The potential benefits that real assets bring to institutional portfolios are as wide-ranging as the asset class itself.
As prices surge, fears around the revival of inflation continue to grow. Whether the current pick-up in inflation proves to be transitory or increases further and becomes persistent, institutional investors will need to assess their current asset allocations, and may want to look beyond traditional stocks and bonds to other asset classes that perform well in various inflationary environments.
In this on-demand webinar, Inflation and Real Assets Investing, PGIM experts discuss findings from QMA’s research Is Inflation About to Revive?: Real Assets Can Insulate Your Portfolio and share insights from the PGIM Institutional Advisory & Solutions (IAS) group's Real Assets Research Program to evaluate how real assets can serve as a hedge against inflation.
During the webinar, we also share:
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>> Hello, I'm Bruce Phelps, head of PGIM's Institutional Advisory and Solutions Group. It is my pleasure to introduce our fifth IAS Real Assets webinar. We launched this webinar series a year and a half ago. And since then, institutional investor interest in real assets has steadily increased. In fact, the most common inquiry we receive at IAS today regards real assets in portfolio construction. Today, my IAS colleague Hirsch Parikh and I are joined by two distinguished PGIM QMA colleagues. Dr. Yesim Tokat-Acikel and Mr. Ed Campbell. You will recognize them from earlier IAS QMA Real Asset webinars. We are delighted to be together with them again. Yesim is managing director and portfolio manager for QMA, working within the Global Multi-Asset Solutions Team. Yesim is portfolio manager for QMA's Commodity Strategies Fund, which aims to generate returns in excess of the Bloomberg Commodities Index. Ed Campbell is managing director and portfolio manager for QMA, working within the Global Multi-Asset Solutions Team. Ed is also portfolio manager for QMA's Real Assets Fund. As a director of dynamic asset allocation, Ed is responsible for portfolio management, analysis, and economic and market valuation research. In other words, we have two of the world's most experienced real asset managers with us today. What brings us together is Ed and Yesim's recent QMA research report titled Is Inflation About to Revise?. Not surprisingly, this report has received much attention, since all investors, including myself, are asking themselves this very question. As you will soon hear, Yesim and Ed have a reasonable inflation forecast of about 2.3% a year over the next 10 years. However, what Ed and Yesim wish to emphasize is that inflation risks are clearly skewed to the upside. To manage this risk, Yesim and Ed demonstrate that investors might benefit with an allocation to real assets. As multi-asset portfolio managers, Yesim and Ed are in a unique position to offer pragmatic insights into how CIOs might protect their portfolios if inflation proves to be higher and more persistent than currently expected. But before hearing from Yesim and Ed, we will first hear from Dr. Hirsh Parikh, head of the IAS Real Assets Research Program. Hirsh has done extensive research on the diversity of real assets, both in terms of performance and in terms of their sensitivities to inflation and economic growth. As a result of this research, Hirsh has identified the four elements of successful real-asset investing. So let's get started. Hirsh, what do you mean by the diversity of real assets, and can you clue us in on the four elements of successful real-asset investing?
