Four Strategies for Fighting Inflation

Transcription

1 Multi-Strategy Four Strategies for Fighting Inflation The transition to the later stages of the business cycle calls for creative portfolio solutions to hedge against increased inflation risk. Here are four ideas. Cyclical Broad-based global growth Falling unemployment Early signs of wage growth Shrinking spare capacity Shifting Macro Trends Secular Increased government investment U.S. tax cuts Central banks allowing prices to run higher Protectionism / tariffs After one of the slowest expansions in history, the global economy is heating up and longdormant inflation pressures are beginning to build. This cyclical shift combined with unusual late-cycle tax cuts, rising protectionism and the unprecedented unwinding of quantitative easing is thrusting investors into uncharted territory. In this environment, we believe investors should consider increasing allocations to reflationoriented asset classes that have the potential to enhance real returns. Potential Implications Higher inflation Higher interest rates Heightened volatility Low fixed income returns Global Real Estate Securities Rent growth has historically outpaced inflation, while correlations with equities are at a 16-year low Global Listed Infrastructure Contracted cash flows often have rate escalators tied to inflation, while increasing economic activity could drive higher throughput volumes Low-Duration Preferred Securities Combines the potential for high tax-advantaged income with low sensitivity to rising interest rates Portfolio Solutions Multi-Strategy Real Assets A history of positive inflation sensitivity and equity-like returns, with lower potential volatility than standalone investments in real assets For qualified institutional and professional investors or their advisors only.

2 Four Strategies for Fighting Inflation Global Real Estate Securities Higher inflation higher rents higher dividends. REITs and other real estate securities have a long history of helping investors defend against inflation, with property values that tend to rise with the overall price environment, plus the potential for growing cash flows as landlords raise rents. Increased construction costs can also deter new property supply, easing competitive pressures. The net effect is that REIT dividends have grown faster than inflation. In the U.S., for example, REITs have increased dividends at nearly double the rate of inflation over the past 25 years (Exhibit 1). Exhibit 1: REIT Dividends Have Grown Faster Than Inflation 2 3.9% U.S. REIT Dividend Growth 15% Annual Average 2.2% U.S. CPI 1 Annual Average 5% -5% -1-4 U.S. REIT Dividend Growth U.S. CPI At December 31, Source: Bureau of Labor Statistics, NAREIT, Cohen & Steers. Data represents past performance, which is no guarantee of future results. Attractive value amid rate concerns. Global listed real estate has delivered strong performance over the long run, with annualized returns of 8.8% since the modern REIT era began in 1991, compared with 8.1% for global equities. (1) However, over the last five years, real estate has been among the most out-of-favor segments of the market, trailing broad equities by 500 basis points annually despite above-average earnings growth and distributions. This underperformance has been largely due to concerns that rising interest rates could lead to higher financing costs, while also reducing the appeal of REIT income relative to bonds. These concerns have caused earnings multiples for real estate companies to contract at a time when multiples for the broad market have expanded substantially. Today, listed real estate companies are trading at an average discount to the private market, with some companies featuring discounts of 2 or more. (2) Exhibit 2: Correlation of Global Real Estate and Global Equities Rolling 1-Year Periods Correlations are at a 16-year low At April 30, Source: Morningstar, Cohen & Steers. Data represents past performance, which is no guarantee of future results. These attractive values come at a time when correlations to equities are at a multi-decade low, illustrating the diversifying potential of real estate (Exhibit 2). Based on our view of generally solid real estate fundamentals and a record $266 billion of private equity dry powder waiting to invest in commercial property, we see this as a good opportunity to increase allocations to real estate through the listed market. (3) Global opportunities. Certain sectors of the U.S. REIT market remain attractively positioned, in our view, as demand should continue to outpace new supply overall. However, certain markets outside the U.S. may have more runway for growth. For example, Continental Europe is benefiting from firm global growth, yet its economy is earlier in the cycle than the U.S. and is likely further away from raising interest rates. We also see value in certain U.K. REITs that seem to have been unfairly punished by uncertainty surrounding the country s exit from the European Union. Japan s economy is awakening from a long slumber, putting Tokyo office developers in a prime position to benefit from reflation. We expect country and sector fundamentals will continue to diverge, highlighting the importance of access to a global opportunity set. Dividend growth has historically outpaced inflation, while correlations with equities are at a 16-year low (1) At May 31, Source: FTSE, MSCI, Cohen & Steers. (2) At April 30, 2018, global real estate securities traded at a 0.9% average discount to net asset value (company assets less liabilities), based on Cohen & Steers estimates. (3) Private equity dry powder as of March 2018, representing total capital commitments in private real estate funds waiting to be called for investment. Source: Preqin. 2

