Diversifying with Real Assets

Asset classes behave differently during times of inflation.  Diversification is an important tool investors can use to balance their portfolios, but what does that mean?  How do real assets fit in? 


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Transcript

Diversifying with Real Assets
Season 1: Episode 11

Welcome to the Real Spiel with Ryan and Kurt.  This is Ryan Katz with USCF Investments. And Kurt Nelson with Summer Haven. 

 KATZ:  Let’s get real about various asset classes in inflationary regimes.  Maybe we need to start with a recap Kurt.  What do we know about various assets classes from stocks, bonds, commodities and how their performance varies during inflationary regimes? 

 NELSON:  Sure.  This is topical and something we are all facing, for some investors perhaps in a surprising way with this steep rise in inflation.  Over the last couple of years portfolios have tended to be pretty lite on real assets and inflation-sensitive assets because inflation was pretty anemic during the 2010’s.  But we can look at history and we can see going back to for example 1970 which would include that steep inflation period during the 70’s when energy prices were really high.  We saw inflation really high and eventually the Fed had to reign that in with very steep rate hikes from chairman Volcker.  So, we think about this, not about a nominal level of inflation, we just think about the rate of change inflation.  I think that’s what really an inflation shock is.  If inflation goes from six to four percent, that’s a disinflationary shock.  If inflation on the other hand goes from two to four percent, that’s a positive inflation shock.  Looking over the last fifty years, we can look at traditional assets like stocks and bonds, they make up most of investors’ portfolios.   But we can also separately break out diversified commodities and see how they perform.  If you were paying attention during the 2010’s, you know that stocks had just a meteoric rise, one of the best runs for 13 years during that huge expansion.  And we know that bears out in the long-term data.  That when inflation is falling, stocks do extremely well.  On a risk premium basis, above the risk-free rate U.S. stocks can earn north of 12% a year historically.  That was about half the time the last fifty years when inflation was falling and that was a great backdrop for equities.  Non-U.S. stocks do as well at almost 9% a year. Not surprisingly bonds do well.  If you think about bonds, they tend to have yields and interest rates that fall as inflation goes lower and lower.  And we saw that with the very, very low interest rates partly imposed by the Fed and the central bankers around the world. And so, when interest rates are declining and yields are declining, you tend to make capital returns, price returns on your bonds and so long-term bonds in the U.S. are almost comparable to non-U.S. stocks – about 8% per year, over the last fifty years when inflation is falling.  Commodities have almost zero return.  It’s just a paltry 0.5% so they have very little return capture. And we saw that last decade.  We saw weak performance for commodities over the 2010’s and extraordinary performance in traditional financial assets like stocks and bonds. So, let’s move to the flipside.  What happens when inflation rises.  So, we are not talking about inflation at 6, 8, 10 percent.  All you need is to have a year over year change where inflation went up.  Even from a low base.  Interestingly, that happened about half the time in the last fifty years.  The performance differences couldn’t be more stark.  U.S. equities and non-U.S. equities fall in performance to only 3% above the risk-free rate, so a fraction of the return capture when inflation is falling.  Bonds also do very poorly because usually when we have rising inflation as we know the Fed is doing and you have rising interest rates, that tends to put pressure on bond returns.  So, long-term bonds go from an 8% return to just over one.  Commodities on the other hand, almost 14 percent – 13.8.  So clearly there is a macroeconomic diversification that commodities behave very differently in positive inflation shocks than traditional assets like stocks and bonds.  So, I think that’s really their time to shine.  And if you look at performance this year, it’s still early, but year to date, commodities by any measure are up quite a bit and equities are really challenged this year.  Whether its Nasdaq or the S&P 500 or foreign stocks.  

 KATZ:  Then in line with that we’ve seen inflation at pretty high levels above 8% the past couple of months, I don’t think it’s even debatable that inflation is transitory.  Over 8% is pretty significant especially as recent investment history has shown us.  But maybe we can talk a little bit about real assets, most would consider real assets as a great inflation hedge but there is a lot of different asset classes within real assets alone.  From diversified commodities to commodity equities to real estate.  Maybe you can talk a little bit about the various underlying asset classes under the umbrella of real assets.    

