Protecting Against Inflation Risk Via Tangible Assets
2018 Investment Themes series: Late-cycle theme #5
Inflation expectations are very low. And yet there is a real risk of surprise to the upside at this stage, especially in the US. A direct exposure to real assets helps to stabilise long-term returns and increase the portfolio’s protection against inflation. Real assets include precious metals (e.g. gold), direct real estate, farms, vineyards and forests.
An underestimated inflation risk
Inflation expectations in developed countries are still relative low. This is particularly true in the eurozone. At this stage, wages and prices are barely reacting to improvements in the economy, which is particularly the case in the US where unemployment has fallen to a record level. This phenomenon is observed in Europe too, for example in Germany. After almost 18 months of falling unemployment in the eurozone, unit labour costs have started rising very slightly (1% y/y). What factors explain less correlation between falling unemployment and rising wages? Economists cite three main reasons: globalisation (international competition); the development of e-commerce (price transparency) and the expansion of the service sector in developed countries (less negotiating power for trade unions). Apart from these main factors which are hampering inflation, it is useful to analyse the labour market more generally. It is important to use indicators which take into account the quality of jobs (involuntary part-time jobs, fixed-term contracts) and a measure of unemployment which includes people who are available to work but are not actively seeking, or people who are actively seeking but are temporarily unavailable.
We estimate that some of the factors mentioned previously may be temporary and some leading indicators point to an improvement in the labour market, in terms of job quality. It is thus likely that a further fall in the unemployment rate will have a greater impact on wages. Inflation expectations underestimate the risk of an acceleration in price growth and our scenario includes higher figures than the economists’ consensus for most countries. It is therefore a good time to consider investment solutions that help to protect against this eventuality. Remember that unanticipated inflation is a major source of loss of purchasing power.
Gold prices were recently penalised by a renewed appetite for risky assets and by the rise in bond yields. However, we remain positive on gold and keep our forecast range between $1,200 and $1,500. Real interest rates play an important role for gold. Moreover gold might recover in the event of an acceleration in inflation or inflationary expectations, which would keep real interest rates relatively low or negative as is the case in Europe and Japan. For capital preservation, as long as inflation-adjusted bond yields remain low, bonds will not compete with gold which does not generate revenues. Gold is one of the few diversification assets still available in today’s extremely correlated world. It should play a safe haven role in the event of heightened geopolitical events or instability in the financial markets.
World gold production dipped in 2017. Due to the lack of investment in recent years, relatively few projects for building or enlarging mines are scheduled to come on stream in the short term.
Central banks in emerging markets (e.g. China and Russia) should continue to amass their gold reserves. Demand for jewellery was disappointing in 2017 but is expected to be relative stable in the coming months. Capital flows in ETFs are the most volatile element of demand. The balance remained clearly positive in 2017, well below 2016 levels. The emergence of ETFs on gold in Asia could provide an additional source of demand.
Direct real estate
Direct real estate (commercial and residential) may offer investors a partial protection against a sudden surge in inflation. If nominal interest rates rise because of a projected acceleration in inflation, then real interest rates (adjusted for inflation) will remain more or less stable. If a property owner finances his own “bricks and mortar” at a capped rate before inflation surges, borrowing costs will remain unchanged while rental revenues will increase.
Protection against inflation is undeniably partial for two main reasons: i) there is a time lag between the rise in prices and the rental indexation, often six months or more and ii) the various indices used for rental indexation do not always fully reflect future inflation.
In the event of inflation, growth in rents tends to occur before values go up. Theoretically, property values could be considered as an infinite supply of growing rental cash flows, which is why rents rely on inflation to climb.
Farms, vineyards and forests
Rural real estate offers an attractive alternative to investors wishing to diversify their portfolio. These assets are not correlated to the financial markets and provide (usually indexed) revenues, while offering a long-term capital appreciation. BNP Paribas Wealth Management has a department specialised in rural real estate transactions in France: Agrifrance. It advises clients (on both the buying and selling side), executes and facilitates transactions involving farms, vineyards, forests and country estates. It also assists would-be buyers in the search for real estate management solutions.
Farms: most farmland (74%) on the market is leased; demand is resilient, rental income is between 2% and 4%, land prices have increased by on average 4% over the past ten years and the French market is more attractive than its neighbouring countries.
Vineyards: different investment strategies may be taken in this area. Top-of-the market vineyards and very well-known appellations enjoy strong price increases as well as good prospects for long-term capital appreciations. However, returns are very moderate. At the low end of the market, vineyards offer reasonable returns (leased vineyards) and moderate potential for capital appreciation, while others offer good potential for long-term capital appreciations.
Forests: timber price volatility has no impact on forest prices. Demand exceeds supply and a premium is added according to the size, ease of management, coherence and proximity to a major town or city.
Despite the recent fall in inflation rates, inflationary expectations remain relatively low for developed countries for three main reasons: globalisation (international competition), the development of the digital economy and e-commerce (price transparency) and the expansion of the service sector in developed economies (less negotiating power of trade unions). We estimate today that certain factors mentioned above may be temporary. And yet there is a real risk of surprise to the upside at this stage, above all in the US. A direct exposure to real assets helps to stabilise long-term returns and increase the protection of a holding against the loss of purchasing power. Such assets include precious metals (gold), direct real estate, farms, vineyards and forests.
Gold and direct real estate: Interest rates and bond yields could exceed the forecasts in our base scenario. This might lead to higher real interest rates which could have a negative effect on gold and real estate.
Rural land: Investments in farms, vineyards and forests are, by nature, long-term investments which may be considered as illiquid. Prices and quality vary considerably due to various factors (degree of renown, location, topography, road/rail/air connections, technical and financial returns). Climatic conditions and plant diseases may also have an impact on valuations.