3 Global Listed Infrastructure Inflation-linked revenues and rising volumes. Infrastructure has historically served as a natural inflation hedge, as revenues are often tied directly to inflation. Many infrastructure companies receive contractual adjustments to user fees that provide either fixed annual increases approximating inflation, or variable increases linked to consumer or producer price changes (Exhibit 3). Certain subsectors, particularly in transportation, may also stand to benefit from rising throughput volumes in a strengthening economy. For example, improving North American production and consumption have led to sustained strength in freight rail volumes, contributing to strong returns for the subsector in 2016/17 (Exhibit 4). Exhibit 6 illustrates the varying sensitivities of different subsectors to inflation and economic growth, underscoring the ability of investors to adapt portfolios to periods of both rising and easing inflation, as well as through different points in the economic cycle. Rising interest rates could pose a near-term risk to infrastructure performance. However, history shows that after negative, kneejerk reactions to sharp increases in Treasury yields, infrastructure has generally outperformed global equities over the ensuing 3, 6 and 12-month periods as the benefits of stronger economic growth and inflation were eventually reflected in revenues. (1) Exhibit 3: Infrastructure Inflation Pass-Through Dynamics Toll Roads Midstream energy Airports U.K. Water U.S. Electric/Gas/ Water Utilities Ports Towers Annual inflation-based toll adjustments Annual inflation-linked pricing escalators for many petroleum product pipelines Annual CPI-based adjustments on regulated fees Annual inflation-linked increases At May 31, Source: Cohen & Steers. Rate-case process allows for inflation-based rate adjustments with a lag Inflation escalators for many longer-term contracts Annual fixed escalators of ~3-5%, approximating inflation Exhibit 4: North American Freight Rail Volume Growth Y/Y Change, 6-Week Rolling Periods 1 5% 0-5% -1 5-Year Average Rail volumes continue to grow materially above the historical trend Extreme cold weather conditions At May 26, Source: Wolfe Research. The midstream fundamental cycle is turning. Since late 2014, infrastructure returns have been weighed down by poor performance from the midstream energy sector, with the Alerian MLP Index still 56% below its high as of March However, for the first time since the energy down-cycle began, the three primary drivers for midstream asset demand are all positive: 1) U.S. energy production is expected to hit record levels in (exceeding Saudi Arabia), supported by rising and stable energy prices. 2) U.S. energy consumption is growing after several years of stagnation. 3) Energy exports have grown exponentially since the crude oil export ban was lifted in 2015 and should continue to do so in a reflationary environment, in our view. These trends continue to push more energy production through pipelines and pull it into demand centers, which should help tighten capacity for midstream assets and drive cash flow growth. Exhibit 5: Infrastructure Subsector Sensitivity Framework Economic Sensitivity Satellites Towers Marine Ports Utilities Inflation Sensitivity At May 31, Source: Cohen & Steers. Data represents past performance, which is no guarantee of future results. Rankings determined by the relative sensitivity of revenues to the Consumer Price Index (inflation) and economic reports, including gross domestic product, employment and trade. Railways Water Airports Pipelines Toll Roads (1) Based on the 12 largest one-month increases in the 10-year Treasury yield from January 2000 to May