>> Yeah. Thank you, Bruce. Let me first recap 2021 performance. 2021 year-to-date performance is like night and day from 2020. In 2020, due to the pandemic, while real assets with lower growth exposure like gold and TIPS outperformed, energy commodities and natural resource with higher inflation or growth exposure underperformed. In 2021, with more than half of the US population [inaudible] and growth outlook as improved. As a result, real assets with higher growth or inflation exposure like energy commodities and core real estate outperformed, and real assets with lower growth exposure like real estate debt and gold underperformed. Not only is the performance varied, but real assets also differ widely in terms of their macroeconomic and market sensitivities. For example, the one year CPI beta for energy commodity implies 22.6% up-move for a 1 percentage point increase in the CPI. Whereas for TIPS, their CPI beta suggests a mere 2% up move for the same 1 percentage point increase. Similarly, the growth beta for core real estate suggest a one standard deviation increase in economic activity may result in a 16% up-move. And in contrast, the growth beta for gold suggests a decline of 15% for the same increase in the economic growth. IAS has developed a portfolio construction framework called RASA, which helps the CIO with thee construction of real-asset portfolios. RASA brings together the four elements for successful real-asset investing. The first element is asset sensitivities to inflation and economic growth. These sensitivities differ widely across real assets and their sectors. CIOs may wish to use these sensitivities to align their real-asset allocations with their investment objectives. The second element of successful real-asset investing is uncertainty. Asset sensitivities are inherently uncertain, so investors may want to account for this uncertainty when constructing portfolios. In other words, a CIO desiring inflation protection would likely prefer assets whose inflation sensitivities are more certain compared to assets whose inflation sensitivities are less certain. The third element is the CIO's investment horizon. An asset sensitivity to inflation and growth differs depending on the horizon. Consequently, a CIO may first wish to determine their investment horizon, and then use [inaudible] to their horizon. Finally, the fourth element of successful real-asset investing recognizes that the sensitivities differ in various economic environments. So instead of taking the entire history to estimate sensitivities, a CIO can better estimate sensitivity in the economic environment of concern to them, like stagflation. On this slide, we help a CIO visualize these four elements of real-asset investing. First, let's find the sensitivities. To the left, the red box and arrow show you the estimated sensitivity to inflation for the Bloomberg Commodity Index. Turning to the second element, the vertical up-down arrow in blue shows you the uncertainty of that sensitivity. If you notice, there are two sensitivity values for commodities that corresponds to one-year and three-year horizon, which are labeled down at the bottom by the green box. On this slide, there are two sets of sensitivities. The chart on the left uses data from all economic environments to estimate sensitivity. Whereas the chart on the right only uses data from stagflation environments, which may be the primary interest of the CIO. These differences in sensitivities -- uncertainty, investment horizon, and economic environments -- have implications for real-assets portfolio construction, as I will show you in the next slide. Here, we show two portfolios that are constructed with very different CIO investment objectives. Suppose a CIO seeks a real-asset portfolio with higher inflation exposure. In other words, a real-asset portfolio that is likely to perform well when inflation is high. With these CIO inputs, RASA generates a high-inflation high-assets portfolio shown to the left. RASA will naturally select assets with high inflation sensitivities, but will penalize allocations to those assets whose inflation betas are less certain. As a result, assets like commodities and natural resource have higher allocations. Whereas farmland and MLPs have lower allocations. Shown on the right is a portfolio with a different investment objective. Here, the CIO wishes to construct a portfolio that may perform well when growth is low. In this case, RASA will select assets with low growth sensitivities. This low-growth portfolio has higher allocations to TIPS, gold, farmland, and real estate debt. This slide shows that RASA generates two very different portfolios depending on investment objectives, again highlighting the diversity in real assets. It is my pleasure to bring in Ed and Yesim into the conversation. Let me start with Ed. Ed, as Bruce mentioned at the [inaudible], you recently published a research report, Is Inflation About To Revive?. Has the inflation outlook just changed from short term that is being more transitory to long term? And is this a [inaudible] when inflation was more supply led? Or is it more like [inaudible] when inflation was more demand led?
