Inflation will be closely watched by asset owners going into 2022, and even if stagflation was to hit the market, investors see diversified real assets across the globe as the best solution to ride through inflationary pressures. These assets will not be an all-round salve, but they are expected to help blunt the impact.
“It’s not as if your tilt into real assets is going to turn a stagflation-scenario negative portfolio into positive, but it's going to mitigate [some of the negative],” said Matthew Peter, Queensland Investment Corporation (QIC)’s chief economist. “And it's going to mitigate by about five percentage points over a five-year horizon,” Peter told AsianInvestor, stressing that even a traditional 60-40 equity and bond portfolio would mitigate such risks if it was slightly tilted towards real assets.
Overall, QIC is looking for a 9 to 11% return in its infrastructure portfolio, and a 5 to 9% return in real estate investments, depending on asset type.
As the world recovers from the pandemic, inflation, or even stagflation, has become the market’s general concern. In the United States, the inflation rate has hit 6.2%, the highest in more than three decades.
“The view that inflation was transitory has been challenged. And there are now reasons to believe that some of the inflationary pressures that we're seeing are more structural,” said BlackRock’s Belinda Boa, head of active investments for Asia Pacific (Apac) and chief investment officer of emerging markets equities.
"Economic decoupling comes with higher costs. So does the massive move through sustainability. Wage inflation is more structural. So central bank normalisation is going to remain a key market focus over the next six to 12 months," Boa said during BlackRock's 2022 outlook webinar.
THE WAY OUT
Meanwhile, QIC sets out four scenarios for the direction the global economy could be headed: Goldilocks, or transitory inflation; stagnation; benign inflation overshoot; and stagflation, according to its report published on November 25. In any given scenario, it finds real asset investment as the key strategy.
Three factors should be taken into account when investors look for hedging assets during an inflationary environment, QIC’s Peter said.
Firstly, they should be assets whose cash flows are tightly linked to movements in the consumer price index (CPI), such as retail real estate like shopping malls with strong track records, he noted.
Major regional shopping malls in Australia have been an important part of QIC’s core strategy in the real estate space. Their sales revenues have contributed decent returns for QIC in recent times. In the core plus strategy, the sovereign wealth fund also has neighbourhood centres with an anchor to supermarkets.
“We would have a differential in the expected return between those types of assets. The lower the volatility, obviously the tradeoff is a lower expected return, but it gives ballast to the portfolio, which we can juice up in terms of return by the non-core,” Peter said.
“The second idea is that you want assets that are going to protect against stagflation where you get growth falling. You want assets that have a low correlation to economic activities, that don't have the ups and downs,” he continued.
This includes infrastructure investment in utilities, toll roads, ports, social infrastructure such as elderly care homes, and public healthcare centres.
Peter stressed that it’s important to have a diversified portfolio in real assets through careful consideration of their theme, rating, and valuation, rather than simply sourcing assets based on where they are located.
The final idea is to invest in assets that can de-risk the capital structure through a fixed-rate debt or through interest rate hedging.
Natural resources such as agriculture also have a long history of outperforming in inflationary periods, Peter added, noting Australia’s rich natural resources can become a good hedge for investors.
QIC managed $69 billion in assets by the end of June, with 31% in global infrastructure and 18% in real estate. Being a state-owned investment manager, the majority of its assets are entrusted by the Queensland government, and the remaining assets are from other Australian super funds and overseas asset owners, including North Asia, Singapore, Europe, and North America.
NO PERFECT HEDGE
Similarly, Korea’s $15 billion Public Officials Benefit Association (Poba) also sees its alternatives-heavy portfolio as resilient under rising inflationary pressure.
“Comparatively, I think we are more prepared for higher inflation than asset owners who have quite a large exposure in traditional asset classes,” said chief investment officer Jang Dong-hun.
Poba invests 58% of its assets into the private market, with a majority in Korea, Europe, and North America. This includes more than 10% of fixed income-type assets such as private debt, infrastructure debt, real estate debt, and structured notes.
“When there’s an interest rate hike, we can pass some of it on to customers or tenants, so the impact to our portfolio is manageable,” Jang told AsianInvestor, noting that he thinks there is still room for current inflation levels to increase.
“However, if inflation goes up very rapidly — depending on its speed, as well as how fast the Federal Reserve raises rates — and the US 10-year Treasury yield hits 4% or 5% levels, higher than rent or usage fee hikes, then I think negative impact, especially to fixed income-type assets, will be unavoidable,” he said.
The US 10-year Treasury yield stood at 1.5% this week. It was above 4% before the financial crisis in 2008.
“We continued to try to have more exposure in real assets and more adjustable-rate products. However, inflation is inflation. Under a higher inflation environment, there is no perfect hedge, and negative impact is unavoidable,” Jang stressed.