MASTERCLASS: Real Assets
- 58 mins 15 secs
Two experts give an overview of the different types of real assets such as commodities and real estate, the benefits of owning them, where they fit into a portfolio, and ways to gain access. They also explain how real assets perform during different economic regimes and examine the impact of historically high inflation.Channel: MASTERCLASS
- Marc Dummer, CAIA, CIMA®, Managing Director & Client Portfolio Manager - Principal Asset Allocation
- David Schassler, Head of Quantitative Investment Solutions - VanEck
Jenna Dagenhart: Hello and welcome to this Asset TV Real Assets Masterclass. We'll give you a better sense of the different types of real assets, the benefits of owning them, where they fit into a portfolio, and ways to gain access. We'll also explain how real assets perform during different economic regimes and examine the impact of historically high inflation. Joining us now, we have David Schassler, head of Quantitative Investment Solutions at VanEck, and Marc Dummer, Managing director and client, Portfolio manager at Principal Asset Allocation.Well, everyone, thank you so much for joining us. Marc, kicking us off here, what are real assets? How do you define real assets?
Marc Dummer: Three criteria: they need to enhance diversification relative to a 60/40 portfolio, they need to offer a positive return, but most importantly, they need to correlate with inflation. If you can meet all three of those, then they are a candidate for a real asset allocation. What do I mean by correlation with inflation? What are the typical asset classes? That can be the inputs to production. Think of that as commodities or commodity sensitive equities like natural resource stocks, so agriculture, metals and mining, energy, timber, water, those types of things. It can also be the companies that are price setters, not price takers. That might mean infrastructure or REITs. We like to pair both the commodities and commodity sense of equities with the infrastructure and the REITs and even some tips to dampen the volatility to make it a livable experience for clients. But real assets really need to meet those three things: enhanced diversification, positive total return, and correlate with inflation.
Jenna Dagenhart: David, how about you? How would you define real assets?
David Schassler: I think Marc did an awesome job. Really simply, real assets offer diversification, specifically inflation protection, because stocks and bonds are super vulnerable during a period of high inflation. If you can get real assets within there to offset that, they play a really nice role.
Specifically, what are we talking about? We break into three categories. First one being financial real assets: gold bullion, gold equities, the second, resource assets: commodities, natural resource equities, and then the third, income-generating real assets, which as Marc alluded to, we're talking about infrastructure, we're talking about REITs. But those are three broad categories of real assets. I do think it's very consistent with Marc's answer.
Jenna Dagenhart: Marc, what are some examples of public and private real assets and what are some of the pros and cons that investors should keep in mind with private real assets?
Marc Dummer: Yeah, so public real assets would include global listed infrastructure, global REITs, global natural resource stocks. That might be global timber stocks or global agriculture stocks, maybe global metals and mining stocks. And commodities, those would be the liquid side. One of the advantages of those is that they're liquid. You can invest in a strategy, get in and out of very quickly. One of the disadvantages of those is that each one of those comes with real asset beta, but they also come with equity market beta, or interest rate beta, or in the form of floating rate data, it might come with credit beta. The challenge is constructing down equity market sensitivity and retaining inflation sensitivity.
The examples of private real assets, instead of buying a timber fund, you would buy the fourth land. Instead of owning agriculture stocks or fertilizer stocks, you would actually buy the farm land. Instead of investing in REITs, you might own the company or loan on a building, those types of things, or infrastructure. Maybe you own a private utility.
The advantage of private real assets is that they typically come with a higher return, a lower volatility, better diversification benefits from a 60/40 portfolio, typically higher income. The draw down is they come with less liquidity, and often at higher fees. Net of fees, we would still say that private real assets should outperform public real assets, and both of those should be an important part of a client's portfolios. But the price that people need to pay to invest in private real assets is just less liquidity, so they need to make sure they can handle the illiquidity.
Jenna Dagenhart: David, when you think about real assets, what specific assets are included?