>> Thank you, Hirsh. So inflation in the US has exceeded all expectations on the upside this year with the headline CPI running at more than 5% and the core CPI running at more than 4% year over year through July. So we've just experienced a massive spike in inflation in 2021. For core inflation, that's the largest increase we've seen in three decades. But the consensus view and the view that we're hearing from central bankers is that this is a temporary/transitory phenomena and that inflation will likely settle back at pre-COVID rates once all of these temporary factors have dissipated. And that's certainly possible, but we believe that the inflation risks are greater than the consensus view. There are transitory factors at play, no doubt, and we can certainly point to one-off factors and base effects. There are price spikes that are related to supply chain bottlenecks and/or reopening issues that will certainly dissipate with time. And you know, we can point specifically to items like new and used cars, which are currently seeing big price increases. Those will eventually lose steam and even reverse direction. So we agree that inflation is likely to come down from current levels, but it's also possible that price increases stay sticky and take longer to fall back to levels that central banks would be comfortable with and that the consensus is currently expected -- expecting. So I -- you know, I saw an article this week on cnn.com reporting that the global shipping prices -- the global shipping crisis, for example, is getting worse. The cost of moving stuff around the world is still rising rapidly with shortages of ships and containers. And this is expected to impact the holiday season. So some of these supply chain issues could take longer to sort out than is currently expected. We don't think a replay of the '70s is likely. We're not expecting anything of that magnitude. So it's probably more likely the -- like the early budding days of '60s-type inflation. We do see a variety of long-term factors that are shifting that could lead to higher inflation over the longer term. We do think that the four-decade trend in falling inflation that the US has experienced has ended and that inflation is likely to head higher over the next decade. You know, as Bruce mentioned, we're forecasting an inflation rate of -- an average inflation rate of 2.3% over the next 10 years. That's higher than the last decade, which was 1.7%. And while there are risks on both sides of this forecast, we do believe the risks are more skewed to the upside. For example, we mentioned in the paper that the potential for a period of 3 to 4% inflation, we view that as a nontrivial risk for investors. So some of the long-term factors that could push inflation higher are outlined on Slide 6 here, and we covered them in detail in the paper. I'll just run through some of them very quickly. Demographics are shifting. So the sweet spot of dependency ratios is souring around the world. We had been in an environment of falling dependency ratios. Looking forward, we're going to be in a period of rising dependency ratios due to global aging. That simply means we're going to have more consumers relative to workers, and that combination tends to be inflationary. Politics, there are changes afoot that are, you know, creating a more inflationary environment in our view. Worsening inequality has shifted voter preferences to the left on economic matters, and US policy makers are actively seeking to create a high-pressure economy in order to boost wages for workers. Globalization has been a force for disinflation, but globalization is no longer advancing. Thus, it is no longer disinflationary. The climate crisis and the climate spending that we anticipate seeing, massive amounts of green investment required to substantially lower carbon admissions could boost inflation, as businesses are likely to move to -- toward more costly, less efficient processes. Finally, technology in productivity is a mitigating factor. So signs that companies are massively accelerating automation and digitization in response to the pandemic, we think that is something that's likely to exert downward pressure on inflation, and it could mitigate or potentially offset some of the factors we've described above. But in general, we do see long-term forces shifting toward higher inflation. Back to you, Hirsh.
>> Yeah. And what comes to my mind is when you said that inflation may rise, however, despite all the stimulus after the global financial crisis, the expected inflation never materialized. What is different this time?
>> Well, the macroenvironment today is very different from the one following the global financial crisis, for one. And we show here on page seven, fiscal and monitory stimulus are an order of magnitude larger today than they were after the last crisis. So if you look at the chart on the left-hand side, you can see central bank balance sheets. The increase this time around was much larger and more timely on a global basis. And if you look at the chart on the right-hand side, in 2020, the increase in government spending in the United States was the largest on record, even greater than the OBJ Guns and Butter policies that we saw in the late 1960s. So in the current environment, the Fed is explicitly targeting inflation overshoot, and both Chair Powell and Secretary of Treasury Yellen have endorsed the concept of a high-pressure economy, which I talked about before, in order to boost wages. Banks today are very well capitalized, and consumers are not over leveraged this time. In fact, they are flushed with cash from all of the fiscal stimulus So we see less economic sparring this time relatively to last time. Banks are more willing to lend in the current environment, and consumers are more likely to borrow this time around. Post-global financial crisis, the stimulus was aimed at financial stability, while the current stimulus is aimed at meeting social need. Lower income earners have a higher propensity to consume, so these redistributionary policies are likely to be inflationary and are boosting demand. After the global financial crisis, fiscal stimulus -- although we had fiscal stimulus -- was pulled back too soon, in part due to the rise of the Tea Party growing concerns about moral hazard and an emphasis on fiscal austerity. Well, there's no fiscal austerity today. The stimulus is lasting longer this time around due to the political concerns on inequality, and moral hazard is not an issue this time around because the pandemic is a global health crisis. So we see fundamental differences between that period and what we see today.
