Inflation and Real Assets – PruFund spotlight article
The M&G Treasury and Investment Office (T&IO) Long Term Investment Strategy team continue to expect inflation to be contained over the long-term but acknowledge that the shorter term risks of inflation have increased. 2020 was a very challenging year for some of the key assets within portfolios, particularly property which has taken slightly longer to recover than your listed, more liquid assets. However, with the spectre of higher inflation potentially looming it is worth reminding ourselves of the strengths of these key real assets and why they can help protect portfolios if inflation does nudge slightly higher.
Why is everyone talking about inflation?
The pandemic and subsequent recovery is causing the price of some goods to skyrocket. In the US, inflation1 was 5.0% year on year in May. In the UK, inflation rose from 1.5% year on year in April to 2.1% in May. Rising prices have been accompanied by an increased interest in inflation; Google trends show searches2 for inflation are the highest for over the decade.
1 As measured by the consumer price index (CPI). All instances of inflation will refer to CPI data, unless otherwise specified.
2 Search interest is the term Google uses for the relative popularity of searches. Each data point is divided by the total searches of the geography and time range it represents to compare relative popularity. Otherwise, places with the most search volume would always be ranked highest. https://support.google.com/trends/answer/4365533?hl=en&ref_topic=6248052
Why is there higher Inflation?
There are several reasons inflation may rise in the short term. Firstly, the enormous swings in economic activity during the pandemic have increased the volatility of commodity prices, for example, the fall and rise in oil prices is feeding through to higher inflation. Secondly, there are also numerous instances of shortages, for example microprocessors, used in everything from smartphones to cars. These disruptions are causing the current high inflation in the US and are likely to cause higher inflation in other regions.
Many market participants are concerned that the scale of government spending in response to the crisis will lead to an inflationary spiral. This is particularly true amongst US investors, where President Biden has implemented an enormous stimulus package. They fear government spending will push demand above the level of supply in the economy and cause prices to rise.
Does this mean much higher inflation in future?
The most likely answer appears to be “not necessarily”. The short-term, sector-specific price increases caused by the pandemic should eventually resolve themselves, as supply chains adjust. It is possible in some scenarios, but not the base case that the current government spending will lead to high inflation. Although difficult to measure, the pandemic has increased the amount of spare capacity in labour markets. This will likely slow the pace of inflation in future. Furthermore, government spending outside the US is not quite as large. As such we expect inflation to return closer to central bank targets, once the pandemic disruption has faded.
However, predicting inflation is challenging and we also need to acknowledge the different possible connotations, which we analyse via a range of different scenarios and their probabilities. We expect the most likely outcome in a few years is inflation closer to central bank targets. However, the probability of a prolonged period of higher inflation is the highest it has been for a decade. For this reason, we continue to invest in a well-diversified allocation to “real assets”, which should perform well across a range of scenarios, and also protect for inflation.
What are real assets and why do we desire them?
Strictly speaking, a real asset is a physical asset like a commodity, a property or infrastructure. However, when we think about inflation and its impact on different asset classes, we prefer to use a broader definition. That means we might include bonds with inflation-linked cash flows or funds that hold physical assets, which others might not. We do this as the returns to these investments are closely linked to the underlying physical assets and importantly provide some shelter against persistent inflation.
In addition to providing attractive risk-adjusted returns and diversification, real assets can also perform better in periods of higher inflation. Our customers care about the future purchasing power of their investments. If our assets have nominal returns below inflation the purchasing power of our customers’ savings will decline. So being able to provide good returns in inflationary periods is important. Therefore, assets that can protect against periods of higher inflation are valuable additions to a portfolio. No asset can perfectly hedge away inflation risk. However, assets with cash flows that have greater links to inflation and the real economy should be able to provide a greater level of inflation protection.
What characterises a good ‘real asset’?
To measure an asset’s usefulness in hedging inflation we look at three key factors:
1. Sensitivity to inflation
Sensitivity is measured by observing the “inflation beta” of an asset class. An asset’s inflation beta measures the change in the asset’s return, relative to the change in inflation. The higher an asset’s inflation beta, the more its return changes when inflation changes. We prefer inflation betas to correlations: an asset class that is highly correlated with inflation but only sees a small increase in return for a large increase in inflation is not a good hedge.
