Alternative investments that could help protect against inflation
For investors concerned about the prospect of rising inflation and the resulting market volatility, there are several categories of alternative investment assets that may be worth considering.
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Since the beginning of the year, the distribution of COVID-19[female[feminine vaccines, plentiful tax incentives and the lifting of restrictions on many activities fueled the economy and generated renewed optimism among Americans. By mid-year, some forecasts pointed to potential growth for the calendar year in the United States, which could be the strongest in nearly four decades.
But there are challenges. The lingering economic effects of the pandemic disruption are still apparent in the form of bottlenecks in global supply chains, shortages of inventory and materials, and a shortage of skilled labor for businesses. This resulted in a surge in the prices of various goods and services and the reappearance of inflation as a legitimate concern.
The prevailing view is that the current surge in consumer prices will be temporary and, as conditions normalize, price pressures will ease. Still, conditions are uncertain and it is possible that the country will experience higher inflation than we have experienced over the past decade, which could persist longer than expected. What does this mean for investors? What are the significant investment opportunities if inflation persists?
For investors concerned about the prospect of rising inflation and the resulting market volatility, there are several categories of alternative investment assets that may be worth considering. Real estate, private credit and commodities have often performed well during periods of rising inflation, which resemble the current environment.
Private real estate
As a “real” or physical asset class, real estate is often sought after for its characteristics of diversification and protection against inflation. The value of the real estate investment is directly related to its appreciation potential and the expected cash flows associated with the income generated by the users of the property.
It is, however, a broad category, with a wide range of risk / reward profiles and property types. Public market options are available in the form of real estate investment trusts (REITs); however, exposure through private vehicles can serve as a better diversifier for equities and experience less volatility than publicly traded REITs.
Income-producing real estate attracts investors for its relatively stable source of return on a portfolio. Currently, the yields of high-quality private commercial properties exceed those of high-quality bonds, providing a greater potential income cushion to a portfolio to offset inflationary impacts.
Unlike traditional bonds, where the coupon rate is fixed at the time of issuance, the income generated by real estate can increase over time due to rising rental or usage rates. In an inflationary environment characterized by a strong economy, rising costs of construction inputs and demand for space that exceeds the available supply, real estate investors could benefit from both higher rental income and a higher level of rental income. real estate value.
Nonetheless, these retail investors should take into account the risks, including property valuation considerations, lack of liquidity, regulation and the use of leverage. Professionally managed private real estate vehicles can offer some protection to investors by limiting voluntary liquidity and applying expertise in asset pricing, tenant underwriting, negotiating rental structures and managing market dispersion. premises and types of properties.
Private credit investments involve debt financing transactions that take place outside traditional public markets. In particular, direct lending is a subset of the space that specifically focuses on lending to private mid-market companies that might not have access to traditional bank financing. These bonds are generally secured by senior senior positions against the assets of a company.
The direct lending market has grown significantly since the global financial crisis of 2008. Private lenders often work directly with private equity firms to create tailor-made capital structure solutions, providing flexibility to borrowers who are not typically not available from traditional lenders.
Direct lending strategies benefit from relatively high returns and low interest rate risk, as the interest charged on loans “floats” with increases or decreases in a short-term benchmark rate, a characteristic structural which can increase protection against inflation. And although there are debt securities listed on a stock exchange with variable interest rates, especially the leveraged loan market, the direct loan market generally benefits from higher interest rates.
Considerations when investing in direct lending include credit risk, a relative lack of liquidity and the negative effect of ordinary income tax applicable to income generated by taxable investors. Given the importance of credit selection and the buy and hold nature of the strategy, it is important that investors have access to it through a professionally managed vehicle that reduces or eliminates voluntary liquidity, and which requires investor commitments for a period that may exceed five years.
Many commodities, including energy, agricultural and industrial metals, are essential inputs in various goods and services that are key components of inflation indices, such as the consumer price index. This relationship creates a close link between commodity prices and general inflation indicators. Gold has also shown some ability to act as a hedge against inflation over time. In addition, over the long term, the performance of a basket of commodity futures has shown a relatively low correlation with stocks and bonds, providing strong portfolio diversification.
Commodities tend to perform better when inflation is on the rise, such as in the 1970s and early 1980s, and may also perform well in times of high demand for physical commodities, such as the period before 2008. However, they have suffered considerably in recent years. decade, failing even to keep pace with monetary returns during this period. Extended periods of underperformance relative to traditional markets can make it difficult for investors to maintain an allocation to commodities.
Commodity investors should consider political and regulatory risks, risk / reward characteristics and implementation factors. Volatility and lower return expectations can make it difficult to commit to commodities within a portfolio, particularly if this surge in inflation is short-term in nature or due to factors that are not reflected. not directly in commodity prices.
The current surge in the prices of many goods and services has raised inflation concerns for investors. While the consensus is that structural disinflationary forces will persist in our economy and mitigate long-term inflation risks, the alternative investments discussed above could allow investors to reduce the negative impacts of inflation while improving diversification. of the wallet.
Jim Baird is CPA, CFP®, CIMA®, CIO and partner of Financial Advisors Plante Moran.
Mark Dixon is CPA, CFP®, CIMA® and partner of Plante Moran Financial Advisors.