The Alternative Investments That Could Help Hedge Against Inflation
Since the beginning of the year, the distribution of COVID-19 vaccines, abundant fiscal stimulus and the lifting of restrictions on many activities have fueled the economy and generated a resurgence of optimism among Americans. By the midpoint of the year, some forecasts pointed to potential calendar-year growth in the United States that could be the strongest in nearly four decades.
But there are challenges. The lingering economic effects of the pandemic’s disruption are still apparent in the form of bottlenecks in global supply chains, inventory and material shortages, and a scarcity of skilled labor for businesses. The result has been a surge in prices for various goods and services and the resurfacing of inflation as a legitimate concern.
The prevailing view has been that the current surge in consumer prices will be temporary and, as conditions normalize, price pressures will ease. Still, conditions are uncertain, and it’s possible that the country could experience inflation that’s higher than we’ve experienced over the past decade, which could persist longer than anticipated. What does that mean for investors? What are considerable investment opportunities if inflation persists?
For investors concerned with the prospects of rising inflation and related market volatility, several alternative investment asset classes may merit consideration. Real estate, private credit and commodities have often performed well during periods of rising inflation, which resemble that of today’s environment.
Private Real Estate
As a “real” or physical asset class, real estate is often sought after for its diversification and inflation-protection characteristics. Value from investment real estate is tied directly to its appreciation potential and expected cash flows associated with income generated by users of the property.
It’s a broad category though, with a wide range of risk/return profiles and property types. Public market options are available in the form of real estate investment trusts (REITs); however, exposure via private vehicles can act as a better diversifier to stocks and experience less volatility than publicly traded REITs.
Income-producing real estate appeals to investors for its relatively stable source of return to a portfolio. Currently, high-quality private commercial property yields exceed those of high-quality bonds, providing a larger potential income cushion to a portfolio to offset inflationary impacts.
Unlike traditional bonds, where the coupon rate is fixed at the point of issuance, real estate-generated income may grow over time as a result of rising rental or usage rates. In an inflationary environment characterized by a strong economy, increasing construction input costs and demand for space that outstrips available supply, real estate investors could benefit from both higher rental income and property appreciation.
Still, these particular investors should consider the risks, including property valuation considerations, lack of liquidity, regulation and the use of leverage. Professionally managed private real estate vehicles can provide some protection to investors through limits on voluntary liquidity and by applying expertise in pricing assets, underwriting tenants, negotiating lease structures and navigating the dispersion in local markets and property types.
Private credit investments involve debt financing transactions that occur outside of the traditional public markets. In particular, direct lending is a subset of the space that focuses specifically on loans to private middle-market companies that might not have access to traditional bank financing. These obligations are typically collateralized with senior, first-lien positions against the assets of a company.
The direct lending market has grown considerably since the 2008 global financial crisis. Private lenders often work directly with private equity firms to create customized capital structure solutions, offering flexibility to borrowers not typically available from traditional lenders.
Direct lending strategies benefit from relatively high yields and low interest rate risk because the interest charged on the loans “floats” with increases or decreases in a short-term benchmark rate—a structural feature that may increase inflation protection. And while there are publicly traded debt securities with floating interest rates—most notably the leveraged loan market—the direct lending market typically benefits from higher interest rates.
Considerations when investing in direct lending include credit risk, a relative lack of liquidity and the negative effect of ordinary income tax applicable to the income generated to taxable investors. Given the importance of credit selection and the strategy’s buy-and-hold nature, it’s important that investors gain access through a professionally managed vehicle that reduces or eliminates voluntary liquidity, and which necessitates investor commitments for a period that could exceed five years.
Many commodities, including energy, agricultural and industrial metals, are essential inputs into various goods and services that comprise key components of inflation indices, such as the consumer price index. This relationship creates a strong linkage between commodity prices and broad inflation gauges. Gold has also shown some ability to act as an inflation hedge over time. Additionally, over the long term, the performance of a basket of commodities futures have demonstrated relatively low correlation to stocks and bonds, providing strong portfolio diversification.
Commodities tend to perform best when inflation is rising, such as in the 1970s and early 1980s, and can also do well in periods of high demand for physical commodities, such as the period leading up to 2008. However, they suffered dramatically over the last decade, failing to even keep pace with cash yields over that time frame. Extended periods of underperformance compared to traditional markets can make it difficult for investors to maintain an allocation to commodities.
Commodities investors should consider political and regulatory risks, risk/return characteristics, and implementation factors. Volatility and lower return expectations can make it difficult to make a commitment to commodities within a portfolio, particularly if that inflation surge is short term in nature or is driven by factors that aren’t directly reflected in commodity prices.
The current spike in prices for many goods and services has raised inflation concerns for investors. While the consensus view is that structural disinflationary forces will persist in our economy and mitigate longer-term inflation risks, the alternative investments discussed above could enable investors to reduce negative impacts of inflation while enhancing portfolio diversification.
Jim Baird is a CPA, CFP®, CIMA®, CIO and partner with Plante Moran Financial Advisors.
Mark Dixon is a CPA, CFP®, CIMA® and partner with Plante Moran Financial Advisors.