As US interest rate cuts have looked increasingly likely, valuations for ‘real assets’ have been creeping higher. The asset class has also circumvented a lot of August’s volatility, reminding investors of its strength as a diversifier. After a tougher period for asset-backed investments, could lower rates be a supportive factor for this part of the market?
Real assets generally include asset-backed investments such as property, infrastructure and transportation assets such as ships and planes. They have had a difficult period, substantially lagging wider equity markets in 2023 and for the year-to-date. While the S&P 500 was up 26.3% in 2023 and has risen 19.5% in 2024, the S&P Real Assets index was up just 7.8% in 2023 and 6.2% this year.
Over the last couple of months, that has started to change. On initial appraisal, this run of strength appears to be a standard response to falling interest rates. However, the relationship with interest rates is complicated, and varies for different types of real asset.
For example, Phil Waller, manager on the JP Morgan Global Real Assets fund, makes a distinction between ‘core’ and ‘opportunistic’ assets.
“A core asset would be a high quality building leased out for five-to-10 years,” he said. “An opportunistic asset would be where an investor buys land, builds the building and aims to sell it on for a decent price. There is more leverage and risk in the opportunistic space and therefore a greater link to interest rates.”
Equally, he added, real estate is more linked to interest rates than other real asset options such as infrastructure or transportation assets. These areas often have longer-duration debt, which is less impacted by short-term moves in interest rates.
Jean-Hughes de Lamaze, fund manager on the Ecofin Global Utilities and Infrastructure investment trust, said: “On the interest rate side, the perception (of a relationship) is larger than reality. Big sharp moves in interest rates lead to big sharp moves in utilities because it is perceived as a bond proxy sector.
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“While utilities often carry high debt, it is also the case that when long-term interest rates go up, it’s often a sign of a booming economy and inflation, and generalist investors tend to favour cyclical investments rather than defensive investments.” Real assets, including utilities, tend to fall into the defensive camp.
He added that the relationship with interest rates is diminishing over the longer-term and the real impact on these companies is minimal. “The earnings base of those companies is barely impacted by rising interest rate phenomenon because inflation has a positive effect.”
Nevertheless, real assets tend to derive a lot of their total return from income, which will become more or less valuable as interest rates rise and fall. Equally, it can impact sentiment. Waller said interest rates have been a driver of negative sentiment, and caused lower levels of liquidity for real assets. He believes a reversal in direction on interest rates should drive investor interest.
Inflation-proofing
With that in mind, while interest rates may be a factor in some reappraisal of real assets, it is not the whole story. Waller believes inflation protection is playing a role.
“A lot of these assets derive a good amount of their return from income and that is inflation-linked. If you’re leasing out a building, or selling energy to the grid, there is a contractual price linked to inflation,” he said. “Investors haven’t had to worry about inflation until recently, but it may become more volatile going forward, given some of the geopolitical considerations.”
There are also structural tailwinds, particularly the energy transition. The move to decarbonise the world’s energy supply is changing the significance and nature of infrastructure assets in particular. At the moment, supply is not necessarily in the right place to meet demand. Significant development is needed to support the change.
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de Lamaze added: “Infrastructure assets used to be very exposed to power generation, which was directly related to the price of commodities. With the evolution towards renewables, the industry is much more contracted. They may operate with 20 year+ contracts, which means companies know the pricing they are going to get.” This has left them less vulnerable to the vagaries of commodities markets.
These assets are also plugged in to the growth of artificial intelligence. Ecofin has done well out of its holding in data centres, for example. Two of the group’s holdings – Vistra and Constellation Energy – have seen a significant re-rating in their share prices over the past year.
Geopolitical problems are also creating opportunities in real assets. There has been a lot of disruption in transport markets, for example, including Houthi rebels disrupting shipping in the Red Sea and Gulf of Aden. Ships have had to take longer routes, increasing costs.
Diversification
In the longer term, Waller said that real assets are being supported by their credentials as a diversifier. “Institutions and private wealth managers have been taking a closer interest. These assets often exhibit a correlation of just 0-0.2% with bond and equity markets, so they are strong diversifiers and that has been true through a number of market cycles.”
This was evident in 2022, when a standard 60/40 portfolio saw double-digit declines, and has been true more recently as investors have fretted about weaker economic growth. They also have low correlation to each other.
The portfolios don’t evolve quickly. These assets are usually illiquid and fund managers can’t respond quickly to shifts in the economic environment. With that in mind, fund managers can’t shift the portfolio in response to falling interest rates.
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Nevertheless, the JP Morgan Global Real Assets portfolio is moving towards less cyclical assets, reducing real estate and leaning into infrastructure and transport, which offer more inflation protection and greater exposure to the energy transition.
Similarly, the managers on the Cohen & Steers Real Assets fund believe infrastructure has attractive valuations and more defensive risk attributes. It is maintaining a defensive tilt because of ongoing uncertainty in the global economy. It is also underweight real estate, though sees value there, particularly in the logistics and self-storage sectors, saying “an end to central bank tightening tends to be followed by notable strength in listed real estate performance”.
Real assets are an option for a more difficult environment, and the income they provide may look more appealing as rates fall. They bring a more cautious tilt to a portfolio. They may provide a ballast should market volatility spike ahead of the US elections in November and in the longer term.
