Market Condition: Stocks and Bonds Are More Correlated
For decades, it has been common knowledge to investors that bonds provide a hedge against stock decline. The logic behind this statement makes sense: When businesses are struggling and there is more volatility in the market, investors look for safer, more secure places to place their money. Bondholders get paid first, and the money left over is available to shareholders, making bonds a safer investment.
Moreover, when the economy is in recession and stocks are struggling, the Fed often cuts rates to stimulate the economy. This makes the higher coupon rates on existing bonds relatively more attractive, driving prices upward.
Furthermore, in the case of bankruptcy, bondholders may have a claim on specific company assets and are the first to be compensated from any liquidation activities.
Unfortunately for many investors, 2022 reminded us that this traditional relationship does not always hold up. We saw global stocks lose around 18% in the same period that U.S. bonds lost 13%. In fact, the correlation between stocks and bonds recently reached its highest level of the century.4
A market in which stocks and bonds behave with increasing similarity calls for alternatives that can further diversify portfolios. Real assets can diversify away some of the risk from this correlation.
Real Assets as a Diversifier
A major benefit of owning real assets in a portfolio is market neutrality. That is, certain real asset classes do not respond to macroeconomic trends or events in the same way that other asset groups do. Reducing a portfolio’s correlation is the best way to achieve diversification benefits. Diversification can lower a portfolio’s risk without compromising expected return when done on the right scale (which we will cover at the end).
Since stocks and bonds are becoming more correlated, investors need to look to alternatives to achieve the same diversification benefits that they might have enjoyed in the past decade through only allocating to stocks and bonds. A lower correlation between securities in a portfolio lowers an investor’s exposure to market risk.
An added benefit of real assets is that not only are most classes less correlated to the stock and bond markets, but they are also less correlated to each other. This means a real asset investor can achieve diversification within its own asset class. Here’s how those return correlations break down over the past 10 years.5
Within the real asset classes, gold and commodities provide the best diversification benefits within real assets, as they have the lowest average correlations to the other asset groups. Commodities also provide the lowest correlation to the bond market, while gold is least correlated with the stock market. However, a diversified mix of many real assets will provide the best benefits and downside protection in any market condition.
Market Condition: Post-Pandemic Inflation
Due to many factors, including post-pandemic stimulus, a breakdown in global supply chains, and elevated energy prices caused by the war in Ukraine, the United States is enduring something it hasn’t had to deal with in many years — high inflation.
At its peak in June of 2022, we were seeing the highest year-over-year inflation since November of 1981. Inflation is extremely detrimental to the economy. It weakens the consumer, drives up input prices for the producer, and destroys portfolio value.
Inflation also caused the Fed to jump into action to cool the economy through interest rate hikes. Shortly following the highest inflation rate since 1981 came the highest Federal Funds rate since 2001. These stricter monetary policies reduce the ability for companies to finance new projects, expand, or innovate. These times of slower growth for the economy mean slower growth for the stock market as well. J.P. Morgan is projecting earnings growth of just 2%–3% next year in the S&P 500.6
In addition to slowing down the stock market, inflation is at least partially to blame for the rising correlation between stocks and bonds. While higher prices are weighing on consumers and hurting equity futures, higher interest rates are making current bonds far less attractive and valuable. These charts from PIMCO highlight this phenomenon.7
Real assets are a great alternative in high-inflation environments, as many sectors have high correlations with the Consumer Price Index (CPI).
Real Assets as an Inflation Hedge
Real assets have historically done well in times of high inflation and are a common inflation hedge in many portfolios. Many real asset groups have high betas to unexpected inflation, as showcased in this chart from PIMCO.7
Important to note from this information is the nearly identical negative beta to inflationary surprises that stocks and bonds share. It’s clear from this data that investors are left highly exposed to inflation risk when only allocated to stocks and bonds, as we saw in 2022.
Also worthy of note is the strong outperformance of real assets over Treasury Inflation-Protected Securities (TIPS). Investors tend to default to TIPS as their only inflation hedging option, as their value is pegged to the CPI. It is clear from decades of return data, however, that real assets have a track record of further outperformance over TIPS in inflationary times and are likely better suited to protect capital when surprise inflation strikes.
