Time To Trim Some (Inflation) Hedges?

By Robin Marshall, Global Investment Research

Arguably one of the greatest frustrations for investors over the past year of rampant inflation was the dismal performance of real assets regarded as ‘inflation hedges’ – namely, inflation-linked bonds, real estate and gold – and their positive correlations to the returns of nominal assets, such as conventional government bonds.

Global asset returns (LC %) – Full year 2022

Negative duration effects at play for some hedges

Why did most inflation-protected real assets disappoint last year? For asset classes with fixed coupons, the most plausible explanation may be the sharp pickup in risk-free government bond yields as monetary tightening shifted into high gear. The resulting increase in discount rates on future cash flows applies to both real and nominal assets. For real asset classes such as inflation-linked government bonds, which differ only by maturity date and coupon, this effect is well-defined and quantifiable, and can overpower the favourable impact of higher inflation accruals.

Thus, inflation-linked bonds with longer maturities and duration suffered bigger losses than shorter-dated equivalents in 2022, particularly in the UK, reflecting the larger drag of higher discount rates on longer-dated cash flows. Most recently issued inflation-linked bonds have very low real coupons, so duration is skewed longer, increasing the sensitivity of total returns to changes in real yields.

Gold held up far better than other traditional inflation hedges in 2022, and relatively well overall, though much of this was the result of the investor flight from risk in the wake of Russia’s invasion of Ukraine. Since skyrocketing to a near-record high in early March, this non-yielding asset has faced stiff headwinds from the steady rise in nominal interest rates on cash and from the soaring US dollar, which make it more expensive for buyers of the precious metal in other currencies.

Timing disparities in inflation expectations

There may also be inflation-expectation timing effects at work. As illustrated below, short-run breakevens spiked globally in the inflationary aftermath of Russia’s invasion of Ukraine and the subsequent hard-line central bank response, while the rise in medium- and longer-dated breakevens was far more subdued. The flattening and, indeed, inversion of yield curves suggest investors expect these monetary tightening efforts will ultimately be successful, though not without recessionary consequences. The decline in the term premium on 10-year Treasuries is further evidence of this.

Global inflation breakevens (basis points)

A tough year for real estate as an inflation hedge

Even the returns of real assets with less homogenous underlying business fundamentals, such as commercial real estate, have struggled. Funding and other cost increases have generally outpaced those of rental incomes across property types over the past year, while pressures on occupancy and delinquency rates rose with the slowdown in economic growth. Rising interest rates have also dented the investment appeal of REITs, particularly relative to risk-free government bonds. REITs were hit hardest in the UK and Europe, where inflation has increased the most.

Regional FTSE EPRA NAREIT Index returns relative to local market (rebased, TR, USD)

Duration, or lease life, has also played a part in the divergences in relative REIT performances – both within and across regions. Lease agreements tend to run longer in Europe than in, say, Asia Pacific, leaving property incomes in Europe more vulnerable to the risks of rising inflation.

Unsurprisingly, REITs with long lease agreements with little or no inflation protection have ranked among the worst performers during previous bouts of higher inflation. They share many of the same characteristics of long duration, fixed coupon bonds. As with inflation-linked bonds, the inflation-protection in European lease agreements has proved insufficient to prevent a year of devastating losses.

Cost-push inflation also unfavourable for cyclical assets

The largely cost-push nature of this recent bout of inflation is another factor behind the underperformance of real assets. The current environment – in which rising reopening demand and severe supply/labour dislocations has driven up input costs while monetary tightening threatens economic stagnation – is hardly a welcoming one for cyclically sensitive assets like real estate.

Infrastructure bucks the trend

Given that infrastructure assets generally have inflation protection and are not subject to business cycles, it is not surprising they performed relatively well in 2022, despite their typically long durations. Core infrastructure assets, such as regulated utilities, tend to have floating-rate return characteristics, whereby cash flows rise as costs increase. Decarbonisation and the transition to renewable energy have also driven demand for listed infrastructure investments, as have their low correlations with other equity and credit sectors.

FTSE Core Infrastructure Index relative returns vs FTSE Global All Cap Index (rebased, TR, USD)

Inflation hedges that work best in low-inflation, low-rate environments

It is worth noting both real estate and inflation-linked government bonds have typically performed best during low-inflation, zero-interest-rate regimes such as in the immediate aftermath of the Global Financial Crisis and before the Covid-19 outbreak – despite their reputations as effective inflation hedges for all seasons. This suggests that the discount rate applied to future cash flows may be the dominant variable underpinning real asset valuations, barring times of outright price deflation. Meanwhile, the pullback in bond yields and US dollar since October has already helped bolster gold. These shifting dynamics pose important investment implications for real assets on any signs the current tightening cycle may be nearing a turning point.

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