Reflation catalysts for real assets

Many investors have come to rely on asset allocations modeled on the old economic order: decades of globalization, falling inflation, slowing economic growth and declining interest rates. We believe the old order is shifting and the global macro environment is now clearly moving in favor of real assets, which can include everything from commodities to real estate to natural resource equities to infrastructure.

Consider how the global economy, which languished in the years following the financial crisis, is now expected to accelerate as more countries embrace fiscal stimulus policies. Meanwhile, inflation has generally been on a steady climb in the U.S. and globally since mid-2015. And the Federal Open Market Committee has raised rates three times in the past 18 months, after no rate hikes since 2006.

We believe this suggests the market is now at an inflection point. But with stocks and bonds trading at or near all-time highs, many investors are on the lookout for assets that can both provide added diversification and withstand the increased risk of inflation surprise.

To see why investors should consider real assets to fulfill these dual goals, let's look at five trends that broadly reversed in 2016 and are most likely to influence markets in 2017 and beyond.

Fiscal austerity to fiscal expansion

Reduced government spending has been a drag on economic growth in recent years, both domestically and around the world. The Bureau of Economic Analysis estimates that, from 2011 to 2015, U.S. GDP growth would have averaged a full percentage point higher if not for the impact of fiscal tightening. With voters increasingly frustrated by the slow pace of growth, we are seeing policymakers reverse course by increasing spending as a tool to stimulate growth. For example, since the start of 2016, numerous countries have announced plans to accelerate infrastructure investment in addition to other large-scale programs already in place. Government spending is already beginning to contribute to global growth, and its influence should only increase as more plans are approved—perhaps including Trump's $1 trillion infrastructure proposal.

Low growth to accelerated growth

Many of the world's largest economies are growing at the fastest pace since the post-financial-crisis rebound in 2010, with some forecasts predicting the global economy is on track to achieve 3.5% growth in 2017. With the U.S., France and many other developed countries shifting to more pro-business/pro-growth policies, we believe this momentum will continue.

Globalization to protectionism

Support for globalization has hit some speed bumps in the past year thanks to the Brexit vote and the election of President Donald Trump, both of which point to a growing popular desire for trade policies that protect domestic industries and jobs. A move to higher tariffs and tighter immigration controls could benefit low-income workers, but they also generally lead to higher labor costs, higher prices on imported goods and a less productive economy. As a result, protectionist policies could lead to periods of unexpected inflation.

Low interest rates to rate normalization

Stronger economic growth and tightening labor markets have prompted some central banks to shift away from quantitative easing and ultra-low interest rates, signaling a potential bottom in the interest rate cycle. We expect interest rates to rise toward historical levels as the economy improves.

Low inflation to increasing inflation risk

Inflation is accelerating globally with inflation potentially doubling over the next two years relative to the previous five-year average, pointing to a higher risk of inflation surprises going forward. Other factors that could contribute to increased inflation risk include higher oil and agricultural prices, the tightening of labor markets in many countries, fiscal stimulus and tax cuts, and uncertainty in monetary policy.

These trend shifts paint a picture of a new and challenging market environment, prompting some investors to diversify beyond stocks and bonds in an effort to adapt to rising inflation risk. This is a positive sign for real assets, which have historically performed well in periods of economic growth and moderate inflation.

Exhibit 1 shows the historical sensitivity of different asset classes to inflation surprise, measuring average outperformance vs. the long-term average for every 1 percentage point that inflation exceeded the prior-year estimate. The data shows stocks and bonds have tended to struggle in times of surprise inflation, whereas real assets have historically outperformed.

Economic growth, employment and inflation readings already are on the rise and could accelerate if tax reforms, deregulation and fiscal stimulus are enacted. After a long period of low inflation — during which certain real assets have significantly underperformed — the transition to a new market regime of higher inflation risk represents a potential multiyear tailwind for real assets.

Vince Childers is a New York-based portfolio manager for Cohen & Steers Inc.'s real assets strategy. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.