Do physical assets offer investors a haven from inflation?
THEIKE PENGUINS and the melting of the ice cap, the natural habitat of investors is changing. Inflation is generally bad news for traditional assets such as stocks and bonds, as it reduces the present value of future profits and coupons. Yet this is where, after a decade of slow growth and sluggish inflation, investors have parked much of their trillions. As consumer prices rise at an uncomfortable rate across much of the world, they are scrambling to protect their portfolios from the changing economic climate.
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A growing cohort places its trust in “real” assets – the physical type, including property, infrastructure and farmland. Could these prove to be a haven of peace in times of change? Investors certainly have good reason to view them as safe places to roost. Inflation often coincides with rising prices for these assets. Economic expansion tends to fuel growth in consumer prices as well as demand for floor space and transport or energy infrastructure.
In addition, these assets produce cash flows that generally follow inflation. Many real estate leases are adjusted annually and linked to price indices. Some – those in hotels or storage spaces, let’s say – get serviced even more often. Income flows from infrastructure assets are also typically linked to inflation, through regulation, concession agreements or long-term contracts. At the same time, the increasing maintenance or energy costs associated with these assets are often either passed on to tenants (for real estate) or fixed over long periods (for infrastructure). And the debts incurred against them – often at fixed rates and in large amounts – become cheaper to repay.
As a result, real assets have performed well during periods of inflation. A recent report from BlackRock, an asset manager, suggests that total returns on private real estate and infrastructure assets around the world exceeded those of major stock and bond indices when inflation exceeded 2.5%. David Lebovitz of JPMorgan Asset Management estimates that a typical pension fund should start by allocating 5-10% of its assets to them, with the share increasing to 15-20% over time. Some big funds are actually bolder: The Ontario Teachers’ Pension Plan, which manages C $ 228 billion ($ 182 billion), wants to increase its allocation from 21% to 30%.
This may all sound very alluring, but it should come with some health warnings. On the one hand, performance has become more difficult to predict: think of commercial surfaces and office buildings (threatened by e-commerce and remote working), airports and power plants (exposed to decarbonization) or still agricultural land (vulnerable to climate change). The asset class may require a greater risk appetite and more homework than its lenders are used to.
Another difficulty is that real assets are difficult to access. They are generally private, which means that only the most sophisticated investors have the resources and patience to find gemstones on their own. The rest could gain exposure in public markets, through real estate investment trusts, infrastructure stocks or exchange traded funds. But these tend to be closely correlated with stocks, making it unnecessary to invest in them. Institutional investors also have access to private funds, but these tend to deploy capital slowly and come at a cost, as their managers typically charge high fees.
In any case, real assets cannot insulate an investor’s entire portfolio against inflation. Their merit is that they retain their own value when inflation is high. But to protect all of their capital, investors need to look for assets that don’t just stand still, but which appreciate more quickly during inflationary surges than their other holdings depreciate. And there isn’t much consensus on which ones are best. Gold, commodities, inflation-indexed bonds, derivatives: each has its champions and its detractors.
Perhaps the greatest danger, however, is that real assets fall victim to their success. Many investors have turned to them already over the past decade as they sought stable returns and sought diversification. Between 2010 and 2020, private real estate assets under management more than doubled, reaching $ 1.8 billion. Finding things to buy is getting harder and harder. Some $ 583 billion raised by the funds since 2013 has yet to be spent. A bubble is possible, says David Jones of Bank of America Merrill Lynch. The definition of a real asset can become stretched. Already, some are pleading for it to include exotic tariffs such as non-fungible tokens, digital media recorded on a blockchain. Much like penguins huddling more and more on a shrinking piece of ice, some investors could find themselves falling into dangerous waters.
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This article appeared in the Finance & Economics section of the print edition under the title “Destruction de l’Habitat”