David Schassler: Yeah, so I just covered them before, but I'll do it again. We focus specifically on the publicly traded side of real assets. When we're talking about gold, we're talking about pair gold bullion and gold equities. There's a lot of upside potential in gold equities, but the stability of gold within a portfolio context is key.
It's the same reason why Marc was talking about why do they introduce infrastructure and REITs. Real assets are a really unique asset class, but a lot of them have a lot of volatility associated with them. Really the key here is create a well balanced portfolio of real assets. Think about your infrastructure, think about your REITs, pairing them with your more volatile components, which are your natural resource equities, specifically your traditional energy, putting them together in a risk weighted or dynamic balanced portfolio so you can have a reasonable risk return profile over time.
It doesn't matter if real asset is too fantastic during periods of high inflation if nobody's going to own them because they're so volatile. The key is providing people with that stability within their mix so they can get that 15 to 20% volatility profile. That's the volatility profile that they're used to with stocks. Think about the S&P 500.
Jenna Dagenhart: Broadly speaking, Marc, what are the benefits of investing in real assets?
Marc Dummer: I think it's helpful to contrast real assets versus nominal assets. The S&P 500 does well when you're in a high-growth environment. When the economy is growing, it makes it easier for company revenues to grow. And if you are in an environment where prices are flat or falling, that means that their input costs, whether it's financing or wages or cost of goods, those are flat or falling, and so their earnings per share are growing at an accelerating rate, and the market rewards that. What about in a low-growth environment when prices are flat or falling? That's when your Barclay's aggregate would do well, because typically interest rates are falling.
We had that environment for about 15 years, maybe since China joined the WTO. But then in 2016 we started to see protectionist policies globally, tariffs and people wanted worried about their supply lines. That's when we started to see input cost rising. In a high-growth environment, when input costs are rising, that's when real assets like commodities and natural resource stocks and infrastructure and stocks and REITs should do better.
What about if you're in a low-growth environment when prices are rising? That's typically when you would see tips and fluttering debt. For a long time, we didn't need to worry about the other hemisphere, the hemisphere which was when input costs were rising. Now, for the last few years, we've had to worry about that. We went through a period where we were importing deflation in the form of goods. Every time we went to buy a TV, it was six inches bigger and a hundred dollars cheaper. Importing deflation that was offsetting domestically produced inflation in the form of services, whether that's healthcare or education, all those continued to go up. Then after the pandemic, we started to see an acceleration in both goods inflation and services inflation, both because we were redomesticating our supply lines and the surge and demand following the pandemic. That's the environment they should expect to see real assets outperform is when prices are rising.
Jenna Dagenhart: Yes, and we've seen a lot of that lately. Let's spend a little bit more time framing the macroeconomic backdrop, which of course is tremendously important to real assets and how they perform. David, what's caused inflation to persist as long as it has?
David Schassler: There's a famous quote from Milton Freeman, inflation is always and everywhere a monetary phenomenon. We know that it's a monetary phenomenon because the price of something, of not something, right? Everything is up. We had extreme monetary dement, right? The US dollars been around for over 200 years, over 230 years. Over 40% of those dollars were created posts 2020. Right? You blow out the money supply, you're going to blow out the demand, and then you're going to figure out where you're vulnerable on the supply side and you're going to figure it out real quick. We have a lot of inflation because of that monetary debasement. But it just didn't start after 2020. Right? This has been decades of excessive government spending fueled by money creation and low interest rates.
Now, Marc's right, we were able to get away with it for a very long period of time because we were importing deflation specifically from China. A lot of that's stopping. The excess money creation has completely overwhelmed the system where these inflationary forces are by far outweighing the disinflationary forces. Now we've had a lot of inflation. And unfortunately, if you look at bouts of significant periods of inflation, you find that this is a problem that's not easily resolved. This is a problem that typically sticks around for a long period of time and it's very hard to deal with. The way you deal with inflation is demand destruction. So, expect volatility, expect more volatility. Things are likely to get worse before they get better. That's the environment for the stock and bond investor. Those that don't have exposure to real assets have suffered a lot. Given that the environment is unlikely to change in the near term, we're encouraging people to buy real assets. Because they're losing. They're losing on their stocks, they're losing on their bonds.
