The experts say now is the time to bolster portfolios by hedging against inflation with strong, real assets investments
When Federal Reserve Chair Jerome Powell admitted “I think we now understand better how little we understand about inflation,” discussions at the 2022 European Central Bank Forum in Sintra, Portugal came to a momentary standstill. It was an acknowledgment that left some feeling dismayed, while others were less surprised.
“The inflation we are seeing today initially began to take hold in early 2021 as Covid vaccines were rolled out and the economy began to recover,” says Laura Lau, Chief Investment Officer, Brompton Funds. “Pundits originally expected inflationary conditions would be temporary, but this has not been the case. We believe this is happening because the pandemic also triggered supply-side inflation, which is structural as opposed to the cyclical inflation we are more familiar with,” Lau explains.
It is this contextual element, this distinction in economic dynamics that illustrates why conventional high interest rate approaches to controlling today’s inflation is an arguably blunt instrument. And while increasing interest rates could potentially push the economy into a recession for the short term, it could also exacerbate underinvestment in supply and potentially drive inflation higher again in the medium to long term.
According to Lau, supply-side challenges call for supply-side strategies.
“Historically, higher rates have only brought inflation down through a recession,” she says. “Part of the problem is that central banks are mostly powerless when it comes to addressing the structural sources of supply-side inflation that we’re seeing this cycle.”
Lau says the factors fuelling supply-side constraints include Russia’s war in Ukraine, the reversal of many globalization trends, demographics, a decade of underinvestment in commodities and infrastructure, and the ongoing cost of decarbonization.
With forces such as these expected to persist for the foreseeable future, investors will need strategies specifically designed to perform well during times of heightened volatility and inflation. This means diversifying with asset classes like real assets, which leverage inflation to generate income growth.
Real assets are long life, tangible assets that often provide essential services and are characterized by high barriers to entry, low maintenance capital requirements, and strong pricing power. Contrary to fixed income assets, real assets prosper during high inflationary periods because of their ability to pass cost inflation onto their customers through inflation-linked contracts and cost recover mechanisms. These companies typically operate in less competitive industries, which allows them to be price setters rather than price takers so cost inflation can be more readily passed to customers than companies that operate in more competitive industries.
“The bond market has had its worst performance since 1949 and stocks have broadly sold off,” says Maggie Meng, Senior Investment Analyst, Brompton Funds. “Real assets have generated superior performance against the traditional 60-40 portfolio so far in 2022 and have outperformed stocks so far as well. Energy and utilities are the only sectors with positive returns this year, both of which are part of real assets.”
In tandem with their natural hedge against inflation, real assets are also being bolstered by unprecedented levels of regulatory support for clean energy that include the Inflation Reduction Act passed in the U.S. and the RePowerEU plan in Europe.
Meng says the Brompton Sustainable Real Assets Dividend ETF is an example of a fund that provides high monthly distributions and the opportunity for capital appreciation during inflationary conditions. This is because it invests in an actively managed portfolio of Global Real Assets companies (primarily real estate, utilities, infrastructure, resources.) Additionally, the fund is complemented by a proprietary covered call options program that works to enhance monthly income.
“Our active covered call strategy allows us to take advantage of market volatility, particularly in environments such as the current market,” says Meng. “By selling call options on our portfolio holdings, we can harvest this volatility by generating option premiums that reduce the portfolio’s overall volatility while enhancing its income. Over time, these types of strategies can provide higher risk-adjusted returns for investors.”
The portfolio management team at Brompton use top-down analysis methodologies to identify attractive sub-sectors, and employ rigorous fundamental analysis, including the integration of Environmental, Social, and Governmental (ESG) factors, to focus the portfolio on well-positioned, large-capitalization Real Assets issuers.
“BREA offers a current annual distribution yield of approximately 5.5 percent and has delivered a 7.9 per cent per annum total return since its inception in April 2020 to September 30, 2022,” says Meng. “Investors seeking capital appreciation, enhanced income, and lower volatility through covered call strategies can find the all-in-one solution in this ETF in particular.”
Right now, investors looking to adjust their portfolios to leverage persistent inflation can look to real assets, a class that has historically performed well on both an absolute and relative basis during periods when inflation is above 2.5 percent. With Canada’s inflation rate still hovering well over that figure and the lag time high interest rates are known to demonstrate, there’s no time like the present to hedge for the future.