How can alternatives act as a hedge to rising rates and inflation?

Could persistent inflation and rising rates be the death knell for the 60/40 portfolio?

Investors are beginning to shift their focus from the pandemic to the consequences of policymakers’ unprecedented stimulus packages. These efforts to support the economy have contributed to rising inflation and interest rates. This shift away from low inflation and negative interest rates, could pose difficulties for traditional, longer duration fixed income and public equities.

With labour markets almost fully recovered from the pandemic, trillions added to the money supply, and supply chains strained from demand and inventory shocks, consumers are experiencing drastic price increases felt broadly across goods and services. 

With increases to housing, food, transportation and energy, the labour force is now expecting wages to adjust accordingly¹. Central bankers globally are now pressured to respond to these trends with both swift and meaningful interest rate increases. That’s because policy rates are lagging the neutral rate of interest by more than 8%². 

This hawkish stance is a step change to central bankers’ prior position of “transitory inflation” from November 2021³. Forward markets estimate that, within two years, short term interest rates in the US will be brought to around 3.0% from today’s 0.3%⁴. 

While long term inflation expectations are anchored, credit spreads remain low (but widening), and profits are at record highs⁵. This shift in policymaking has ignited investor’s fears of tightened financial conditions, contracting earnings, and defaults.

In what has been an unusual time for global markets, stocks and bonds have been correlated to the downside and suffered significant losses in 2022. Investors are justifiably concerned that the bastion of the 60/40 portfolio⁶ is not suitable for a period of rising inflation and interest rates as shown by figure 1 below. 

There is clearly a need for different sources of growth and income.  Let’s examine how both traditional and alternative asset classes respond to a challenging market environment and propose an optimised portfolio.

How could alternative sources of income combat rising rates?

Alternative credit may provide outperformance during periods of rising interest rates due to structural advantages over traditional, long duration fixed income. 

Senior loans have floating rate coupons that reset upon issuance and an effective duration of zero. This asset class has only had two years of negative returns over the past 30 years⁷, despite three global recessions and multiple episodes of rate hikes. 

As most developed market fixed income asset classes have fallen in 2022, the lower duration of loans combined with higher yields may make them an attractive option. Should central banks raise rates as aggressively as the market anticipates, historical analysis of hiking periods shows that loans have outperformed corporate credit and aggregate bonds on both an absolute and a risk adjusted basis⁸.

Should interest rates continue to rise, loans could be well positioned to outperform longer duration credit and treasuries. By isolating the nine periods since 1993 where the 10-year Treasury increased more than 100 basis points, loans have outperformed. Remarkably, loans averaged a 6.9% return⁹, while traditional income assets were all negative (figure 2).

Using forward looking risk measures, and sensitivity analysis to macroeconomic shocks, we can isolate the risk factors attached to these asset classes. Assuming an increase of 100 basis points in inflation or rates, loans (+5.8%) and private credit first lien (+2.65%) are expected to see positive performance.¹⁰  Conversely, global aggregate bonds are negatively exposed when rates rise (-5.39%) and when inflation rises (-0.16%).¹¹

Forecasts are not reliable indicators of future performance.

Could real assets provide a solution to negative real rates?

Housing, the largest component of the Global Consumer Price Index, had growth of 17.5% year on year as of March 2022. Rental inflation growth year on year for the same period was 15.4%. For both measures, this represents the highest level of annual growth ever recorded¹².

Mirroring broader inflation, construction costs¹³ have risen due to supply chain issues in materials. Real estate may provide investors a hedge to inflation as a pass-through vehicle, due to its return components of income and appreciation. In fact, rising construction costs might limit new supply from entering the market, potentially benefiting owners of existing real estate.

Real estate’s inflation hedge derives from revenue streams that can quickly adjust in an inflationary environment due to lease terms and structures. As inflation increases, the correlation of private real estate to inflation tends to strengthen – in periods where inflation is more than 5% it rises to 0.83.¹⁴

Historically, inflation correlations have been similar for both components of real estate’s total return (appreciation 0.36 and income returns 0.34). During periods where inflation is more than 5%, correlations have increased to 0.73 for appreciation and 0.76 for income returns.¹⁵

Could different sectors of the real estate market see varying performance? 

Over the long term, inflation has had the highest correlation with the apartment (0.53) and office sectors (0.44). Meanwhile, correlations with the retail sector have been weak at just 0.2. During periods where inflation is more than 5%, inflation correlations increased substantially for apartment, industrial and office sectors. But correlations with the retail sector remained weak (figure 3 below).

Property sectors characterised by shorter lease terms allow the owner to quickly reset rents during an inflationary period. For residential sectors, the tenant is responsible for utility costs and the landlord for all other operating and maintenance costs; for self-storage, the landlord is responsible for all operating and maintenance costs. 

Property sectors characterised by longer lease terms, like retail, offices and industrial parks, allow the owner to reset rents only for expiring leases. Longer-term leases typically include pre-set rent increases to offset inflation during the term, but these can vary in magnitude and timing.

Capitalisation rates and their spread to treasuries are typically the measures used by investors to estimate their compensation for taking on real estate risk. We posit that the relationship of capitalisation rates to treasuries are highly correlated over the long term. They have been in secular decline for 30 years but are not very correlated over the short term. 

In fact, in 6 of 7 periods where treasuries have risen for three quarters or more since 1993, capitalisation rates have actually fallen. Looking forward, should higher rates persist, we would interpret this as a sign of a strengthening economy, a positive for real estate demand that potentially mitigates the impact of bond yields on capitalisation rates.

How can investors optimise portfolios with alternative assets?

We recognise that investors may have a multitude of constraints when substituting traditional assets for alternatives. In an exercise to determine the impacts of adding a small portion of alternative assets to a traditional portfolio¹⁶ we developed the following allocation in figure 4 below. Notably, Treasury Inflation Protected Securities are left out of this optimised portfolio as other assets provide a better hedge to inflation and rates, and an improved risk adjusted return.

As a result of this optimisation we found that:

• An investor can potentially improve portfolio yields. The optimised portfolio delivering 2.45% rather than 2.09%.
• Could increase probability of outperformance during rising inflation and interest rates.
• Reduce downside exposure in the event of a market sell-off.

Forecasts are not reliable indicators of future performance. Transitioning from a traditional 60/40 allocation to a 55/25/20 allocation, through the addition of alternative assets, could allow investors to hedge some of the macroeconomic risks facing their portfolios.