>> Thanks, Ed. One question I have is about stagflation. We have seen some slowdown, and there is a possibility of stagflation. Could overheating or stagflation be the next debate? What roles should real assets play in an institutional portfolio in next 24 months as Fed officials start thinking of tapering?
>> Well, we've definitely reached peak growth in Q2. And you know, as things are slowing, we've seen a variety of different data points, miss consensus expectations. The City Group Economic Surprise Index, for example, is now in negative territory. Well, we don't think that peak growth will be followed by an ominous slowdown. We think peak growth will be followed by moderation in growth. The delta variant is definitely weighing on things temporarily here, but we still see solid growth rates ahead. So we're not in the stagflation camp. I think it's important to recognize how strong growth is right now with DDP through the second quarter running at about 12 -- running actually more than 12% year on year. So in terms of a role that real assets should play in an institutional portfolio over the next couple of years, traditional stocks and nominal bonds have thrived in the low-inflation period of the last few decades. But with are view that inflation is likely to rise on a longer term basis, and with inflation currently running well above central bank targets on a shorter term basis, we think investors should consider insulating their portfolios with an allocation to real assets. So an allocation to real assets is prudent for two reasons. The first is that real assets are an effective inflation hedge. They're likely to outperform nominal assets such as stocks and bonds in a period of rising inflation levels and upside inflation surprises without sacrificing exposure to economic growth. Second, real assets are an effective diversifier to stocks and bonds. So real assets have done well this year in an environment that you expect them to do well, as -- you know -- Hirsh reviewed up front. I think that could continue looking forward. And as we note in the paper, you don't really need high inflation for real assets to outperform. Some of the tables that we show in the paper show that moving it from a 0 to 2% inflation environment, which we've been in, to a 2 to 3% inflation environment, which we anticipate, you know, historically there's been a big improvement in the performance of a diversified real-assets portfolio relatively to a traditional 60-40. And if we do get into a risk scenario where inflation goes to 3 to 4% for a period of time, real assets tend to outperform a 60-40 in that environment. So certainly real assets represent a tactical opportunity in the current environment. There are not many areas of financial markets today that are currently cheap or even attractively value, but that is the case for certain real assets. You know, certainly in the case of commodities, energy stocks, and material stocks. So we think that real assets are an attractively valued inflation hedge and a good diversifier for institutional portfolios.
>> Thanks, Ed. [inaudible] helpful. Yesim, let me now turn to you. How have the long-term dynamics that Ed described, like demographics and climate spending, impacted your capital market assumption?
>> Thank you, Hirsh. It's a pleasure to be here with you guys. So capital market assumptions underpin the long-term outlook for our strategic allocation in multi-asset portfolios. In constructing these long-term forecasts can start from two principles. One being the asset class fundamentals, as that can be our macroeconomic expectations, some of which I've laid out. So these are discussed by our investment professional within the team, and we review these expectations on a quarterly basis to provide best recommendation to our clients. So let me start from the growth side. On the growth side, we expect economic growth in developed countries to continue to be moderate over the next decade. There are two main reasons for this. The first one is the constrained labor force growth. And this is driven by the local domestic demographics. And second reason is we don't see a significant offset from productivity growth at this point. And the combination is kind of providing a moderate growth outlook in the next decade. And third, a factor that we're considering is climate change and what are its implications for economic growth and inflation, which is a little bit less traditional, I would say. So in terms of climate impact, the physical changes due to climate change and the risks that they bring are a headwind to growth in most countries we look at. But the transition risks that are needed to go to a sustainable economy can play differently, depending on how our governments and the societies react. And they can be actually stimulative if, you know, the spending that's needed is financed by governments, some of which are [inaudible] articulated. Then, moving on to the inflation side, in contrast to growth being moderate and in line with the last couple decades, we expect inflation to be higher in the next decade than what we experienced in the last decade. And again, as mentioned, while we don't expect a significant pickup in long-term inflation -- so our long -- you know, 10-year inflation expectation is still a moderate -- you know, amount of 2.3%, we do think the risks are to the upside on the inflation side. And while we haven't changed our baseline expectation materially at this point, this is definitely a risk we're monitoring as part of our investment process.
