Everyone seems to have an opinion about inflation these days. Take what you hear with a grain of salt.

Since reliable surveys of U.S. consumer inflation expectations were initiated in the late 1970s, outlooks for the year ahead have missed the mark by more than 100 basis points nearly half the time. And until recently, estimates had been too low or too high with roughly equal frequency. The past decade, however, saw an unprecedented stretch of lower-than-expected inflation, while 2021 saw the largest inflation surprise in 40 years, as deflationary forces reversed and were augmented by new drivers of inflation (Exhibit 1).

While it may be true that “nobody knows nothin’” when it comes to forecasting inflation, the mere threat of a sustained higher inflation regime is inspiring many investors to reconsider the potential implications for their asset allocations—as they should.

At December 31, 2021. Source: Bloomberg, U.S. Bureau of Labor Statistics, Cohen & Steers analysis.
Past performance is no guarantee of future results. Inflation measured by the year-over-year change in the U.S. Consumer Price Index (CPI) for all urban consumers. Inflation estimate based on the 1-year-ahead expected inflation, as measured by the University of Michigan survey of 1-year-ahead inflation expectations, the longest-running high-frequency series on inflation expectations, starting in 1978. When analysis does not involve expected inflation, we use our full database of asset class returns extending to 1973. 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 end notes for index associations, definitions and additional disclosures.

Average annual real return, 1973–2021

At December 31, 2021. Source: Bloomberg, U.S. Bureau of Labor Statistics, Cohen & Steers analysis.
Past performance is no guarantee of future results. Inflation measured by the year-over-year change in the U.S. Consumer Price Index (CPI) for all urban consumers. 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 end notes for index associations, definitions and additional disclosures.

Median U.S. CPI inflation has been about 3% over the past 50 years—meaning half the years were above 3% and half were below. On average, real (inflation- adjusted) returns for stocks and bonds have skewed heavily in favor of periods of below-median inflation (Exhibit 2), implying that traditional asset allocations have likely benefited disproportionately from the prevalence of low inflation in recent years. And today, with real interest rates in deeply negative territory and equity valuations rivaled only by those seen during the tech bubble of the early 2000s, we believe most stock/bond allocations offer little margin of safety to defend against a prolonged, adverse inflation environment.

The need for inflation protection and diversification has taken on added significance amid a potential turning point in long-term economic trends, driven by historic fiscal spending on a global scale and central banks conditioned to let bouts of high inflation persist longer than under prior frameworks. Add to this mix tight labor markets that are driving wage inflation higher and a turn toward more disciplined capital management in natural resource industries that appears likely to drive a new bullish commodities cycle. For many institutional investors, this has led to a greater focus on real assets.

This growing category—once limited primarily to real estate and precious metals—now represents a sizeable allocation in many institutional portfolios, spanning infrastructure, commodities and natural resources, held privately and through listed markets. In contrast with inflation hedges such as CPI swaps, the appeal of real assets is rooted in their potential to help defend against inflation while also offering prospects for attractive long-term returns.

In this report, we examine the role of listed real assets in helping investors build portfolios that may offer 1) enhanced risk-adjusted return potential and 2) resiliency in a variety of economic and market environments.

Allocations to real assets have traditionally sought to achieve three primary objectives:

1. Deliver outperformance in inflationary periods
2. Enhance risk-adjusted returns via differentiated market sensitivities
3. Maintain strong returns over full market cycles

The one factor common to all real assets is their positive sensitivity to inflation surprises. The reason for this is simple: inflation often affects both asset prices and revenues of real assets, either directly through contractual inflation linkages or indirectly through fundamental economic drivers. This ability of real assets to counter inflation offers potential benefits to portfolios in the short term, as prices climb, and in the longer term, should inflation rates continue to surprise to the upside.

The result of these inflation relationships has historically been strong returns in environments of rising and unexpected inflation, whether looking at individual real assets categories or a diversified real assets blend (Exhibit 3).

At December 31, 2021. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers.
Past performance is no guarantee of future results. (a) Represents common period of available asset class returns. Rising inflation measured as a positive difference between the year-over-year realized inflation rate and the lagged 1-year inflation rate. (b) Unexpected inflation data begins in 1978. Inflation measured by the year-over-year change in the Consumer Price Index for all urban consumers, published by the U.S. Bureau of Labor Statistics. 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 diversified blend of real assets shown above is composed of 27.5% real estate, 27.5% commodities, 15% natural resource equities, 15% infrastructure, 10% short-duration fixed income and 5% gold. 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 end notes for index associations, definitions and additional disclosures.

