows. Real assets typically outperform traditional stocks and bonds during “stagflationary” periods of lower-than-expected growth and higher-than-expected inflation.

Within an economy characterized by a regime shift toward higher inflation, and real assets generally trading near 20-year lows relative to stocks, an allocation may offer an effective way to boost inflation sensitivity, enhance diversification and improve a risk-return profile.

Why the commodities recovery may continue

Russia’s invasion of Ukraine in early 2022 has thrown a spotlight on commodities as virtually every sector—from energy to agriculture to metals—has surged on supply concerns stemming from the war. While a welcome de-escalation of the conflict could cause commodities to pull back for a spell, we believe the macroeconomic conditions that have driven many commodity prices to multi-year highs could remain very constructive over the longer term. We believe the potential for a lasting economic recovery bodes well for an extended period of strong commodity consumption.

Inventories for most commodities were at multi-year lows before the pandemic hit, leaving producers scrambling to meet the now surging demand as economies reopen. A lack of investment in supply in recent years means ramping up output will take time. Also, Covid-related production issues and supply chain constraints that plagued many sectors during the pandemic (particularly metals) are still lingering.

After a challenging decade for commodities, we see potential for a sustained, broad-based rally, driven by three key factors:

• A highly supportive macroeconomic backdrop
• The strongest supply/demand fundamentals in a decade
• Attractive portfolio benefits—including inflation sensitivity—driving speculative inflows