Real assets, whether property, gold, commodities or infrastructure, have been seen as the go-to assets for an inflationary environment.
At a time when cash flows are difficult to predict and the valuations of financial assets are blown about by rising rates, there is a refreshing solidity in toll roads, airports or bricks and mortar. These areas are likely to hold their value better than financial securities where the value is less tangible.
The most recent Asset Risk Consultants (ARC) analysis shows that private client managers are taking on more ‘real assets’, including infrastructure, property and private equity.
It is a refrain echoed by many fund managers.
Pictet said that, alongside commodities, it saw value in “gold, infrastructure and real estate”; while Bruce Stout, manager of Murray International, has employed ‘real assets’ to navigate a new era of higher inflation.
However, real assets are not a panacea and need to be selected with care. It is clear that the share prices for some commodity and mining companies now have significant price rises built in.
There are structural weaknesses in certain parts of the property market, which diminishes their efficacy as an inflation hedge, and not all infrastructure is created equal. Gold’s protective role against inflation has been over-played.
So where are the bright spots within the real asset complex?
Too much space in retail
In the best scenario, Marcus Phayre-Mudge, manager of the TR Property fund, says property assets should give a good margin over fixed income, plus rental growth. However, that is not universal.
“We focus on property where tenant demand is stable, or improving, and there is lack of new space.
“When we look at the development cycles over the 30 years, there was a long period after the financial crisis when banks weren’t lending. More recently, there was also a deferred developed cycle through the pandemic.”
This knocked supply in certain key segments.
He adds: “In multi-let industrial there has been little new construction and space has been taken out for other uses. Office space was converted to residential, for example.
“There is too much space in retail, particularly shopping centres, but retail warehousing is coming back and lacks space. The final important point is indexation – it is crucially important that leases are tied some form of indexation.”
In the UK, the typical five-year upward only rent review has become less common in the wake of the pandemic.
As such, TR Property is focused on long-term income with explicit index-linkage: this includes healthcare names, supermarket income Reits, plus investment trusts such as LXI Secure Income Reit and Tritax Big Box Reit.
See also: UK warehouse Reits sell-off looks overblown
Higher inflation should trigger immediate uptick in NAVs
Fairview Investing co-founder Gavin Haynes also has faith that much of the infrastructure segment will provide protection against inflation: “Infrastructure covers a wide range of areas, but we expect to see huge amounts of investment, particularly in renewables infrastructure.
“It generates an attractive income stream and a lot of its earnings are linked to inflation. As such, this really can provide protection for portfolios.”
The managers of infrastructure trusts are clear that if inflation rises higher, there should be an immediate uptick in the NAV of the portfolio.
Giles Frost, director of International Public Partnerships, says: “There’s a real and genuine linkage in our assets. We don’t have caps on inflation, nor does every one of our assets have 100% protection, but generally speaking public infrastructure assets do offer a very significant level of inflation protection because of the mechanisms that are negotiated with the government bodies at the time these assets are created or regulatory frameworks are put in place.”
Edward Hunt, manager of HICL Infrastructure, says many of the trust’s assets – trains or water, for example – have ‘mechanical’ linkage to RPI or CPI, creating an overall sensitivity to inflation expectations of 0.8%.
“In other words, if inflation is 1% higher, investors would see their return increase by 80bps, all other things being equal.”
New investors may be too late to the party
It is worth noting that this is based on the group’s assumptions of inflation, which are already relatively high.
At the moment, HICL is assuming RPI inflation of around 6%. As such, if RPI is 9% rather than its forecast of 6%, then HICL’s NAV would increase by 4p. Meaning inflation needs to be higher than expected rather than simply high.
There is also a question as to the extent that this is already priced in.
Certainly, these ‘real asset’ areas have performed well over the past 12 months. The AIC Infrastructure securities sector is the top-performing investment trust sector over one year, with the average fund up 23.2%. Commercial property is not far behind, with the average fund up 19%.
Infrastructure is perhaps the only laggard, but investors would still be happy with an average rise of 6.5% at a time when markets have been so volatile.
Nevertheless, some still trade on significant premia to net asset value – 18.4% in the case of 3i Infrastructure.
This is also true for the commodities sector, which has been true to its reputation as an inflation hedge in recent months, but where a lot of the potential supply disruption and Ukraine crisis impact may now be reflected in prices.
Certainly, commodity prices can tick higher, particularly if inflation continues to outpace expectations, but it may not offer a lot of upside for new investors today.
Real assets have, by and large, worked well for investors in this recent inflationary outbreak as long as investors have selected carefully.
If inflation outpaces expectations, this will still be a happy hunting ground.
However, they have moved a long way very quickly, so it is worth a cautious approach.
