When faced with inflation, investors will often reach for real assets. From real estate to commodities, these sectors can provide some protection – but some of their attributes can also be deal-breakers.
One real asset category that comes to the mind of many who want an edge against inflation is infrastructure, especially utilities. But that is an error, states David Sekera, Chief U.S. Market Strategist at Morningstar. In fact, “utilities are one of the areas most negatively impacted if inflation persists,” he says, “Over the last 30 years, when inflation rose more than 3%, 2-year forward returns were negative.”
Mostly because of their heavy regulatory environment, “utilities have no pricing power,” Sekera continues, “They have fixed revenue streams, but variable costs and they have a lag of 6 to 18 months before they can catch up with their costs. They have massive infrastructure costs that can take a long time before these can be passed on to consumers.”
Lease Prices Lead the Way
REITs are the ready area where hopes to stay ahead of inflation can materialize. “They can generally keep up with inflation,” Sekera says, “but stick with subsectors that benefit from short leases, like apartments, senior homes, hotels even more. On the other hand, stay away from specialized sectors like cell towers or triple-net lease structures. They are locked in with long-term leases and, even if they have inflation escalator clauses, these are often capped or simply not adequate for the type of inflation we’ve had recently.”
Indeed, our present inflation has come with strong spikes, explains Eric Menzer, Senior Portfolio Manager of the Manulife Real Asset Investment Fund. “Much of the real estate market can’t adjust rents quickly enough,” he notes, “it all comes down to lease lengths and where they are in relation to the market.”
There is one aspect investors must be alert to, Menzer warns: “As inflation goes up and growth slows, there could be a correction in real estate prices.”
Menzer’s fund is one of a handful of funds that give investors direct access to real assets rather than to stocks. It is telling that the original institutional version of the fund was up 8.59% by June 24, before this summer’s rally, Menzer reports,. One key feature of his fund is its low correlation of about .45 to stock and bond markets while performance, he says, is driven by exposure to agriculture and commodities.
Commodity Dynamics
However, farm assets and commodities must be approached carefully. The agro-industry “doesn’t move to the same rhythm of any other economic sector,” points out Seth Goldstein, Equity Strategist on the Energy and Resource Team at Morningstar, “Farm assets are not bad inflation hedges, but not the best either.”
On the farm front, a factor like inflation will have little influence on prices if a key region like South Africa experiences a bumper crop or if Ukraine suffers a supply shock, as it presently does. Fundamentally, Menzer points out, “weather and supply/demand are what drive the prices.”
Mineral and energy commodities can also offer protection from inflation, “but it depends on the valuation of each specific commodity and when you bought it,” warns Sekera. For example, timber is one commodity that Menzer’s fund specializes in, and which has presented tremendous price growth since the pandemic, but “we’ve seen inflation in lumber well before the present rise in the consumer price index,” Menzer notes.
Among mineral assets, lithium presently exhibits stellar growth that has little to do with inflation. “Demand is far outpacing supply each year, Goldstein explains, and that resulted in record prices of US$70,000/ton last year while in mid-2020 they stood at US$7,000. We think demand will continue to grow by 20%, which will see it increase by a factor of five by 2030, and supply will constantly lag.” Key drivers here are battery storage and electric vehicles. Lithium “is one of the best ways to play the long term secular growth of electric vehicles,” Sekera asserts.
But is lithium per se an inflation hedge? Yes, Goldstein answers: “In a normal market, it would be, and in a similar way to other commodities. If supply and demand were balanced, then growth would evolve according to inflation.”
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