Inflation vs Stagflation - How do Real Asset Portfolios Differ?
Be wary of economic growth sensitivities in your real asset portfolios if the economic environment were to be stagflationary.
The Great Lockdown recession brought on by the coronavirus pandemic is unique in many ways. While gross domestic product in the US is expected to shrink at an annualized 25% in the second quarter, the demand destruction is not ubiquitous. In fact, demand for groceries, logistics and data has been unprecedented, allowing ‘stay-at-home’ providers to report solid growth.
In March, the global stock markets entered into a bear market with volatility not seen since the global financial crisis (the VIX index spiked to more than 80). Although the US equity market has snapped back sharply from its March lows, investors nevertheless question the virility of the rebound given the global coronavirus pandemic.
In such an environment, which alternative assets can an investor turn to? Institutional investors have been increasing their allocations to real assets, over and above their allocations to real estate. A general misconception about real assets is that it involves investing in physical commodities like oil, which returned -56.5% in March as Saudi Arabia and Russia disagreed on a production cut. In today’s economy, data are more real than oil.
Last year we published "The Diversity of Real Assets" where we discussed how the macroeconomic and market sensitivities of real assets differ, not only at the asset class level but also at the sector level. Accounting for these differences and aligning the choice of real assets and sectors with an investor’s investment objective is necessary.
As an example, many of the goods and services that have been in high demand during the pandemic - the rush for orange juice to build immunity, toilet paper for sanitation, home deliveries while we’re in lockdown, internet to study and work from home, and gold coins for safety - have a common theme: real assets.
Farmland – We showed in our paper that farmland historically has negative sensitivity to growth level and surprise (i.e., countercyclical); a farmland REIT that we track returned 3.6% in March. In commodities, the selloff in grains was -0.6% and in fact, due to low stock and 100-year-low plantation, wheat returned 8.4%. In contrast, corn returned -7.4% with slashed ethanol production. In softs, orange juice returned 25.3%, whereas with worldwide retail store and factory shutdowns cotton returned -16.8%, as prices hit 10-year lows.
Timberland – Generally, the timberland asset class is a growth asset. Exposure to timberland REITs that we track returned -14% on average. However, in our paper we discussed how during the global financial crisis the demand for pulpwood didn’t falter, unlike for sawn wood, due to a drop in demand for housing. Even now, a high demand for toilet paper and packaging also means continued demand for pulpwood timber, providing price support in Q1 2020.
Real Estate – While the brick-and-mortar-heavy retail REIT sector was hit hard (-38.9%), the industrial sector (-7.1%) and warehouses fared relatively well. Shifting consumer buying patterns increased warehousing demand, which also led to a hiring spree for warehouse and delivery workers. Similarly, an increase in internet traffic due to content streaming as result of work/study from home has led to increased demand for data centers (specialty sector, down 2.0%).
Infrastructure – While listed infrastructure had a similar selloff as equities (-14.2%), not all sectors performed as poorly. With increased internet traffic we also saw increased capital expenditure from telecommunication companies. The communication infrastructure sector fared relatively better, returning -3.0%. Water and electricity distribution infrastructure also held up better and returned ~-6%. Due to demand destruction, brownfield sectors which are often perceived safer fared poorly (airports -32.3% and ports -24.6%).
Gold – Gold has a role to play in both stagflation and stagnation environments. We saw in March that while gold’s daily correlation to equity returns may have been positive (i.e., both gold and equity had selloffs on the same day), overall for the month gold returned 1.6%.
Such wide dispersion in real assets and sectors within suggests having a diversified portfolio exposure, and perhaps also having a portfolio that is actively managed.
A Stagnation Protection real asset strategy portfolio is expected to perform in low growth and low inflation economic environment as it combines some of the defensive assets and sectors discussed above. This Stagnation Protection portfolio would have improved outcomes for institutional investors like corporate pension plan sponsors who are mindful of the potential for a surplus shortfall in a stagnation environment.
*Article written for LinkedIn
Sources of Data: Datastream, Dow Jones, Brookfield, London Bullion Market, MSCI and Bloomberg, as of March 2020.