 NELSON:  Sure.  And in fact, we did some data analysis to try to contrast and compare these for our own research because we were curious ourselves.  How do assets like real estate or diversified TIPS and inflation-protected bond portfolios behave relative to things like commodity equities or energy equities or our bread and butter which is diversified commodities.  As you would expect, things like commodity equities, energy equities, commodities themselves do quite well when inflation is rising.  Interestingly, real estate doesn’t seem to do as well – has weaker performance when inflation is rising.  Even though real estate tends to be real property and you think there might be a real hedge there, as prices are going higher, the reality is that interest rates going higher tends to damage access to financing.  It causes the cost of the debt burden to be higher.  We know that from mortgages going up.  People are expecting that housing prices may soften a bit because mortgages are so incredibly expensive now versus what they were a year ago.  So real estate prices are still really high right now but higher and higher inflation and higher and higher interest rates which usually co-appear, tend to be a head wind actually to real estate.  TIPS are interesting. I think the biggest issue is that they are adjusted by CPI which moves around month to month, year to year, and you get an adjustment to your return in that government bond.  However, usually when inflation is rising and CPI is going up, you are dealing with very high interest rates as well.  And higher interest rates in a long term 5- or 10-year TIPS bond is going to have a reverse effect to the compounding yield that you get from the CPI adjustment.  So, TIPS if you hold them until maturity will just cover you for inflation but the ride could be rocky as the long duration to a lot of these portfolios gets negatively affected by higher interest rates.  Moving to the other kind of traditional real assets that we think of – commodity equities, energy equities, and commodities, we find that they all do better when inflation is higher.  I think commodity equities and energy equities do not perform as well. They kind of are in the long-run kind of 4-5% behind commodities themselves during these high inflation shock periods.  And I think it’s because they are both companies as well as having an inflation beta through their commodity industry.  So, equities we know don’t tend to do as well when inflation is rising.  The fact that these are operating companies with shareholders and higher input costs, higher labor costs when inflation is high tend to be a headwind and we find that among the various real assets we have looked at, actual diversified commodities do the best when inflation is rising.

 KATZ:  Yes, and also important to point out that commodity equities often times hedge out their direct commodities price risk through the futures market as well.  One other asset class that we haven’t touched on and I think would make sense to bring up would be gold. You have seen this massive run up where the last couple of years in commodities equities have suffered somewhat and gold has really been range bound.  

Why is that and why do people kind of feel like gold is also a great inflation hedge.  

 NELSON:  So, gold is really good as a store of value.  It’s been used that way for centuries or thousands of years.  There’s an old saying that 300 years ago an ounce of gold would buy you a nice wool suit and dinner and a pair of leather shoes and that’s kind of true today.  Gold is maybe around $1,800 an ounce and depending on where you buy your suit and where you go to dinner and where you buy your shoes is probably about the same.  It doesn’t have a risk premium in the way that other productive commodities do because we don’t consume gold.  We extract it, refine it and store it but it doesn’t get consumed.  It gets stored in a vault and used as an alternate currency typically.  Because of that it doesn’t generate any yield on its own when you hold physical gold in a vault.  Now when interest rates are really low there really isn’t any opportunity cost.  Because if you had a checking account or savings account or short-term bond portfolio or money market instrument you are not really earning that much interest.  But when rates go higher, I think there is a tail wind to gold through the impact of inflation and inflation beta but there’s a head wind because higher interest rates and higher return on cash is an opportunity cost for a gold investor.  So, I think it creates volatility and noise but it’s not a direct drive transmission of higher inflation in the way that commodities that are consumed whether they are industrial metals, agriculture, energy products, even in the precious metal space – platinum, palladium, silver are largely industrial.  They are not really a primary store of value or wealth like gold is.  They are pretty unique that way.  That said, gold is a great risk off asset that investors have used traditionally when there are periods of steep significant financial distress.  If we start to see cracks in the equity market, in the crypto market and other assets that have appreciated a lot, I would not be surprised for investors to turn back to gold because it’s been that kind of steady store of value for investors around the world for a long time.   

 KATZ:  Absolutely.  And I think one of the most important things and most important tools that investors have is diversification so not only across equities and fixed  income portfolios but also within real assets as well.  

 This has been the Real Spiel with Ryan and Kurt.  We will talk to you soon.