4 Four Strategies for Fighting Inflation Multi-Strategy Real Assets Inflation sensitivity the unifying attribute of real assets. Real assets are commonly known for their inflation-hedging characteristics. However, real asset performance is not so much related to the absolute level of inflation, but whether inflation exceeds expectations the inflation-surprise factor. Historically, real assets have tended to benefit from periods of unexpected inflation, contrasting with below-average returns for stocks and bonds (Exhibit 6). Years of successive downward inflation revisions since the financial crisis have worked against real assets, contributing to their significant underperformance recently particularly in commodities. However, we believe increased inflation risk and improving fundamentals have created a more favorable backdrop for real assets. With many listed real asset categories currently trading significantly below their highs, we see this is as an attractive value opportunity for establishing a real assets allocation. Bullish outlook for commodities. Among real assets, commodities have generally been the most sensitive to unexpected inflation indeed, one of the main reasons investors own commodities is to hedge inflation risk. This is because the factors that cause inflation (strong economic Exhibit 7: Commodities Linked to Inflation Surprise Commodities 1-Year Return (lhs) 1 Year Inflation Surprise (rhs) 8 8% 6 6% 4 4% 2 2% Global Real Estate Securities Liquid Real Assets Commodities % -4% -6-6% Global Listed Infrastructure Global Natural Resource Equities At March 31, Source: Bloomberg, Bureau of Labor Statistics, Cohen & Steers. Data represents past performance, which is no guarantee of future results. Exhibit 6: Sensitivity of Returns to Unexpected Inflation (a) 1978 Q % 6% 3% 3.3 An inflation sensitivity of 3.3 indicates that for every 1% that inflation exceeded its prior-year estimate, real assets outperformed their historical average by 3.3% In contrast to the positive response by real assets, inflation surprise has generally resulted in underperformance by stocks and bonds Diversified Real Estate Infrastructure Natural Resource Real Assets (b) Equities Commodities U.S. Bonds U.S. Stocks 4 Average Real Return 6.4% 6.6% 6.9% 5.4% 2.7% % Sensitivity to Inflation Surprise 3.3% % 6.7% -2.1% -0.3% Expected Real Return for every 1% Y/Y Inflation Surprise At March 31, Source: Bloomberg, Bureau of Labor Statistics, Cohen & Steers. 9.7% 7.6% 10.9% 12.1% 9.4% 1.9% 7.9% Data represents past performance, which is no guarantee of future results. (a) Sensitivity to inflation surprise is a proprietary calculation that measures the typical response of real (inflation-adjusted) returns to the year-over-year inflation surprise, defined as the difference between the realized inflation rate and the lagged 1-year-ahead median inflation estimate from the University of Michigan Inflation Survey. (b) Diversified Real Assets represented by an equal-weighted blend of global real estate securities, commodities, natural resource equities and global listed infrastructure.

5 growth and/or capacity constraints late in the business cycle) also tend to drive commodity prices. Also, rising food and energy costs are key contributors to official inflation measures: in the U.S., these components represented 21% of the 2017 CPI increase. It should not be surprising, therefore, that commodity returns have been closely tied to inflation surprise (Exhibit 7). It follows that commodities and commodity-related businesses should be among the primary beneficiaries of today s heightened inflation risk. From a fundamental perspective, the rebalancing of commodity supply and demand has been underway for several years now, and we estimate that many commodity markets are now balanced or in deficit. With the improvement in global growth, commodity consumption has also picked up, creating tighter conditions. Energy: Producers have shown greater discipline in capital spending, and we expect global consumption to exceed aggregate output, likely resulting in further inventory declines. Metals: Generally the furthest along in rebalancing, drastic spending cuts on new mines in recent years should allow deficit conditions to persist, since new mines can take years to bring on line. Agriculture: Grains have taken longer to rebalance, but should enter deficits in 2018 due to stabilization in global acreage expansion and recent weather-related production disruptions. We believe the combination of favorable supply trends, improving consumption and increased inflation prospects creates a compelling argument for commodities. Benefits of the blend. We believe that an effective way to gain broad exposure to real assets is through a strategy that invests across multiple real asset categories such as real estate, infrastructure, commodities and natural resource equities. This approach offers a one-stop liquid real assets solution, potentially dampening the swings in returns that investors may experience with separate allocations to individual asset classes. In addition, due to the low historical correlations among different types of real assets, a blended real assets portfolio has the potential to deliver inflation-hedging characteristics with a better balance of risk and return (Exhibit 8). Exhibit 8: Annualized Nominal Returns and Standard Deviation 1978 Q Reward (% annualized nominal return) 12% 9% 6% 3% U.S. Bonds Diversified Real Assets (a) A blend of listed real assets has historically produced equity-like returns with lower volatility than equities or individual real assets categories. 6% 8% 1 12% 14% 16% 18% Risk (Standard Deviation) Infrastructure Global Stocks U.S. Stocks Real Estate Commodities Natural Resource Equities Annualized Nominal Return Diversified Real Assets (a) Real Estate Infrastructure Natural Resource Equities Commodities Global Stocks U.S. Stocks U.S. Bonds 9.8% 9.8% 10.3% 9.8% 7.1% 8.6% 10.3% 7.3% Annualized Real Return 5.8% 5.8% 6.3% 5.8% 3.1% 4.6% 6.4% 3.4% Risk (Standard Deviation) 12.5% 16.5% 14.6% 17.4% 16.9% 14.7% 15.1% 7.3% Sharpe Ratio x At March 31, Source: Bloomberg, Dow Jones, FTSE, S&P, St. Louis Fed, Thomson Reuters Datastream and Cohen & Steers. Data represents past performance, which is no guarantee of future results. (a) Diversified Real Assets represented by an equal-weighted blend of global real estate securities, commodities, natural resource equities and global listed infrastructure. 5

