How inflation impacts real assets
Article6 minutes09 December 2022
Prices have been spiking around the globe, with record-high inflation rates in a number of countries.
In Australia, inflation has been much more muted, but overall, prices are higher than they’ve been for several years, and economists are undecided on how long higher prices will remain.
With the global economy rapidly launching back into recovery mode, real asset investors need to be thinking about implications of the continued recent spike in inflation.
Historically, real assets have performed better than other asset classes during inflation hikes, and they’re uniquely equipped to provide investors with a means to ride out the current inflationary surge. There are several key reasons for that.
Income from real assets is generally linked to inflation. As prices rise, so too does income.
During economic upswings, real assets such as real estate and infrastructure tend to do well as demand increases, rents rise and utilisation improves.
Over the long term, real asset returns historically beat other sectors during inflationary spikes.
What's driving inflation?
The recent escalation in headline inflation rates is driven by the convergence of a multitude of factors at both the macro and micro levels.
1. Household costs have risen quickly. This has been driven by rising demand for consumer goods and higher gas, coal and oil prices, which are cascading into higher consumer costs. They are also contributing to bottlenecks in production and shipping.
2. Labour shortages are driving wage costs higher. This is particularly the case for services such as hospitality, construction and manufacturing, which typically rely on migrant labour. The shortages that have emerged in the labour force have driven wages growth in most developed economies.
3. Economies have rebounded faster than expected. Despite not feeling quick, or painless, by comparison to other pandemics and global catastrophes, COVID-19 was comparatively short and benign. The immediate and substantial response from governments and central banks, pushing interest rates to all-time lows and holding them there, will provide a significant tail wind to consumer and business spending well beyond the pandemic crisis.
Inflation isn’t always a bad thing
Inflation in an economy, when contained and limited, can be classified as a ‘good thing’. This is less because of its actual effects on the economy, and more about what accompanies its emergence. Inflation is primarily the consequence of labour and resource scarcity, driving up the cost of goods and services for consumers and businesses.
Inflation is often accompanied by strong growth in economic output. Labour scarcity brings lower unemployment and higher wages. Thicker household wallets empower consumers to spend more, which creates improved company profits. In short, economic booms go hand in hand with some form of escalated inflation.
Today's inflation also aligns with an improvement in economic prospects for the global economy, as it recovers from the lockdowns of COVID.
This will prove beneficial to the real assets sectors including shopping centres, tourism and airports as consumers take their newfound wealth, and accumulated lockdown war chests and go on a spending bonanza.
How do real assets respond to and manage inflationary risks?
The good news for investors is that returns from most real assets are resilient and well correlated to inflationary risks, primarily due to their inherent ability to absorb inflation through rental income.
There are four key factors that set real assets apart in their ability to combat inflation.
1. Higher demand. A sharp rise in inflation rates has historically been associated with an increase in economic output and GDP growth. This is broadly positive for all asset classes, but particularly real assets which benefit greatly from the higher demand that comes from an uplift in economic growth.
2. Fixed income increases. Commercial leases and contracts associated with commercial office and logistics markets typically have inflation-linked annual rent increases written into the contract.
3. Productivity arbitrage. Environmental, societal and governance factors and technology have enabled sectors to deliver higher returns despite a rising cost base.
4. Low-income volatility. Renters lock into leases for set terms. In many real assets, what’s known as long weighted average lease expiry (WALE) can shield investors from fluctuations.
Strategies for success – active asset management is key
Inflation and interest rates have a significant impact on investment performance; however, they are determined by central banks and governments, removing control from investors’ reach.
Investors can access sector, market and manager selections, which are critical to achieving an optimal return through an inflationary cycle. Active asset management is key.
Investors have several tools and strategies at their disposal to achieve a desirable investment performance, including income profile and sector selection.
What is the lease structure? How is income derived? What sectors underpin that lease and what is their risk profile during an inflationary event? Assets with long WALE and contract income are typically inflation adjusted during their term, allowing investors to hedge returns against fluctuations in market costs.
On the infrastructure side, assets with cost increases from rising inflation during economic upswings, can also benefit from utilisation rates on the revenue side, such as patronage through airports.
While all real assets are highly correlated to inflationary pressures, not all sectors are equal in their delivery of return performance. Some sectors are more prone to market-level risks that can undermine their inflation fighting abilities, such as office and logistics sectors which are prone to supply risk.
Targeting markets with low-supply outlooks, linked to stable underlying income streams is crucial to success. In the post-COVID world of high household savings, and post-lockdown social activity, we expect airports, large entertainment-driven shopping centres, and ecommerce-driven logistics facilities to be standout performers for returns.
We also expect renewable energy assets, and other ESG-driven asset classes to benefit from long-term government support tailwinds. These should be considered as a wrap to any asset selection to enhance returns. For example, a logistics facility with a solar roof can increase income returns by 100-200 basis points based on anecdotal evidence of roof rents versus market rents.
Why this inflationary cycle is containable?
Our view on inflation is to be alert, but not alarmed at the current cycle. Despite the headline inflation rate likely to remain elevated in the short term, the risk of a sustained breakout remains unlikely and containable.
Inflation can still be brought under control through higher interest rates, with central banks holding significant leverage to reduce the money supply, without impacting growth recovery.
Additionally, reduced government spending over the medium term through fiscal constraint and wound-back stimulus while the global economy normalises, as well as supply chains reopening will also help.
On the consumer side, pricing is holding at modest growth rates and despite record unemployment lows, wage growth is elevated but not excessive.
Inflation is on the rise in developed economies, though not as severely in Australia. This means investors need to align their investment strategies to hedge against the impact of higher prices. The long-term impacts are important, not just the short term.
In our view, real assets provide an attractive option in an inflationary environment. We believe active asset management is also critical to achieving strong performance outcomes.
This material (“Material”) has been prepared by Dexus Asset Management Limited (ACN 080 674 479, AFSL No. 237500) (“DXAM”), the responsible entity and issuer of the financial products mentioned in this Material. DXAM is a wholly owned subsidiary of Dexus (ASX: DXS). Read Less
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