By Harry Darke, investment manager, Architas
Since 1992, the Bank of England has included an inflation target as one of its monetary policy objectives. This factor highlights the fundamental tension between interest rates and inflation; too much or too little inflation can spark a change interest rate policy to try and influence its future path.
The impact of this relationship on consumer, corporate and government behaviours, supply and demand dynamics and currency fluctuations creates a thought provoking dynamic for real asset investors.
What is a real asset?
Real assets are traditionally defined as physical or tangible investments that have positive sensitivity to price levels in an economy and benefit over time with inflation. We consider the real assets universe to be broader than this traditional definition and includes an array of investments with ‘real’ characteristics including sensitivity to general price levels, contractual links to inflation and inflation sensitivity through linkage to interest rates.
Relationship with real assets
Understanding the relationship between inflation and interest rates is central to creating a portfolio of real asset investments. We believe a sensible approach is to invest based on the macroeconomic environment that you expect, paying close attention to expected rather than current movements of inflation and interest rates.
No single type of real asset will provide positive returns in all environments, meaning a strategy with a structural bias to one or two asset classes may struggle through certain periods.
This argues for an unconstrained approach to real asset investing rather than a benchmark relative approach. With no benchmark the objective becomes creating attractive risk adjusted returns which protect against inflation over the long run.
The real asset paradox
The real asset universe includes a wide range of investments with some valuations driven by supply and demand, some that are a function of discounted cash flows and some with elements of both. Real asset valuations can also be driven by adjustment in the general price level of transactions and contractual inflationary adjustments to cash flows.
With valuations dependent on both interest rates and inflation, the real asset paradox is born: inflation can drive real asset valuations up but also encourage policy makers to raise interest rates, potentially driving real asset valuations down.
How does this affect investing in real assets?
Given inflation and interest rates affect the investments in different ways, we use a framework to assess which assets are attractive and which may become challenged, based on our view of the path of both inflation and interest rates. Holding a blend of different investments and rotating them over the cycle is the best approach to navigate the real asset paradox.
Where are we today?
The current market situation is a legacy of the emergency support that followed the global financial crisis of 2008 – a combination of near-zero target rates and quantitative easing on an unprecedented scale. The subsequent sequence of macroeconomic crises has prevented G4 central banks from embarking on policy rate normalisation.
At the root of central bank inaction is weak growth. Cautious investing and increasingly restrictive regulation of banking and credit provision have constrained many traditional channels of market stimulation.
Bouts of weak inflation, disinflation and deflation have been experienced, driven by excess capacity in labour markets and excess supply in the natural resources sector.
How to position within real assets?
The fragile economic backdrop and sensitivity of central bank reactions to global events means we cannot confidently follow a single real assets investment strategy. Developed market inflation expectations remain low and prices are trending downwards as excess commodity supply comes up against China’s slowing growth profile and reduced demand for resources.
Despite falling unemployment in the US and UK there has not been upward pressure on the cost of labour. Technological progress allows us to do more with less physical goods; this has changed consumer buying behaviour and allowed companies to rely less on the traditional input of workers.
These issues lead us to believe that we are still some way off of high inflation levels, though we may see a small rise in the near future. On the interest rate side our expectation is that we will soon see central bank interest rate rises and, unless global growth increases surprisingly rapidly, we expect rates to follow a gradual upward path.
Despite the real asset paradox – real assets are for all seasons and our current positioning is based on these fundamentals. Right now we don’t believe that the environment is positive for commodities; the will of central banks to move on rates encourages floating rate exposures and cautions against low yielding investments; lower interest rates make high yielding real assets attractive; and disinflationary forces encourage an element of stable fixed rate exposures as a hedge against rate expectation disappointment.
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