Written by: Stephen Bonnyman | AGF
The inflation and interest rate moves over the past year have induced substantial volatility in global equity markets, forcing the reset of many valuation parameters and influencing market performance and breadth. While interest rates may contract from existing levels, we believe the very low rate environment of the past decade is unlikely to come back anytime soon. Inflation might well be harder to tame than implied by the broader market or by the U.S. Federal Reserve (Fed)’s goals, and inflation protection may be a potential consideration in portfolio construction over the medium term.
This backdrop, coupled with the rising risk of an economic recession, could drive investors to seek opportunities with stable and growing yields, lower volatility earnings and lower correlation to the broader equity market. Real Assets (i.e. Commodities, Real Estate, Infrastructure, Utilities) have traditionally offered all those qualities, and, in many instances, these opportunities are currently available at undemanding valuations.
While often forgotten, Real Assets also form the backbone for most of the thematic developments that dominate the existing news cycle.
Globally, for example, the Utilities sector has suffered some of its worst years of underperformance as rising rates and narrow market breadth pushed investors into fewer sectors and stocks. The global Utilities sector now trades at some of its lowest observed multiples in many years (relative both to itself and to the broader market), even though margins and earnings for the group are improving. The largely capital-intensive Real Asset universe has broadly suffered from a lack of reinvestment funding over the past decade, which has allowed increasing pricing power to incumbent providers and created the potential of new opportunities for greenfield and brownfield investment.
Additionally, Utilities have traditionally outperformed in periods of falling inflation and falling rates (which would lead to the soft landing the market is looking for), and the opportunity for steady earnings, solid balance sheets and stable dividends may be the catalyst for investors to return to the group. In our opinion, a properly structured Real Asset portfolio can provide with the possibility of positive real returns, solid inflation protection, lower recession risk, lower volatility returns and meaningful diversification from the broader equity market.
While often forgotten, Real Assets also form the backbone for most of the thematic developments that dominate the existing news cycle. In the years to come, therefore, we believe they should play a key role in energy pricing and scarcity (Energy and Utilities); the dependence of electric vehicle production on lithium, nickel and other metals (Mining); renewable power and electrification’s need for generation and grid stability (Utilities, cables and towers); the unique power requirements and reliance on data centres of artificial intelligence (Real Estate); the expanding shortage of housing; and the ongoing challenge of food supply and food inflation (Fertilizers, farmland, logistics).
In short, an actively managed allocation to Real Assets may prove critical to investment performance over the next cycle, allowing investors to both participate in emerging trends and protect their portfolios from near-term economic risk.