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Farewell to Real Assets? Not Yet

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Farewell to Real Assets? Not Yet

Written by: Abdur Nimeri, Ph.D

REAL ASSETS VOLATILITY: ASSET CLASS VS. THE PORTFOLIO

The global economy continues to exhibit subdued growth and below target inflation. Central bank policies have begun to diverge as financial markets react with ramped-up volatility and gyrating risk asset prices. The behavior of commodities has been especially noteworthy.

The wild ride has caused many investors to reconsider their commodity and real asset holdings. However, volatility should not drive the decision to own or not own these investments. Market sell-offs certainly spark investor anxieties but they also raise awareness of the risk management benefits of owning real assets. A careful pairing of these assets can help improve a portfolio’s performance and risk profile over a strategic investment horizon. Let’s look at how a blend of real asset equities that includes infrastructure, real estate and natural resources can help investors navigate periods of market volatility.

MONETARY POLICY AND REAL ASSETS: HINDSIGHT IS 20/20

The U.S. Federal Reserve’s decision on December 16, 2015 to raise its policy rate is an important shift that reflects high confidence in the strength and durability of the U.S. economy’s expansion. In comparison, most other developed countries’ economies are growing more slowly and their central banks remain in easing mode, as do the larger emerging market economies of China and India. Select others, such as Russia and Brazil, have been raising policy rates. Notwithstanding these outliers, monetary accommodation continues to be an important consideration for global investors. Because monetary policy plays a pivotal role in the pricing dynamics of real assets, the divergent paths now being pursued by central banks will complicate the growth trends of real-asset-based economies.

BAD LUCK

No doubt, monetary policy developments will have ripple effects on many real-asset-based economies. Typically, rising U.S. interest rates harm commodity export nations (e.g. emerging markets) via capital outflows, reduced industrial output, currency devaluation and negative trade balances. A trend of rising U.S rates makes projects more expensive, puts added pressure on debt- leveraged investments and raises costs for imported goods and services. Commodity producing nations will face challenges meeting current liabilities because of lower export revenues, reduced capital markets access and diminished collateral values. In such a scenario, it is likely for investors to think about shifting out of emerging market holdings into U.S. dollar assets. However, the distortions to commodity prices resulting from central bankers’ quantitative easing can alter expected market responses, creating potential headwinds for non-diversified real asset investors.

QUANTITATIVE EASING DISTORTS SUPPLY/DEMAND DYNAMICS

In the short-term, global aggregate demand lags the sustained production growth for most categories of natural resources and commodities. This demand shortfall is especially felt among commodity exporting nations.

In particular, the subdued growth in China’s property market presents downside pressure for various industrial metal producers. As such, pricing for major metals – aluminum, copper and iron ore – is experiencing significant downward revisions. A similar situation exists in the petroleum industry, where West Texas Intermediate oil prices have moved below many producers’ production cost. Lower petroleum prices pare production, reduce capital expenditures and lower gross margins for high-cost oil producers in the United States, Mexico and Russia. Persistent low oil prices take their toll on more established producers as well. Large OPEC (the Organization of the Petroleum Exporting Countries) producer Saudi Arabia has been forced to reduce fuel credits for its citizens and liquidate financial assets in order to maintain social programs. Among the oil producers, Canada is increasing its energy investment, while many OECD (Organisation for Economic Co-operation and Development) and non-OECD countries are pulling back because of uncertainty about future oil prices.

Part of the decline in commodities prices during fourth quarter 2015 (and partial rebound in 2016) can be attributed to a strengthening U.S. dollar, while many major commodities are exhibiting overcapacity. This robust supply, stoked by producers ramping up volumes in order to meet escalating debt obligations, produces a distorted view of real assets’ true growth prospects. While the rate of growth in the space is slowing, many longer trend drivers remain supportive for core real assets (e.g., demand for industrial metals and fuel tied to urbanization).

THE CABARET IS STILL OPEN FOR BUSINESS: THE OTHER REAL ASSETS

Clearly, many examples in the current commodity space paint a sobering view for natural resource investors. However, long-horizon demand dynamics present a counter and more positive outlook, arguing for a diversified mix of real assets that includes infrastructure and real estate. For investors with a strategic horizon, the long-term case for real assets investing is firmly aligned with the positive demand dynamics in the emerging markets.

Urbanization in emerging countries is expected to steadily drive construction and infrastruc- ture demands. The population shift to urban centers should lead to strong demand fundamentals for core industrial metals. This is already being observed in the demand dynamics of copper and seaborne iron ore. Copper, the third largest industrial metal behind iron and aluminum, is projected to stay in demand mainly driven by infrastructure investments in emerging markets. New housing construction (single and multi-family) in developing markets is expected to continue, boosting demand for copper. Likewise, growth projections for seaborne iron ore and nickel, both critical to infrastructure development, are anchored in strong emerging market ambitions.

Projected growth of infrastructure in emerging economies is highlighted in Exhibit 2. In particular, note China’s demand is expected to exceed 10% of gross domestic product (GDP) for the foreseeable future. As emerging economies shift more towards consumer segments and urbanization, the demand for housing, road networks, toll highways/bridges and commercial construction is expected to grow. In summary, broad trends in the emerging markets are   fueling a greater investment interest in an expanded set of real asset classes.

PORTFOLIO POSITIONING FOR THE LONG HAUL

In light of the recent price weakness and volatility in the commodity space, many investors have elected to divest completely or reduce their exposure to real asset investments, mainly natural resources. However, an alternative course of action chosen by a cadre of strategically focused investors is to embrace a balanced and diversified risk management approach to real asset investing.

Research demonstrates that an optimally combined real assets allocation may present a better way to manage overall portfolio volatility. A multi-asset portfolio of component real asset prod- ucts is expected to capture the potential benefits of the asset class without taking on unintended risks that can occur when making tactical allocations to individual real asset sub-categories.

Since real assets benefit from durable inflation adjusted returns, the inflation hedging impact of an optimized multi-asset real asset solution may be beneficial when added to a traditional 60% equity / 40% fixed income blend.

To summarize:

1. Maintaining real asset exposure amid challenging market environments may improve inflation-adjusted annualized returns in periods of rising inflation while also providing downside protection via income and equity-like upside returns.

2. This may allow investors with strategic horizons to participate in economic growth cycles while experiencing a smoother risk-adjusted return profile.

3. In the hunt for unique sources of return, real assets play a key role helping to drive global growth. We believe they also will provide strategic long-term investors with new ways to construct more efficient and balanced portfolios.

For more information contact FlexShares at 1-855-FlexETF or visit us here.

 

1 Source: International Monetary Fund (IMF); data represents all commodities, includes Fuel and Non-Fuel Prices Indices as of December 31, 2015; 2005 =100

2 Source: PricewaterhouseCoopers and Oxford Economics; data represents global projected infrastructure spend as a function of GDP. Forecasts are inherently limited and cannot be relied upon.

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