Authored by :
Director of Asset Allocation, Stephen Marshall and Gabriel Husain Kennan, Senior Associate – Institutional Consulting Services
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“…a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.” – Janet Yellen
The first consideration when constructing an investment portfolio focuses on the allocation to equity and fixed income – stocks and bonds. There is good reason for this. In its most basic form, asset allocation is a decision on how much of each asset an investor should hold. This broad manner of investing is largely appropriate. A well-diversified portfolio should include assets for growth – equity, and assets to provide stability – bonds.
In this white paper, we illustrate the challenges these two asset classes face in fulfilling their roles of growth and stability in the current macro-economic environment. However, listing challenges without proposing solutions is not particularly helpful. Our thesis then is that real assets – real estate, infrastructure, commodities, and natural resources – are valuable solutions to the challenges posed by the current investment landscape.
Before continuing, it is important to stress that we are not suggesting that thoughtful portfolio construction should not include a significant allocation to both equities and fixed income. Investing is most effective when considered over a long-term horizon. Stocks and bonds certainly will retain their preeminence in any diversified portfolio invested for the long-term. Instead, we are suggesting further diversification into real assets. We believe the current economic environment warrants their inclusion now and for the foreseeable future.
We first address the challenges faced by equities.
The S&P 500 is currently priced at 22.2x projected earnings as of November 10, 2020. Putting that into perspective, the long-term average is 16.1x projected earnings. Equities are trading at 1.4x their long-term average.
Two other observations give us pause concerning equity valuations. First – the S&P 500 has traded at a multiple of 20.6x, which is 1 standard deviation above its long-term average, or higher since mid-April 2020. In past instances, such lofty valuations were only sustained for 10 months on average before a drawdown occurred (Figure 1).
Our second observation is a consideration of earnings as yield. Forward earnings of 25x can be thought of as equivalent to a yield of 4.00%. Comparing that to long-term yields on both aggregate bonds and municipals suggests that equity valuations are indeed stretched in the short-term (Figure 2). Consider further that achieving a “fixed-income-like” yield does not come with the low volatility associated with fixed income assets.
In our view, these metrics suggest that diversification away from traditional equities is prudent.
The argument that fixed income faces a significant battle to retain its role of capital preservation is both straight forward and more nuanced.
It is easy to see that fixed income faces challenges. In response to the pandemic, the Federal Reserve (the Fed) reduced interest rates to the Effective Lower Bound (near zero). The yield on the 10-year Treasury was as low as 0.51% (at the close on August 4, 2020). The market’s expectation for inflation over the next five years (as measured by the difference in yields on nominal versus inflation protected treasuries) plunged to less than .20% in the aftermath of the COVID-19 lockdown and has since recovered to 1.68% (as of November 10, 2020). The market’s expectation for future inflation and recent actual inflation indicate that higher prices will erode the spending power of assets invested conservatively in U.S. treasuries, U.S. municipal bonds, and other safe-haven fixed income investments. This diminishes their ability to preserve wealth. Furthermore, while inflation expectations have increased, they remain below our long-term expectations given recent monetary policy.
However, fixed income portfolios are not invested solely in U.S. treasuries. Qualified (non-taxable) accounts typically include corporate bonds, mortgage backed securities, and other instruments with a spread above the yield on treasuries of similar duration. That extra yield however does not come without risk and are themselves low given the near zero yield on treasuries and a significant recovery in bond spreads, thanks to Fed policy. Yields on municipal bonds held in taxable accounts are similarly depressed.
To understand what to expect from yields going forward, we need to understand how the Fed has responded to macro-economic impulses in the past and how it intends to respond in the future. The Fed has a dual mandate – to promote price stability (currently codified by a 2% inflation rate as measured by Core PCE) and maximum sustainable employment (currently estimated to be a 4.1% unemployment rate, or NAIRU – the non-accelerating inflation rate of unemployment). That requires a bit of a balancing act. When unemployment gets too low, employers must pay higher wages to attract or retain workers. To maintain profit margins, employers then must raise prices to offset the higher labor cost.
Historically, the Fed responded to higher inflation by raising rates when the 2% threshold was breached, thus slowing the economy and reducing inflationary pressure. The 2% inflation target acted as a “trigger” to tighten monetary policy.
A recent statement by Fed officials signals a significant shift in this policy. On August 27th, Chairman Jerome Powell announced the long-awaited shift from a “trigger” function to “average inflation targeting” at the Jackson Hole economic symposium.[1] Under such a policy, the U.S. Central Bank will modify its response to inflationary pressures; rather than raise rates anytime the 2% target is hit, it will allow inflation to remain elevated (and rates to remain low) to instead target an average inflation rate of 2% over an unspecified period.
The arithmetic to calculate the average has not been explicitly defined. In other words, it is unknown how long the Fed will allow inflation to run above the 2% target, nor is it known how high above the 2% target the Fed will allow inflation to run.
Despite not knowing these specifics, we can expect the policy of average inflation targeting to result in lower rates and higher inflation for some time. Average inflation for the past year was 1.5%. For the past three years, it was 1.73%. For the past five years, 1.66%. Consider this: we should only expect the Fed to raise rates when both full employment is achieved and inflation rises above 2%. This criteria has only been met in 10% of the months since 1960 (Figure 3). In fact, the last time inflation was above 2% was in 2012 – inflation was last above 2.5% for two consecutive months in 1993.