6 Four Strategies for Fighting Inflation Low-Duration Preferred Securities High current income with a focus on capital preservation. When faced with the prospect of rising inflation and higher interest rates, many investors will rotate into shorter-term fixed income securities that are less vulnerable to rising rates, often sacrificing yield in the process. Low-duration preferred securities could offer a way to regain some of this lost income while keeping a defensive position relative to interest rates. Preferreds generally pay higher income rates than bonds due to their subordinate position in the capital structure, making them an appealing option for yield-seeking investors. These securities come in a variety of structures, which can significantly impact their interest-rate sensitivity. Fixed-rate preferreds may have high durations, whereas those with coupon resets including fixed-to-float and floating-rate securities can have relatively short durations. Most of these shorter-duration securities are found in the institutionally focused over-the-counter market. In fact, of the nearly $1 trillion in preferred securities issued globally, two-thirds have a duration of five years or less. As shown in Exhibit 9, low-duration preferred securities can offer an attractive mix of high current income and low interest-rate sensitivity. As a result, this strategy may defend better than other fixed income investments in periods of rising interest rates. In the recent period of rising Treasury yields from September 2017 to February 2018, lowduration preferreds outperformed many other types of fixed income (Exhibit 10). Exhibit 9: Yield and Duration Comparison Yield 5% 4% 3% 2% Low-Duration Preferred Securities Low-Duration Corporate Bonds Low-Duration Municipal Bonds 5-Year Treasury 1% 2 Years 3 Years 4 Years 5 Years Duration At April 30, Source: ICE BofAML, Cohen & Steers. Data represents past performance, which is no guarantee of future results. Yields shown on a yield-to-worst basis. Duration shown on a modified duration-to-worst basis. Tax-advantaged income for taxable institutions and assets. Institutions that file taxes as C-corporations in the U.S. may gain tax benefits from investments in preferred securities, as dividends paid to them by other tax-paying C-corps are generally eligible for the dividends received deduction (DRD). This applies to taxable institutions that own preferred shares of a taxable C-corp. The amount of the DRD depends on the ownership stake, with a minimum deduction of 5 of dividends received. This means that for corporate investors with a 21% tax rate, the effective tax on preferred income may fall to 10.5%. For family offices that oversee taxable assets, it is worth noting that many preferreds are forms of equity and pay qualified dividend income (QDI), which is taxed at a lower rate than the interest payments from bonds. This means that preferreds may offer an income advantage both before and after taxes relative to many other fixed income categories, including those with much higher durations. Exhibit 10: Fixed Income Performance During a Sharp Rise in the 10-Year Treasury Yield 9/7/17 (2.05%) to 2/28/18 (2.87%), 82 Basis Points Over Six Months Total Return 4% 2% -2% -4% -6% -8% Low-Duration Preferred Securities U.S. High Yield 30-Year Treasury 10-Year Treasury Municipal Bonds Corporate Bonds Low-Duration Municipal Bonds Low-Duration Corporate Bonds At February 28, Source: Morningstar Direct, Cohen & Steers. Data represents past performance, which is no guarantee of future results. 6

