Inflation and the Case for Real Assets

At this point, I think we’ve moved on from the notion that the inflation we’re seeing could be considered “transitory.” It’s been with us for a while, and it will take some time before we see any effects from the Fed’s upcoming rate hikes.

If you’re interested in protecting against inflation, there are some asset classes you may want to consider adding, if you haven’t already.

With the exception of the band I placed around my wife’s finger, I’ve never been a big fan of owning gold. I have however, invested in both farmland and passive real estate. You’ll learn more about why these can be useful during times of inflation in the guest post that follows.

This article was submitted by FarmTogether Founder and CEO, Artem Milinchuk. FarmTogether is a sponsor of this website, supporting our charitable mission.

 

real assets

 

Inflation is currently top of mind for many investors. With data showing that consumer prices climbed over 7% in 2021–the largest increase in four decades–this comes as no surprise.

Inflation doesn’t just make it harder to buy groceries or drive to work — it can also do serious damage to your portfolio and make it harder to achieve your long-term investment goals. According to a recent CNBC survey, around more than half of respondents said inflation is their biggest worry for 2022.

Read on to learn more about how inflation impacts traditional investments and why many investors turn to alternatives as a way of hedging against rising inflation.

 

Why inflation spells trouble for traditional investments

 

Prolonged inflation is bad news for investors. In a traditional 60/40 portfolio, 60% of capital is invested in stocks and the remaining 40% in bonds. While the portfolio has delivered relatively consistent returns over the past few decades, it may be time to rethink this mix.

For one thing, rising inflation reduces the value of outstanding non-inflated-adjusted bonds. The coupon on a bond is a fixed payment until maturity. As inflation rises, it reduces the real value of the coupon payment, meaning your investment is earning you less bang for your buck over time. You might receive the same $100 coupon payment every quarter but $100 buys you less and less.

Inflation can also be a problem for bond investors if the Fed chooses to combat it by raising interest rates. This means that new bonds in the market will have higher coupons than existing bonds, which reduces the market price of lower-coupon bonds with a similar risk profile. This makes sense — all else being equal,  would you rather own a bond yielding 5% or 8%?.

The relationship between stocks and higher inflation is less straightforward, but inflation can also cause problems for your equity portfolio. Although the market has continued to outperform, high inflation can eat into company profits as the cost of inputs rise. Inflation can also reduce revenues, as customers start feeling the sting of higher prices and reducing their spending. Finally, rising interest rates increase the cost of borrowing for businesses, which can throttle growth and even put a company at risk of default.

Putting this together, it’s time for concerned investors to start thinking outside the box.

 

Real assets provide a tried and true hedge against inflation

 

In a rising interest rate environment, sophisticated investors increasingly turn to real assets as a way to protect their long-term returns. While the drivers of value vary from asset class to asset class, real assets tend to be positively correlated to inflation — that means when inflation increases, so should returns. In contrast to bonds, your investment continues to produce a steady real return.

Within the category of real assets, though, investments vary significantly in terms of volatility, whether or not they offer passive income, and how closely correlated they really are with inflation.

Here are the top real assets that investors use to hedge against rising inflation and how they might fit into your portfolios in 2022:

 

Gold

The most common hedge against inflation is gold. Many investors flock to gold because it seems like a reliable store of value and the performance of gold is uncorrelated with the performance of the stock market. For investors trying to protect themselves from runaway inflation, however, gold may be a disappointment — historically, the metal has shown very little correlation with CPI.

As the chart below illustrates, while gold may have outperformed inflation in the 1970s, it actually underperformed inflation between 1980-1984 and 1988-1991. Another disadvantage of gold is that it doesn’t provide dividends, so gold investors aren’t getting the same passive income benefit that other real assets might provide.

 

total returns
Source: CNBC, Morningstar

 

Real Estate

Real estate is another real asset that can perform well in an inflationary environment. Investors with existing residential real estate can increase rents, which allows their income to stay flat or increase in real terms. This puts them in a much better position than bondholders, for example, who are stuck receiving the same payment, which can buy them less and less. Inflation also tends to lead to an increase in asset values, meaning real estate owners have the benefit of appreciation as well.

Commercial property owners can end up slightly less well-off in periods of high inflation if they don’t have inflation escalation built into their lease agreements, given that commercial property leases can be 10 years or more, making it harder to adjust rates and pass higher costs onto tenants.

Inflation can make it harder for new investors to get into real estate, however. It increases the cost of construction, making new homes more expensive. It’s also typically accompanied by an increase in interest rates, making mortgages more expensive for new home buyers.

 

Farmland

One under-invested real asset that performs extremely well in inflationary environments is farmland. Farmland is less well understood than many other real asset classes because it’s been historically difficult for retail investors to access. The majority of farmland is still owned by family farmers, and for many years attractive opportunities have been hard to find without specialized knowledge and a large checkbook. However, technology-enabled platforms offering fractional ownership are starting to change this for everyday investors, which is good news.

Farmland offers two investors three streams of income: lease payments through rental agreements with the operator, periodic payments from the sale of crops, and appreciation of the underlying farmland. When inflation increases, so does the price of crops, meaning that current income to investors is closely linked to the consumer price index (CPI). Rising crop prices also increase the value of the land itself, which benefits investors when the land is sold. The relationship between farmland income and CPI is nicely illustrated in the chart below:

 

Farmland Returns
Source: NCREIF

 

 

Diversify and hedge against inflation with real assets

 

In inflationary environments like today, it’s not hard to see why so many investors turn to real assets to protect and grow their wealth. Unlike bonds, which lose value as interest rates rise, real assets tend to increase in value thanks to explicit or implicit linkages with CPI.

Some real assets like real estate and farmland also offer the benefit of passive income combined with low volatility, making them a good substitute for fixed income in a portfolio.

 

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2 thoughts on “Inflation and the Case for Real Assets”

  1. Having often driven through the countryside and thought that it was something of incredible value, I like that technology has opened up this new asset class. However there really isn’t enough information that is coming out about what the fee structures are for these new investments.

    In all honesty, my worry is that these products are designed to harvest money from investors that like the “story” of investing in farmland. (BTW, this is similar to my view of hedge funds with their 2+20 fee structure).

    So, I’m interested but skeptical. My suggestion, which I hope is not too blunt, is that if the author wants to increase confidence, they should do a followup article being very transparent on fees and compare to a traditional REIT.

    Reply
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  3. There are some things I don’t like about real estate as an uncorrelated hedge. One is that home prices may be currently in a pricing bubble, so while long term prices should stay up with inflation it would not be surprising at all to see prices take a significant hit in the short term. And that short term could last ten years. Higher interest rates will drive many prospective buyers out of the market and inflation usually brings higher interest rates. As for commercial property the trends of remote working and electronic retail replacing brick and mortar retail could leave the space over supplied for many years making it hard to drop prices enough to find tenants. Or none of that could happen. But some of these trends are new and are not reflected in real estate’s past performance vs inflation. It really is different this time in some important ways, or maybe not?

    Reply

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