Marc was talking about this, most companies struggle with inflation. Think of inflation as the game of hot potato. Inflation comes in, most companies try and pass it on to their customers fast as they can without getting burnt by the inflationary hot potato. They can't send it along fast enough, so what they do is their profit margins get hit, their stocks are worth less. By the way, interest rates are rising to accommodate the new regime, putting downward pressure on earnings. Fixed income investors are in the same boat. We started out with no yield cushion here, so duration risk was a very real thing. We've got a huge surge in interest rates and the Feds talking about doing more. If inflation doesn't let up, as we expect it not to, expect higher rates for longer than people would expect. Bottom line, we think that people really should have a core allocation to real asset, especially given the forces that we're facing right now.
Jenna Dagenhart: I want to get into that a little bit more in just a second. But Marc, what's the best environment to invest in real assets and what's the worst environment for real assets?
Marc Dummer: Yeah, so the best environment for assets is when you're in a growing economy and prices are rising. We did a 50-year look back, looking at three factors. Are interest rates climbing, is the Fed, increasing interest rates, is inflation likely above 3%, and is the economy expanding or contracting, and combinations of those three. Let's say that we agree inflation is going to be above 3%, and let's say that we agree interest rates are climbing. Let's say that we're uncertain, but we believe that the US economy is likely headed into recession in 2023. Historically in that environment, real assets on average were up 13%, looking back over the 50 years. What about the S&P 500? It was down in that contraction environment and the Barclays aggregate was up in a contraction environment, single digits, so real assets dramatically outperformed nominal equities and nominal bonds.
What if you're not sure? What if the economy's expanding, but you agree inflation is above 3% and interest rates are climbing? Real assets were still on average up 13%, but the S&P 500 was positive and the Barclay's aggregate was just minorly positive. The best environment for real assets is when in prices are rising or likely to be above 3% and when interest rates are climbing. The worst environment for real assets is when you have deflation concerns. I think back to 2015 when oil was plummeting. If anybody had exposure to MLPs, you can remember with a lot of pain what happened to MLPs. Deflation can affect every real asset. Every real asset was negative in 2015, even though inflation was still slightly positive. Real assets are hypersensitive to changes in inflation expectations. That same thing happened in 2018, basically every real asset was negative in 2018. So, right prices, rising inflation expectations help real assets, falling inflation expectations can really be a headwind to real assets.
Jenna Dagenhart: Inflation is really hard to get rid of, as you mentioned David. It stays with us, it tends to. Do you see any of the inflationary pressures that you mentioned subsiding, David? How much longer do you think inflation will remain elevated? You said you think it's kind of here to stay?
David Schassler: We do. Well, here to stay, you've got to be more specific about the timing. We did a study. We went back and we looked from 1960 through the mid 2000s, and past historical inflation regimes globally. We found that on average, once inflation exceeds 5%, how long does it take to fault to 2% or lower? The answer globally, going back from 1960s, is 18 years. Fighting inflation is a marathon, not a sprint. This idea that they're going to get real tough on interest rates, they're going to beat down inflation, it's going to disappear tomorrow, that's super unlikely. What they're effectively saying is this time is different. And any time somebody tells you this time is different, that's a really good time to start getting nervous. The more likely scenario here is that you're going to have periods of high inflation, deflationary pockets, high inflation again, deflationary pockets. You're going to see for an extended period of time that inflation, the average rate of inflation throughout the decade, was materially higher than 2%.
