Addressing Real Assets headwinds head-on

Market index returns

Year to date since December 31, 2022 as of August 23, 2023

^{Index definitions: Global Real Estate = FTSE EPRA/NAREIT Developed Index; Global Infrastructure = Dow Jones Brookfield Global Infrastructure Index; Natural Resource Equities = S&P Global Natural Resources Index; Commodity Futures = Bloomberg Commodity Index; TIPS = Barclays US TIPS Index; Global Equities = MSCI World Index; Real Assets Index = 30% FTSE EPRA/NAREIT Developed Index, 30% Dow Jones Brookfield Global Infrastructure Index; 15% S&P Global Natural Resources Index; 15% Bloomberg Commodity Index, 10% Barclays TIPS Index. Source: Bloomberg, DWS. Past performance is not indicative of future results. It is not possible to invest directly in an index.}

Market commentary:

Broader equities are delivering strong year-to-date returns overall, driven in large part by stellar performance from a small set of mega-cap tech stocks. Meanwhile, nominal performance across Real Assets categories has remained under pressure. What gives? In this week’s special report, we shed some light on what’s keeping a lid on Real Assets returns and the shifting macroeconomic signals that suggest we may soon see these headwinds abate.

Digging deeper: Last week, we mentioned that seeking to identify the inflection points within trends in global business, economic, and credit cycles can help assess directional risks across asset classes, companies, sectors, and regions. But what exactly does this look like? After strong relative performance during the latter half of 2021 and early 2022, Real Assets have faced two primary headwinds:

Rising Real Rates
Disinflation

Below, we provide a view of trailing 12-month changes in real rates and CPI. Not only are the recent rise in real rates and decline in CPI among the largest in the last twenty years, but they have also happened simultaneously.

12-month change in real rates & headline inflation

Chart 1.png

^{Source: DWS, Bloomberg. Left chart shows trailing 12-month changes in U.S. real interest rates (USGGT05Y INDEX). 20-year history as of July 2023. Right chart shows trailing 12-month changes in U.S. headline inflation as represented by U.S. Headline CPI (CPI YOY Index). 20-year history as of July 2023.}

This one-two punch has resulted in a level of relative underperformance that has historically been followed by a period of attractive nominal returns. Importantly these headwinds are likely behind us as:

The forward curve suggests at most one additional hike from the Federal Reserve; thus, the likely rate of change of real rates should be flat to down as we move towards year-end.
The disinflationary period is in the rear-view mirror, as CPI has fallen from 9% in June 2022 to 3.2% in July 2023. The consensus forward CPI path is flat, and with the recent rise in energy prices, we believe it could even be higher over the coming months.

Why it matters: Below, we seek to illustrate what the dissipation of these headwinds could mean for Real Assets.

An imminent end to the current hiking cycle: While predicting the path of rates can be a fool’s errand, the weight of the evidence suggests that the majority of the rise in interest rates is behind us, which should see a key headwind abate. This is supported by an analysis of listed U.S. real estate performance into and out of the last Fed hikes across historical rate-hiking cycles, which has shown that real estate, in particular, has struggled in the period leading up to the last rate hike of a given cycle but exhibited strong nominal performance (between 10-25%) over the 6 months following the last rate hike of a given cycle.

U.S. Real Estate performance into and out of the last Fed hike of past cycles

Chart 3.png ^{Source: Bloomberg, DWS. Performance represented by the EPRA NAREIT U.S. TR Index relative to the index level at the date of the last hike as shown on the chart. As of July 2023.}

Decelerating rate of change in inflation: Additionally, our view is that inflation, which witnessed sharp declines driven by commodity prices easing after a meteoric rise in early 2022 and supply chains normalizing, will begin to stabilize over the next few months. This deceleration in the rate of change of disinflation is among the most positive developments for Real Assets as it should remove a key headwind – one that is evidenced by the historical underperformance of Real Assets versus the traditional 60/40 portfolio during periods of sharp drop-offs in inflation. Additionally, while we do not have a crystal ball, there are plenty of signs that inflation may not ease back down to the Fed's 2% target, but could remain sticky and hover closer to the 3% level (or even reaccelerate). While the 2010's were a decade of low inflation and real asset underperformance, prior cycles where inflation was higher coincided with outperformance in Real Assets versus traditional classes.

Rolling 12-month returns

Chart 4.png

Rolling return difference versus inflation

Chart 5.png

^{Source: Bloomberg, DWS. The top chart shows rolling 12-month returns of a Real Assets Blend and Global 60/40 portfolio since 12/31/2002. The bottom chart shows the rolling return differential and annualized headline CPI. The Real Assets Blend consists of the following blend of real assets categories consistent with what is shown in our weekly dashboard: 30% FTSE/EPRA Nareit Developed Index; 30% Dow Jones Brookfield Global Infrastructure Index; 15% Bloomberg Commodities Index; 15% Global Natural Resources Index; 10% Barclays U.S. TIPS Index. The Global 60/40 portfolio consists of a 60/40 blend of the MSCI World Index and Barclays Global Aggregate Bond Index. As of July 31, 2023}

The bottom line: With the fundamental case for Real Assets alive and well and key headwinds poised to abate, valuations screen attractively at current levels. A 20-year historical drawdown analysis suggests current levels may offer an attractive entry point for Real Assets. In particular, global real estate and global infrastructure tend to bounce back from oversold conditions.

Within global infrastructure, each time the rolling 12-month return has fallen below -10%, forward 12-month returns averaged +12.4% while forward average 24-month returns were +25%.
For real estate, which has seen steeper drawdowns on a rolling basis, forward 12-month returns after a 20% drawdown have averaged 17.5%.

Additionally, both global infrastructure and real estate have proven over multiple decades to have competitive returns compared to global equities*. However, over the past few years, these asset classes have struggled versus their own history. The chart below shows that on a rolling 7-year basis, these asset classes are in the bottom decile of rolling returns, further reinforcing the potential for a strong rebound.

^{* This statement is based on a calendar-year analysis of Global Real Estate securities and Global Infrastructure securities returns as represented, respectively, by the FTSE EPRA/NAREIT Developed Index and Dow Jones Brookfield Global Infrastructure Index versus Global Equities represented by the MSCI World Index. Over the last 20 calendar years ended December 31, 2022, average calendar-year returns for Global Real Estate securities and Global Infrastructure securities have exceeded those of Global Equities.}

Rolling 7-year returns - current percentile

Chart 6.png

^{Source: Bloomberg, DWS. The above chart shows the current percentile of trailing 7-year returns versus respective index history as labeled. The Real Assets Blend consists of the following blend of real assets categories consistent with what is shown in our weekly dashboard: 30% FTSE/EPRA Nareit Developed Index; 30% Dow Jones Brookfield Global Infrastructure Index; 15% Bloomberg Commodities Index; 15% Global Natural Resources Index; 10% Barclays U.S. TIPS Index. As of July 31, 2023}.

What we are watching: Looking ahead, inflation expectations, as well as GDP growth, are expected to slightly decelerate in the third quarter. As a fresh wave of mixed economic data tempers July’s idealism, we feel more comfortable with current valuation levels while continuing to lean defensively given the uncertain macro environment. Overall, we continue to advocate for portfolio diversification via a holistically managed allocation to liquid real assets, which can help preserve and grow capital while providing diversification benefits throughout a variety of economic regimes and capital market cycles. We will return next week with a full monthly recap of August performance and more unique insights to offer on Real Assets.

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