• Property replacement 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.

• 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.

• 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 toll roads and airports, local government agreements allow service rate increases based on fixed amounts above the inflation rate.

• Demand for essential resources (energy, food, metals) tends to be independent of rising or falling prices, typically allowing 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.

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. This desynchronization of payoffs creates opportunities to build portfolios designed to perform well in a variety of scenarios. Real assets’ distinct economic sensitivities tend to differentiate them from stocks and bonds, most notably in relation to inflation and growth regimes.

Exhibit 4 shows the historical inflation-adjusted performance of asset classes, relative to their long-term average, grouped by positive and negative surprises in economic growth and inflation. This analysis yields several observations:

• Real assets have typically performed well in reflationary conditions (unsurprisingly), as well as in stagflation—historically a challenging environment for both stocks and bonds.
• Commodities and resource equities are generally the most sensitive to upside inflation surprises, regardless of the growth backdrop.
• Real estate has been somewhat less geared to inflation trends and more tied to economic growth than commodity-linked real assets.
• Infrastructure has been fairly consistent across all regimes, including greater resilience in stagnation than other equity categories.
• A diversified real assets blend has delivered above-average returns in three of the four economic scenarios shown.

These differentiated responses to growth and inflation surprises demonstrate the potential of real assets to enhance portfolio stability over full economic cycles, potentially helping to offset periods that may be more difficult for generating attractive returns through stocks and bonds.

At December 31, 2021. Source: Cohen & Steers proprietary analysis, Survey of Professional Forecasters, University of Michigan Survey of Consumers.
Past performance is no guarantee of future results. Returns represent annualized average, categorized according to whether U.S. gross domestic product and the U.S. Consumer Price Index were above or below their prior-year estimates, based on the Philadelphia Federal Reserve Survey of Professional Forecasters 4-quarter-ahead real GDP forecast and the University of Michigan survey of 1-year-ahead inflation expectations, respectively. Percent of periods represented in each regime: Recovery: 24%, Reflation: 25%, Stagflation: 16%, Stagnation: 35%. 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 end notes for index associations, definitions and additional disclosures.

Real assets have historically generated strong returns over full market cycles, with all but commodities delivering performance in line with or better than global stocks over the past 50 years (Exhibit 5). The long-term average for commodities has been depressed by a decade-long bear market from 2008 to 2018, driven by the downshift in China demand and an oversupply cycle. However, commodities have since experienced substantial improvements in supply/demand fundamentals and a more supportive macroeconomic backdrop, providing potential catalysts for a sustained multi-year recovery.

The results below also demonstrate the potential benefits of combining multiple real assets within a single portfolio. A diversified real assets blend has historically delivered competitive returns with significantly less volatility than global stocks or standalone real assets, capitalizing on diversification benefits available within and among the different real assets categories.

At December 31, 2021. 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 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 end notes for index associations, definitions and additional disclosures.

Historically, no single real asset has excelled across each of the criteria of inflation sensitivity, diversification potential and total returns. Some real assets have historically performed better on certain dimensions than others, requiring investors to consider various strengths and tradeoffs according to the specific role of real assets in their portfolio. Below are common considerations investors may evaluate when determining desired exposures.

• Strong total return potential
• Balance of capital appreciation and income
• Potential for enhanced risk- adjusted returns
• Higher sensitivity to real rates and credit markets

• Significant historical outperformance in periods of accelerating economic growth and higher inflation
• Low correlation to global stocks, indicating meaningful diversification potential
• Higher sensitivity to energy prices and U.S. dollar

• Equity-like total return potential
• History of reduced volatility and greater resilience in down markets vs. global stocks
• Inflation-linked revenues in certain subsectors
• Access to secular opportunities in renewable energy and digital infrastructure

• Strong total return potential
• High inflation sensitivity
• Performance typically moves ahead of economic cycles
• Lead/lag with commodities

Although every investor’s needs are different, Cohen & Steers offers multi-strategy solutions that we believe provide an attractive balance of characteristics for most investors.

A central consideration in our portfolio construction is the inverse relationship often found between risk-adjusted returns and “inflation beta,” a measure of the sensitivity of asset returns to unexpected inflation. (For example, real estate’s historical inflation beta of 2.5 indicates typical outperformance of 2.5% for every 1% that inflation exceeded the prior-year estimate.)

As shown in Exhibit 6, industries and asset classes with higher inflation beta have generally produced a lower Sharpe ratio over the long term, indicated by the downward-sloping regression line.