The Fed has had a difficult time achieving its dual mandate. In particular, it has not been able to create an “inflation cushion” by encouraging realized inflation of 2% with any degree of consistency in the past fifteen years, for a variety of reasons: globalization, debt crisis overhang, lower GDP growth versus potential in the U.S. due to demographic factors, etc. It is the inability to generate 2% inflation with the existing reaction function (“trigger”) that prompted the change in policy (“Average Inflation Targeting”). This shift in the reaction function makes it much more likely that the Fed will achieve realized inflation higher than 2% in the future.
So far so good. But combining low nominal (observable) yields and higher inflation leads to negative real yields. The implication of negative real yields is clear – current “safe” yields – including U.S. treasuries and higher quality municipal bonds – provide a yield that does not match increases in the general level of prices of goods. This is “purchasing power destructive.” Investments that do not keep pace with inflation provide less purchasing power in the future. It is this relatively rare phenomenon that drives our thesis related to real assets.
Our preliminary conclusion? Stretched equity valuations and historically low nominal yields on fixed income investments, coupled with the Fed’s new inflation reaction function, argue for some diversification away from financial assets (stocks and bonds) and into real assets.
Real assets are physical assets that carry an intrinsic value due to their physical nature and properties. Real assets include precious metals, commodities, real estate, infrastructure, and natural resources. The value of real assets derives from their connection to a physical asset, and they often act as a better store of value than financial assets in periods of rising prices. While it is possible for individual stocks and bonds to go to zero in terms of value, real assets can – in many cases – retain some value due to their physical nature. The intrinsic value of these assets may also increase due to higher utilization, increased demand, or scarcity of supply, depending on the real asset under analysis. Real assets have a tangible form, as opposed to financial assets that derive their value from a contractual right (bonds) or an ownership claim (stocks).
What are the benefits to clients? Real assets have historically demonstrated an ability to hedge inflation and offer stronger returns during periods when inflation is rising. Inflation typically increases as economic activity accelerates and bottlenecks in the production of goods and services arise. The increased demand for goods and building activity that results in periods of high economic activity produce a corresponding increase in demand for the inputs used to make and transport those goods – prices rise. In addition, many real estate and infrastructure assets have inflation provisions built into their leases and contracts, giving them a direct link to consumer prices (CPI). In addition, it is important to pay attention to the difference between expected inflation and the inflation that occurs. This result, the inflation surprise, often has a larger effect on the returns of real and nominal financial assets than inflation on its own. Let us dig a little deeper into the various sub-assets within the broad Real Asset category.
Commodities and natural resources are basic, interchangeable goods that are often used as raw material inputs of other goods or services. The feature that separates these from other goods is that their quality has little variance between multiple producers. While an automobile may have vastly different quality coming from one manufacturer to another, a barrel of oil is virtually the same regardless of the producer. Commodities and natural resources can include the following:
- Agricultural products – grains, fruits, etc.
- Livestock – beef, pork, etc.
- Fossil Fuels – oil, coal, natural gas
- Precious metals, minerals, and elements – gold, silver, lithium, copper
Commodities often have costs associated with transportation and storage, although financial instruments such as futures contracts and products like ETFs can minimize investors’ exposure to these costs while providing exposure to the price returns of the asset. Commodities do not generate income, and their value fluctuates based on changing supply and demand dynamics. Investors’ return on commodities is generally driven by price appreciation. Many commodities see a boost in demand during periods of inflation due to their connection to overall economic activity.
Real estate is another widely used real asset. Real estate properties benefit from price appreciation due to increased demand or limited supply but have the additional benefit to investors of providing income. Whether residential or commercial, real estate properties provide income through rent payments to their owners. In contrast to many fixed income investments, real estate income often increases with inflation as leases commonly include an escalation clause – a provision that allows the owner of the property to increase rent in line with inflation.
Infrastructure is another real asset category that consists of systems that form the structure of the economy. These systems include transportation, utilities systems, and communication networks. While most infrastructure projects are publicly funded and run, the increasing cost of these projects has created opportunity for outside private investment. In addition, smaller scale infrastructure assets such as oil pipelines and cell towers are often entirely privately owned and operated.
Infrastructure assets are generally considered to be more stable and defensive than real estate and other real assets, with most of their return coming from income. The income generated from these investments often benefits from increasing inflation for two reasons:
- Inflation often signals higher economic activity, which leads to greater use of infrastructure assets which creates more income.
- Infrastructure contracts, like real estate leases, often have provisions built in whereby fee increases may be marked to inflation increases.
Conclusion
Real assets – real estate, infrastructure, commodities, and natural resources – are valuable solutions to the challenges posed by the current investment landscape.
Relatively high valuations in equities and historically low yields on fixed income create challenges for a portfolio that starts with a traditional 60/40 asset allocation mix. Specifically, the ability of fixed income securities to properly hedge risk assets is reduced (but not eliminated) at very low yield levels. In addition, we believe there has been a secular shift in future inflation due to the Fed’s updated reaction function – from “trigger” to “Average.” Equity risk premiums are reduced, real yields on fixed income securities are negative – the combination of these long-term drivers of asset price returns argue for some diversification away from financial assets (stocks and bonds) and into real assets.
Important Disclosure: This content is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. An investor should consult with their financial professional before making any investment decisions.
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[1] Powell, Jay (2020), ‘New Economic Challenges and the Fed’s Monetary Policy Review’, at “Navigating the Decade Ahead: Implications for Monetary Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming (via webcast), August 27, 2020
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