>> Thanks, Yesim. So as a CIO, what should I expect from my real-asset allocations going forward?
>> Well, that's a very relevant question. As part of our capital market assumptions coverage, we look at TIPS, commodities, and REITs within the real assets spectrum. And as you've shown earlier, over the business cycle horizon, commodities -- all these assets and Broadway real assets -- have very interesting and desirable inflation-hedging properties. But from a strategic allocation perspective, when we think about the next decade, the questions are a little bit different, and we have to have an approach that makes sense for the horizon we're looking at. So let me just take a step back and give you a little bit a sense of how we're approaching this. So we look at returns in three different components. Income, growth, and valuation. So when I first want to touch on TIPS, you know, [inaudible] actually think about inflation hedging, TIPS are the most hedged inflation by instruction. Unfortunately, the challenge is if you invest in TIPS, there's only that income component of return, and there is really no growth participation. Right? While you are hedging return, you're going -- giving up capital appreciation and growth exposure in your TIPS allocation. In pricing risks in the long term and building return expectations, our finding and assumption is that inflation premium is satiated with TIPS, and the liquidity premium have opposite signs that offset one another. Therefore, you know, nominal and real bonds tend to have the same return expectation, and US TIPS at this point have a bit more longer duration than US treasuries. And therefore, our return expectation is slightly higher for TIPS than nominal treasuries. Then, moving on to REITs. Then for REITs, you also have attractive income, but in addition to that, you have growth. Right? The -- you know, the income of REITs growth with inflation is our baseline assumption, which means that you have these two components of return that add up to something more attractive. Plus, REITs are reasonably fairly priced in our framework, especially compared to equities, which we see have been extended in terms of valuation. Therefore, for the next decade, our expectation is that REITs are kind of comparable to return expectation to equities and provide an attractive opportunity. And finally, I'll turn to commodities. So as you've shown earlier,, commodities have historically provided a good hedge against inflation over shorter periods -- compared to a decade -- over the business cycle, and also against unexpected inflation. However, the question at hand for along-term tenure kind of outlook is what are the more structural linkages between inflation and commodities? And there, our current framework builds it up from interest expectations and the inflation expectations that are linked. Unfortunately, what we're experiencing recently is -- as you know, the linkage between the inflation expectations and interest rate have really derailed. And they have [inaudible]. So we're actually reviewing our methodology here to understand whether we can -- whether we need to tweak it to have a better representation. But given our current methodology, we are expecting low-digit -- you know, returns from commodities. Not as attractive as equities or REITs, but still providing very attractive diversification properties for a portfolio.
>> Yeah. So let's stick with commodities. Now although commodities are a small portion of the CPI basket, they are still very volatile, and thus a large contributor to headline CPI changes. So Yesim, how do commodities matter in inflation debate? Is commodity volatility a noise, or could it be a harbinger of new inflation [inaudible]?
>> Yeah. Well, as you articulated, commodities are a natural hedge to inflation because by construction, they're part of the commodity basket that's used to measure the CPI. Although the weight of commodities have declined in the commodity basket, they are still the most volatile component and tend to be the marginal mover and set expectations. So while, as you've shown, that the commodities response to inflation could depend on the commodity, could depend on the time period, when you look at commodities as a complex, they still provide attractive inflation-hedging properties, especially against unexpected inflation. And over shorter business cycle periods because of the elastic supply and demand and local challenges that you have, some of which I had articulated in part of the discussion around, you know, shorter term issues. So we think that this is here to stay. And as I'd mentioned earlier, for commodities, the last decade was very challenging. Right? Because as you see here in our chart, you know, when the inflation is below 2%, commodities are not a very attractive asset. There have been, you know, a lot of overextension of supply as well. And -- however, when you look at inflation a little bit more moderately in line with our expectations in the 2 to 3% range [inaudible] plus having -- you know, potential inflation on the upside risks as we're seeing in the 3 to 4% range, we think commodities start to look very attractive as a necessary input with elastic supply and demand, especially over shorter term periods. And what we think, they're -- real assets and commodities are providing, specifically to a portfolio, is in kind of our baseline expectation of 2 to 3, you know, 3 to 4%, you're not really giving up much return compared to some of the more traditional assets in your portfolio. But what you're getting is a natural -- I'm going to call it "insurance". Because if the risks materialize and inflation is higher than 4%, which is not our base case but is a possibility, you naturally bought some insurance in your portfolio. And even if, you know, inflation is moderate, you still have [inaudible] and returns comparable to your other nominal assets. And I think that's the value proposition here.