At December 31, 2021. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers proprietary analysis.
Past performance is no guarantee of future results. 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. 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. Inflation beta is the sensitivity of returns to unexpected inflation. Inflation beta was determined by calculating the multivariate regression beta of 1-year real returns to the difference between the year-over-year realized inflation rate and lagged 1-year-ahead expected inflation, including the level of the lagged expected inflation rate. Expected inflation as measured reflects median inflation expectation from University of Michigan Survey of 1-year-ahead inflation expectations. Realized inflation is measured using the Consumer Price Index (CPI) for all urban consumers, published by the U.S. Department of Labor’s Bureau of Labor Statistics. 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 end notes for index associations, definitions and additional disclosures.

However, by exploiting the diversifying correlations among listed real assets, we believe investors can potentially mitigate much of this cost by targeting an allocation mix that seeks to maximize expected risk-adjusted returns at a given level of inflation beta.

Exhibit 7 illustrates the idea, displaying the central tendency of results from Monte Carlo simulations that begin with historical real assets correlations and volatilities but introduce expected returns as unknown, random variables (bound within a range determined by historical relationships with global equities and Cohen & Steers’ capital markets assumptions). The asset mix at each level of inflation beta represents the combination most likely to deliver the highest Sharpe ratio according to our Monte Carlo analysis.

Investors may favor different types of real assets depending on the desired
inflation sensitivity

At December 31, 2021. Source: Barclays, Bloomberg, Dow Jones, FTSE, S&P, Refinitiv Datastream, Cohen & Steers proprietary analysis.
Results of this analysis may vary. The information generated by the simulation is illustrative in nature and does not reflect actual investment results and is not a guarantee of future results. Sharpe ratio maximizing portfolios based on Cohen & Steers simulations of all underlying real-asset asset classes shown above, using historical returns data from 1978–2021 and Cohen & Steers capital markets assumptions. Inflation beta is the sensitivity of returns to unexpected inflation. Inflation beta was determined by calculating the multivariate regression beta of 1-year real returns to the difference between the year-over-year realized inflation rate and lagged 1-year-ahead expected inflation, including the level of the lagged expected inflation rate. Expected inflation as measured reflects median inflation expectation from University of Michigan survey of 1-year-ahead inflation expectations. Realized inflation is measured using the Consumer Price Index (CPI) for all urban consumers, published by the U.S. Department of Labor’s Bureau of Labor Statistics. 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 end notes for index associations, definitions and additional disclosures.

From this analysis, we can draw several conclusions:

• Investors seeking any amount of inflation sensitivity will likely want to consider an allocation to commodities. Due to their low correlation with other real assets, commodities have also historically reduced overall portfolio volatility.
• Real estate is likely to be a meaningful component in any dedicated real assets allocation due to its attractive balance of expected risk-adjusted return potential and inflation sensitivity.
• Infrastructure and resource equities potentially offer additional attractive diversification benefits, with resource equities favored by investors seeking greater inflation sensitivity.
• Adequate diversification across real assets may enable access to higher levels of inflation sensitivity, with little impact on expected risk-adjusted returns—as well as meaningful volatility reduction—versus less diversified or standalone approaches.

Our analysis to this point has focused primarily on the tradeoffs among the real assets categories across the key dimensions of inflation sensitivity, diversification potential and expected returns. However, investors may need to account for other market sensitivities, depending on their allocation objectives.

In our own portfolios, for example, we generally seek exposure to additional diversifiers (e.g., smaller allocations to gold, short-duration credit and inflation- linked bonds) to help further reduce portfolio risk over time. As always, investor considerations will vary, but most important is the understanding that thoughtful diversification across real assets is likely to deliver improved risk/ reward outcomes, however risk and reward are defined.

As investors consider how to best protect against the risk of higher inflation, history shows that including real assets in a portfolio may provide key benefits, including the potential for:

• Inflation sensitivity when needed
• Attractive risk-adjusted returns over full market cycles
• Added benefits from diversified real assets exposures

Moreover, the repeated and unprecedented disinflation surprises of the 2010s weighed on real assets returns while the broader market surged to ever- higher levels. This has resulted in historically attractive real assets valuations relative to equities, even after the group’s strong returns in 2021 (Exhibit 8).

We believe this combination of potential inflation benefits, diversification and relative value represents a compelling opportunity to realign portfolios to take advantage of what real assets can offer.

At December 31, 2021. 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 Datasteam 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 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.