Kyle Wales, Portfolio Manager at Flagship Asset Management
Investor hopes of inflation easing sufficiently to prompt a central bank pivot have been dashed time and again in the second half of this year. In an environment that looks eerily like the 1970s, REITs are the one asset class that could overcome the shortcomings of asset classes like commodities and gold that did well during the Volcker era.
During the 1970s, a decade best known for its high inflation, Paul Volcker had to increase interest rates to a peak of 20% in 1980 before taming inflation - a period of monetary contraction that has become known as the “Volcker Moment”. That’s significantly higher than the Fed Funds Target Rate, which sits at a mere 3.25% today.
Then, as now, oil played no small part. In the 1970’s, there were actually two separate oil crises. The first of these, in 1973, was caused by OPEC embargoing countries that supported Israel in the Yom Kippur War. The second, in 1979, was caused by the Iranian revolution. Today, Russia’s invasion of Ukraine caused supply disruptions in key commodities including natural gas and oil.
As we head towards a new year that is expected to have its fair share of headwinds, the burning question facing investors is: Where can they take refuge in a high inflation environment? Interestingly, if past experience is anything to go on, the answer is not equities.
The chart below, which references US assets, shows the annual returns that various asset classes have delivered during those periods where inflation exceeded 5%.
Source: Bernstein
Even though neither equities nor bonds performed well, bonds actually outperformed equities during these periods. The reason for this was twofold. Firstly, very high rates of inflation are often accompanied by low economic growth rates (hence the term “stagflation”). Secondly, equities are longer-duration assets than most fixed income assets so equity valuations suffer as the result of a higher discount rate being applied to the stream of future cashflows to which equity holders are entitled.
Historically, the best places to be invested during that period were oil, which, as then and now, is most often the driving factor behind higher inflation, followed by a broader commodities index. Gold follows in third place and real estate investment trusts (REIT)s in fourth.
How likely are asset class returns today likely to mirror those in the Volcker era?
Both commodities (whether oil or a broader index) and gold have very significant shortcomings, which may be hard to overcome next year.
Let’s begin with commodities. The cleanest way for a financial investors to gain exposure to commodities is through an ETF, which “rolls” commodity futures i.e. it buys commodity futures with a certain expiration date and, when that date arrives, rolls those futures into futures with a later expiration date. However, the price of a commodity for future delivery is usually higher than the spot prices of that commodity to account for the storage costs and interest charge compensating the person whose capital is tied up in storing the commodity. These charges need to be deducted from the return quoted above and could possibly move the return on commodities into negative territory.
Gold also has its shortcomings. Unlike other commodities, the largest gold ETFs are physically backed. As I stated above, there is no implicit interest rate charges built into pricing of physical gold ETFs but there is a “negative carry” from holding gold, which is the opportunity cost of holding an asset that doesn’t generate income. This cost increases as interest rates increase, which is the situation today. Secondly, while the role of gold as a store of value has been entrenched for centuries, there are a number of asset classes that are vying with it for this role today, among them Bitcoin. These asset classes may further impair its desirability as an inflation hedge.
REITs surmount all of these problems. Firstly, there is no implicit interest rate charge or negative carry that needs to be recouped, only an opening yield that is typically set to grow in line with contractual escalations. It is these contractual escalations that make margin squeezes less likely for REITs than for equities. Secondly there are no storage costs.
However, not all REITs are created equal. Those with long duration leases with escalations set at a fixed percentage (as opposed to CPI-linked escalations) may actually find themselves in a very similar situation to the one faced by most equities. It is therefore a certain type of REIT that would perform best, namely those with short duration leases that are better at passing on rising inflation more quickly. REITs that fit the bill are residential REITs, storage REITS and hotel REITs.
Those investing internationally can access a basket of REITs with short duration leases by investing in an ETF called “Nuveen Short Term REIT ETF” (code: NURE). Those investing locally will have to choose among the individual REITs themselves.
How long inflation will be with us is an open-ended question but it presents investors with a unique set of challenges that need to be considered. That may mean adjusting asset allocations, if necessary, and building exposure to asset classes one might have over-looked.
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