7 Why Invest With Us Cohen & Steers is a world leader in liquid real assets and alternative income, with a global team of experienced investment professionals dedicated to understanding these complex and often inefficient markets. Founded in 1986, we have a strong track record of providing innovative diversification solutions and delivering results for our clients. To learn more about these strategies, visit cohenandsteers.com/insights. Index Associations and Definitions An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Page 2 Global Real Estate Securities: U.S. REITs: FTSE Nareit Equity REIT Index contains all tax-qualified REITs, except timber and infrastructure REITs, with more than 5 of total assets in qualifying real estate assets other than mortgages secured by real property that also meet minimum size and liquidity criteria. Global REITs: FTSE EPRA/Nareit Developed Real Estate Index is an unmanaged market-capitalization-weighted total-return index, which consists of publicly traded equity REITs and listed property companies from developed markets. Global equities: MSCI World Index consists of a wide selection of stocks traded in 24 developed countries, weighted for market capitalization. Page 3 Global Listed Infrastructure: Infrastructure: FTSE Global Core Infrastructure 50/50 Net Tax Index, a capitalization-weighted index of worldwide infrastructure and infrastructurerelated securities (net of dividend withholding taxes), with constituent weights adjusted semi-annually according to three broad industry sectors: 5 utilities, 3 transportation, and a 2 mix of other sectors, including pipelines, satellites and telecommunication towers. Global equities: MSCI World Index (see above). Page 4 5 Multi-Strategy Real Assets: U.S. stocks: S&P 500 Index is an unmanaged index of 500 large-capitalization stocks that is frequently used as a general measure of U.S. stock market performance. Global stocks: MSCI World Index (see above). U.S. bonds: ICE BofAML U.S Year Treasury Index: composed of U.S. Treasury notes with a 7-10 year maturity. Real estate: Through February 2005: U.S. REITs; thereafter: Global REITs (see above). Infrastructure: Through July 2008: 50/50 Blend of Datastream World Pipelines and Datastream World Gas, Water & Multi-Utilities, encompassing global indexes of companies in their respective sectors, compiled by Thomson Reuters Datastream; thereafter: Dow Jones Brookfield Global Infrastructure Index measures the stock performance of publicly listed infrastructure companies representing all sectors of the infrastructure market. Commodities: Through July 1998: S&P GSCI, a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities; thereafter: Bloomberg Commodity Total Return Index, a broadly diversified index composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metals Exchange. Natural Resource Equities: Through May 2008: Datastream World Oil & Gas and Datastream World Basic Materials, encompassing global indexes of companies in the basic materials sector, compiled by Thomson Reuters Datastream; thereafter: S&P Global Natural Resource Equities Index, includes 90 of the largest publicly traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors diversified, liquid and investable equity exposure across three primary commodity-related sectors: Agribusiness, Energy and Metals & Mining. Page 6 Low-Duration Preferred Securities: Low-Duration Preferred Securities: ICE BofAML 8% Constrained Developed Markets Low Duration Capital Securities Custom Index tracks the performance of select U.S. dollar-denominated fixed- and floating-rate preferred, corporate and contingent capital securities, with remaining term to final maturity of one year or more, but less than five years. 5/10/30-Year Treasuries: ICE BofAML Current U.S. Treasury Index series are one-security indexes consisting of the most recently issued U.S. Treasury note with the indicated maturity. Corporate Bonds: ICE BofAML Corporate Master Index tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. Low-Duration Corporate Bonds based on a subset of this index, representing securities with maturities of 1-5 years. Municipal Bonds: ICE BofAML Municipal Master Index tracks the performance of U.S. dollar-denominated investment-grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Low-Duration Municipal Bonds based on a subset of this index, representing securities with maturities of 1-5 years. U.S. High Yield: ICE BofAML U.S. High-Yield Indextracks the performance of U.S. dollar-denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Important Disclosures Data quoted represents past performance, which is no guarantee of future results. This material is provided for informational purposes only and reflects the views of Cohen & Steers, Inc. and sources believed by us to be reliable as of the date hereof. No representation or warranty is made concerning the accuracy of any data compiled herein, and there can be no guarantee that any forecast or opinion in these materials will be realized. This is not investment advice and may not be construed as sales or marketing material for any financial product or service sponsored or provided by Cohen & Steers, Inc. or any of its affiliates or agents. This is not an inducement to buy or sell commodity interests. Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. 7

8 About Cohen & Steers Cohen & Steers is a global investment manager specializing in liquid real assets, including real estate securities, listed infrastructure, commodities and natural resource equities, as well as preferred securities and other income solutions. Founded in 1986, the firm is headquartered in New York City, with offices in London, Hong Kong, Tokyo and Seattle. Publication Date: June Copyright 2018 Cohen & Steers, Inc. All rights reserved. cohenandsteers.com Advisors & Investors: Institutions & Consultants: VP664-INST 0618