Commentary: The case for using real assets to hedge inflation

With inflation levels the highest in 40 years and the Fed dramatically raising rates to combat inflation, institutional investors are increasingly recognizing the benefits of exposure to real assets, specifically focusing on natural resources, infrastructure and real estate. Though many investors believe we may have reached peak inflation levels, most agree that the transition back to the Fed's stated inflation target of 2% is a long way off. This has created a risk that inflation and subsequent Fed rate hikes may surprise to the upside for 2023.

In an increasingly volatile global market environment, real assets can offer what many investors are looking for: the potential for income, diversification and capital preservation, all while providing inflation protection. Thanks to product innovation within real asset sectors in recent years, investors now have access to a wide variety of investment vehicles and an unprecedented supply of opportunities.

We believe all three asset classes (natural resources, infrastructure and real estate) are compelling tools to combat inflation on their own — but consider them particularly effective when combined, since each tends to perform well at different points of the economic cycle. Let's explore the case for each of these investment types in an environment of volatile inflation and growing investor concerns.

The case for commodities as an inflation-hedging asset class is based on the tendency for inflation to translate into higher prices for raw materials such as oil, natural gas, metals and agriculture products. Investors have seen this play out in portfolios year to date. Crude oil, for example, jumped 41% from January through June, while soybeans and wheat prices grew 12% and 10%, respectively. Prices have started to come down in recent weeks, but supply issues still exist and global events such as the fallout from Russia's invasion of Ukraine are still affecting commodities markets.

Our preference is to invest in natural resource equities over commodity futures contracts for three reasons: it avoids the need to roll commodities futures contracts that can be a performance drag over the long term; it allows for investment in commodities such as water and timber with limited futures coverage; and many natural resource companies pay dividends, leading to income generation that commodities futures do not provide.

Of course, investors should be aware that a key risk for equity-based natural resources strategies is that the same inflationary pressures causing raw materials prices to rise could increase the input costs for companies that process, transport or distribute finished products. To address this, investors need to focus on the earlier part of the natural resources supply chain, or what we call the upstream portion, which is where companies are involved in the extraction of commodities before higher prices are ultimately passed on to downstream producers.

Attractive, late-in-the economic-cycle infrastructure securities, such as access to water and waste services, can be viewed as a longer-term defensive play. Due to the nature of infrastructure assets, these projects tend to be highly stable and less sensitive to shifts in the broader economy, and provide protection against rising prices.

Infrastructure investments often operate in pseudo-monopolistic environments that are highly regulated, have large barriers of entry and enjoy inelastic demand. This translates into fairly predictable cash flows and maintenance costs, many of which allow for price increases tied to inflation. For example, utilities that face higher prices for the fuels they use to generate electricity generally are allowed to pass those costs on to their customers, keeping their cash flow more predictable in volatile energy markets.

Beyond price stability, there's also a significant income component for investors. Our research shows that over the past 10 years, 45% of the total return of global real estate and 52% of global infrastructure has come from dividend income.

However, infrastructure is not without risks, as changes in regulatory environments and governments can lead to a more conducive or restrictive operating environment for single infrastructure projects. This is why we advocate for a globally diversified approach to infrastructure investing that covers as many different types of infrastructure assets as feasible. We believe that by including areas such as communication infrastructure and outsourced government services, such as health-care facilities and postal systems, greater diversification can be achieved than through a strategy overly concentrated in energy utilities and pipelines.

Investment in global real estate — commercial and residential — can similarly offer a range of benefits in the current environment. Some types of real estate stocks are less resistant to rising interest rates, while at the same time the sector has historically paid higher dividend yields than other equity classes, offering an alternative source of potential income.

Today, the increasing cost of raw materials and supply chain bottlenecks from the pandemic have affected real estate projects. Resulting delays in the completion of new residential real estate projects have hampered new supply and sent prices for existing single-family and multi-family properties higher. On the commercial side, as businesses look to protect themselves from goods shortages by increasing inventories closer to major sales hubs, demand for warehouses and industrial real estate has been extremely strong.

To implement real assets exposure in a portfolio, investors have several options. The three investment types discussed herein have diverse risk and return profiles, so in aggregate, the asset allocation can be very agile and tailored to suit specific needs.

Investors seeking to capture higher growth and willing to tolerate more risk can build an asset allocation that more heavily weighs global real estate and natural resource equities. Those looking to blend a real asset mix with historically less price variance can tilt their allocation toward global infrastructure.

With a backdrop of inflation and interest-rate uncertainty, real assets offer an attractive and flexible addition to any institutional portfolio seeking both the potential for attractive returns and a hedge against inflation, particularly in today's challenging environment.

Christopher Huemmer, is a Chicago-based senior investment strategist at FlexShares ETFs, part of Northern Trust Asset Management. This content 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.