State Street SPDR ETFs: Strategic Allocation to Real Assets
Despite central bankers’ best efforts and consumers’ wishes, inflation risk is unlikely to go away and stay away, according to State Street SPDR ETFs. This year’s rapid repricing of inflation expectations is a fresh reminder of both the limitations of inflation forecasting and the risks that unanticipated inflation can pose for investors who do not address inflation risk in their long-term, strategic asset allocations.
The asset manager comments:
'Inflation-hedging assets such as commodities and natural resource stocks have strongly outperformed in the first half of 2022, but some investors are now left wondering what role real assets can play going forward if inflation begins to gravitate lower. We strongly believe that, in addition to their inflation-hedging role, real assets exhibit desirable characteristics that support their inclusion as a long-term core component of a diversified and balanced portfolio.
Real assets can be a valuable source of diversification when combined with broad equities and nominal bonds. Many real assets are also income-producing, offering attractive returns when inflation is stable. When expected returns for stocks and bonds are low, real assets can serve as a potential source of total return. And while skilled investors can certainly benefit from tactical decisions to overweight or underweight inflation-sensitive assets to reflect shorter-term inflation expectations, we believe the broad characteristics of this asset class argue for a diversified core strategic allocation that can help meet investors’ risk and return objectives.
Inflation Hedging
Understanding how asset classes perform across different inflation regimes can help investors to build an appropriate hedge into their strategic asset allocation. Figure 1 displays the quarterly returns of US equities and fixed income, a common balanced asset allocation approach, standalone real estate via US Real Estate Investment Trusts (REITs), global infrastructure equities, and a diversified custom real asset composite the comprises commodities, global natural resource and infrastructure equities, US REITs, and US intermediate-term Treasury Inflation Protected Securities (TIPS). Returns are shown for four discrete inflation regimes: inflation, reflation, disinflation and deflation.
As Figure 1 shows, during periods of high and rising inflation real assets have historically demonstrated their most competitive returns relative to both traditional equities and fixed income. In addition, during these inflation regimes a diversified real assets allocation did improve returns relative to a standalone allocation to US REITs, global infrastructures equities, and TIPS.
Early business cycle expansion, which is often characterized by reflation, has historically been supportive for a range of real asset classes and for equities, but has traditionally been more challenging for fixed income assets. Disinflation environments, characterised by inflation declining while remaining above 2% YoY, have favored all asset categories with positive returns to varying degrees.
Periods of low and declining inflation defined here as deflation have historically served as a headwind for real assets. It is also in these inflation regimes that traditional equities and nominal bonds have produced some of their strongest returns and were most likely to outperform real assets. This latter point supports the concept that, while real assets can serve as an insurance policy against some of the more negative inflationary outcomes, this insurance policy may represent an opportunity cost in some of the more favorable environments for broad equities and nominal bonds.
Looking Forward
Fast forward to mid-2022. Those investors who have experienced a year-to-date outperformance of real asset returns over traditional equities and nominal bonds may be wondering if inflation-hedging assets still have a role to play in their portfolio, if and when inflation levels begin to gravitate lower.
A quick reversion to pre-pandemic inflation levels cannot not be assumed – one never knows if and when a “new normal” is being established. Central banks have limited influence on the supply-side constraints that are currently boosting inflation, and questions remain as to whether traditional secular drivers of low inflation (e.g., globalization, technology, and wage stability) may be lastingly altered by the emergence of new thematics such as energy transition, reshoring, and labor shortages. We would therefore argue that a prudent long-term, strategic portfolio positioning should account for a full range of inflation outcomes.
Resiliency
Looking back at Figure 1, we can see that for those quarters of elevated (above 2%) but declining inflation (i.e., disinflation), the Real Asset Composite produced returns that were, on average, roughly equivalent to those of a traditional 60/40 portfolio. And while past performance is certainly not a guarantee of future results, investors might take some comfort in historical examples which demonstrate that declining inflation isn’t necessarily synonymous with negative returns for real assets. In sum, as long as the inflation regime did not dip into deflation territory, maintaining a measure of inflation protection in a balanced portfolio did not materially detract from returns in either the disinflation or reflation regimes during the time frame analyzed.
We can see in Figure 2 that an allocation to a diversified portfolio of real assets (represented by the Real Asset Composite) can also meaningfully enhance a balanced portfolio’s sensitivity to inflation, as measured by the beta to US CPI.'