2. Stability of hedge inflation
This measure tells us how consistently an asset class beats inflation over time. Holding an asset with a high inflation beta but a poor inflation hedging stability is not helpful. We estimate stability by calculating how often an asset generates real returns while inflation is rising.
3. Added costs/benefits
An asset class that aims to purely protect against rising inflation, such as TIPS, would generally come with an opportunity cost. This is because expected returns of other asset classes with a similar level of volatility will likely be higher. Therefore, minimizing this cost is a sensible approach. We prefer asset classes, such as real estate or infrastructure, that come with some added benefits, in the form of an illiquidity or origination premium.
Inflation hedging characteristics of individual asset classes?
Infrastructure assets often have the benefit of long-term inflation linked cashflows and possibly capital appreciation. In addition, these assets can offer an illiquidity or origination premium and are usually less correlated to other asset classes, such as equities. However, each infrastructure asset is unique and needs to be looked at individually which is where the skills of our internal team M&G Alternatives team comes in. Examples of sectors invested in within PruFund portfolios include Energy (power, transmission, storage), Transport & Logistics (ports, rail, roads, freight), Water and Waste (water treatment, recycling), Telecoms (fibre, data-centres) and Social (hospitals, schools, prisons).
Real estate assets benefit from a stable source of contractual income, currently offering an attractive real yield. Historically, through normal economic cycles, property has been effective in hedging inflation caused by economic activity. In some cases, rental income can be linked to inflation through annual uplifts in rent. It is again not a homogenous asset class. Studies show that across sectors, residential properties provide the best inflation hedge compared to office and industrial. The PruFund range of funds have some exposure to residential property through the M&G Residential Property Fund and are aiming to gradually increase this exposure.
Equities (including REITS) generally provide a poor short-term inflation hedge since many businesses are not able to fully pass on higher input cost to their customers. However, over the long-term equities historically produce positive real returns.
Commodities as asset class varies across energy, metal and agriculture. Therefore, individual commodities do not have a homogenous level of risk/return or inflation hedging properties. They generally have a strong inflation sensitivity over the short-term, which tend to diminish over the long-term due to higher real rates leading to higher carrying costs of inventories3. Technological improvement also adds to the negative real returns over longer periods as the cost of commodity production is driven down. Due to the low real returns and high volatility, PruFund Funds do not hold commodities.
Treasury Inflation-Protected Securities (TIPS) is expected to perfectly pass through inflation. However, the level of inflation hedge is not always consistent over all time horizons. Historically when inflation consistently surprised on the upside, interest rate increases were less than the increase in inflation. This resulted in a partial inflation hedge. While TIPs may provide some inflation protection, holding them can lead to performance drag as real yields are currently negative. As a result, PruFund Funds do not hold TIPS at SAA level.
Nominal fixed income offers the worst inflation hedge. Fixed rate bonds fall in value as inflation expectations and discount rates rise. If an investor holds the bond to maturity, there are no nominal losses but the purchasing power of the bond’s cashflows will have fallen.
What does it mean for our portfolios?
A key element of the 2021 and prior strategic asset allocation (SAA) reviews was to assess each asset classes sensitivity to inflation, focusing on the medium to longer-term inflation hedging characteristics. In particular, tangible real assets such as infrastructure, real estate, and private high yield benefit from long-term inflation-linked cashflows, accompanied by possible capital appreciation. However, each has different elements of inflation hedging characteristics. Thus, we maintain exposure to a large and diverse basket of real assets much of which generates additional returns via risk, illiquidity or origination premia, in addition to their real cashflows, rather than simply favouring an asset class the hedges inflation well, but at the cost of a weaker return (e.g. TIPS).
The overall exposure to real assets in PruFund Growth (depicted by the broad yellow-green spectrum) has always been a real differentiator compared to many other funds with a similar risk appetite (as illustrated by the charts below). It is however important to note that depending on which Prudential multi-asset fund you look at, the possible benefits from holding real assets will be vary.
Source: T&IO, June 2021. Data for PruFund Growth is from the Long Term Investment Strategy, T&IO and data for the IA Mixed 20-60 sector is taken from FE Analytics using the top 20 funds by AUM (as at June 2020) as a representative sample of the sector. Please note that the IA Mixed 20-60 sector is made up of collective funds but we have used this sector in order to capture the comparison of funds with a similar equity exposure to PruFund Growth
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