>> So now, Yesim, you manage a commodities portfolio. What changes at the strategy level have you made lately? For me, is it -- my question always is like is it goal or [inaudible]? Or maybe it's not a right question. So you can help me.
>> [laughs] It is a [inaudible] question. So I'd like to just set up the contacts, right? I was just talking about 10 years now. Now I'm going to talk about the couple of months horizon. Right? So depending on the horizon that you're looking at, what matters starts to change, and that's something to be considered. Right? As you mentioned, commodities are a very heterogeneous asset class within [inaudible] and have very significant return dispersion, which makes them very interesting -- attractive for adding value to active management. So in our active commodity strategies, our forecast horizons tend to be shorter, and our views can change quickly based on a number of off factors that we're monitoring for each individual commodity from a bottom-up perspective. So our systematic investment process monitors a number of signals at the individual commodity level. Things like inventories, hedging, adverse speculative demand, curve -- imbedded curve in the commodity futures, contracts, and also things like investor sentiment, as well as the risks that are out there. So these factors are monitored on a daily basis, and depending on these, we change our positioning. That said, we're currently overweight energy, industrial metals, and grains in the portfolio, while we're underweight neutralish [phonetic] precious metals, more underweight, actually [inaudible] and livestock. That said, again, these views can change. However, [inaudible] since 2021 has been a year where we're finding our [inaudible] and our bottom process to be tilting towards on the margin poor growth and poor inflation commodities. In a reasonably consistent way, we control these to make sure our alfa is uncorrelated to somatic betas, that there's a little bit of [inaudible] pro growth and inflations health in that portfolio.
>> Thank you, Yesim. So Hirsh, thanks a lot. You mentioned the four elements of successful investing in real assets. So my question is is this just theory? Or can a CIO practically implement your framework to construct a real-assets portfolio?
>> Bruce, now they can. So we recently worked with PGIM's innovation group and launched RASA Interactive, a web application. Here, I show you the dashboard from the application where CIOs can analyze their real-asset portfolios or conduct [inaudible] analysis to see how their portfolio sensitivities would vary by making allocation changes. They can also use the dashboard for constructing real-asset benchmarks or for pure comparison. On the left pane, we show a CIO's current real-asset portfolio. Being concerned about inflation, suppose the CIO wants to further increase the three-year inflation beta of the portfolio without making any substantial changes to the growth beta. The CIO then modifies the allocations, as shown on the right pane. By allocating from TIPS to farmland, MLPs, and natural resource, this CIO is able to increase the portfolio's inflation beta while keeping the portfolio's growth beta essentially unchanged.
>> So thank you, Hirsh, Thank you, Yesim, and thank you Ed, for an excellent discussion on institutional investing in real assets in today's environment with its concerns about future inflation. For me, the key takeaways of the discussion today are baseline inflation for the next 10 years is likely risen, but not dramatically so. However, and perhaps more importantly, the risk for investors is not this expected increase in inflation, but that inflation may surprise to the upside, perhaps reaching a persistent inflation rate of 4% a year. And third, investors can manage this risk with allocations to real assets. And RASA Interactive can be a useful construction tool for CIOs. On behalf of all of us from PGIM, thank you very much.
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The potential benefits that real assets bring to institutional portfolios are as wide-ranging as the asset class itself.