To further express the potential capital preservation benefits of owning real assets through inflationary times, we can look at real returns (inflation-adjusted) during these periods. This graphic from Cohen & Steers supports the claim that an allocation to real assets protects the investor from the negative impacts that inflation can have on the markets.8
These figures reflect the “average real returns in periods of rising and unexpected inflation June 1991–March 2022.” Again, commodities lead the way in terms of performance during these periods, but this is where we see other real asset groups thrive as well. Again, we believe that a diversified set of real assets is the best way to protect portfolios in tumultuous conditions.
On a risk-adjusted basis, real assets outperform other asset classes during periods of rising inflation as well. As this graphic from AllianceBernstein shows, such periods exist almost half of the time.9
Inflation is a normal part of a healthy, growing economy. However, it can have negative impacts on portfolios if they are not prepared for its effects. Long-term investors should protect their portfolios from the negative side effects of inflation through real assets.
Market Condition: The U.S. Stock Market Is Expensive
The final current market condition that supports our belief that now is a great time to diversify into real assets is the fact that the U.S. stock market is at one of its most expensive points in history. Using Yale economist Robert Shiller’s CAPE ratio (CAPE = cyclically adjusted price/earnings), we can see that investors in the S&P 500 are paying an extremely high premium for the earnings these stocks produce.10
Outside of recent years, the U.S. stock market has only been this expensive twice: the late 1920s and the late 1990s. We believe that expensive stocks are a potential catalyst for a relative performance change between the U.S. stock market and many other asset classes, including real assets. The steady CAPE growth beginning shortly after the global financial crisis in 2008–09 was a product of loose monetary policy, low inflation, and increased globalization — all three of which are trends that have been reversing for the past few years.
When looking for ways to rebalance a portfolio, valuations can provide investors insight into areas that might be cheap relative to other asset classes. As we will see, the real assets sector is one of them.
Valuations of Real Assets
Investors looking for value in one of the most expensive stock market environments we’ve ever seen can look to real assets to find investments trading at a discount to the market and to history. Across many asset groups, real assets are relatively cheap compared to their history and have been that way for quite some time.
Even through the inflationary period of the past year, commodities are still trading well below their historical average — as they have been since 2012.11
Important to note here is that commodities, on a stand-alone basis, do experience high levels of volatility, which can be concerning to the risk-averse investor. However, when allocated at the right scale, commodities can lower the overall volatility of a diversified portfolio due to their market neutrality, lower relative correlations, and strong inflation-hedging properties.
Now, relative to the U.S. market, energy — a component of natural resources — has traded at a 22% discount on average this century. Today, the energy sector is currently valued at a 50% discount to the U.S. market, over one standard deviation off its mean valuation.12
Even the real estate sector, which has been valued higher than the U.S. market for most of the century, is valued below its historical average, relative to the market.12
Soaring valuations in the stock market make it difficult to expect above-average returns on capital for the long term. Reversions to the mean are common and often inevitable in the investing world. When stocks are charging one of their highest premiums of all time, real assets provide a much-appreciated discounted investment for long-term investors.
Real Asset Investment: How To Size Your Real Assets Position
The retail investor should consider allocating up to 15% of their portfolio to real assets to achieve diversification benefits and a strong inflation hedge.
Diversifiers are key to protecting your portfolio’s capital, especially in tough market conditions. Current market trends and the aftermath of a disruptive and destructive 2022 highlight the importance of planning for the future. Stocks and bonds are more correlated than they’ve been in almost 30 years and cannot be relied upon to provide the same diversification benefits that they have in the past decade. Inflation reached its highest point since 1981 in the past two years, and its effects are still being sorted out in the economy today. On top of that, the United States stock market is trading at one of its highest premiums ever, making above-average returns hard to count on in the future at current prices.
Real assets provide portfolios with increased diversification through lower return correlations, both within their own asset class and with other classes. Additionally, real assets are a reliable inflation hedge against both expected and unexpected inflation. Finally, many real asset groups are trading at discounts relative to their historical averages — providing strong upside potential.
With only a relatively small allocation for portfolios, investors can capture the potential benefits that real assets can provide.