If that's the case, if that's the case, like Marc was saying, you'd expect real assets to continue to perform. Real assets right now are experiencing a bull market. Commodities specifically are in a bull market. Commodities are up double digit year to date. They're up around 50% over the last two years, but people don't want to acknowledge that. It's the most hated bull market ever because very few people saw high inflation coming, so they didn't have an allocation, and most people gave up on rail assets because we were in this super long period of low inflation that gave us low interest rates, that gave us a super strong market tape for growth stocks, and the extension of the bull market that started in the 1980s.
A lot of people just gave up on real asset investing. Now they're looking at this major asset class, that's up a lot, that's in it bull market by any reasonable standard, and a lot of people are dismissing it because they know with certainty that inflation's just going to disappear. For us, this is really a risk management conversation. Nobody knows what's going to happen tomorrow, and we don't know the path inflation with absolute certainty. What we can do is we can look back at history and we could say when we've had a problem this magnitude in the United States and globally, what has the outcome been? The outcome unfortunately has been once the inflation genie is fully outside of the bottle, it's super hard to put back in. The expectation should be high inflation's going to be with us for an extended period of time, defined as materially higher than 2%.
Jenna Dagenhart: Marc, real assets held up in the first part of the year but have fallen off quite a bit. Why the recent sell off even though inflation remains so elevated?
Marc Dummer: Yeah, it's interesting. I mean, to follow on David's point, commodities typically run in these super cycles and these super cycles on average are about 15 years in length. But there are pockets of time when they might give some back. But you shouldn't ignore the super cycle. We think that we are in another commodity super cycle and we're only two years into it. What happened in the first half of this year, real assets dramatically outperformed nominal assets. If I look at a diversified portfolio of real assets, they outperform the S&P 500 by probably 10%, but the S&P 500 is down 21%. Real assets, a diversified portfolio of real assets, it's not unreasonable to see them down 11%, dramatically outperforming. But why are they down when inflation is up?
Real assets are sensitive to inflation, which has helped them stay high relative to normal assets, but everything is sensitive to recession risk and everything is sensitive to tightening financial conditions. That's what we've seen in the first half of this year. Recession risk has risen, tightening financial conditions. We went from, to David's point, the most easy financial conditions on record, the 15-20 year study we looked at, to now almost as tight as during the global financial crisis. Not there, but tighter.
Recession risk really weighed on real assets. They typically are the first to get punished when recession risk rises because people are worried about growth. But I'd argue for what it's worth that the valuations on real assets are now quite cheap relative to their historical averages. I get a report every week that'll say what percentage of the time has this asset class been cheaper or more expensive than it's right now? Not looking at it relative to other asset classes, not looking at it relative to fundamentals or technicals, but just relative to its own history. If I look at a diversified portfolio of real assets, only 2% of the time have people paid less for a dollar of earnings than they are right now. The S&P 500 is still in about the 60th percentile, dominated by large cap. Midcap and small cap is cheaper, but large cap is still quite expensive. For those people that wonder if they missed the opportunity to invest in real assets, or they're wondering now what gives, now's a great time because those sold off pretty dramatically with the rise of recession risk.
Jenna Dagenhart: When you look at inflation today, it's the highest we've seen in a very long time, more than four decades. David, how is this current inflationary cycle similar and different than previous cycles?
David Schassler: I get this question often. A lot of times people want to debate me and they'll say, "Well, Dave, the inflationary regime looks more like the 1940s because we had a lot of debt back then, more so than 1970s." And I say to them, "Well, it doesn't really matter for our purpose." The reason being is that, in the 1940s, it took about a decade for inflation to subside. In the 1970s, it took a lot longer. People don't realize we actually had well above 2% inflation, well into the mid 1990s. It took a long time.
The point being is we can debate, and the thing is that you can learn not every one event is just like the previous event. We can learn information from the 1970s. We can learn information from the 1940s. We can learn information from the more global inflationary events, and we look at each individual country. The bottom line is the one commonality that they have is that once this extreme inflation starts, it typically starts on the monetary debasement side and it lasts for a very long time. It really comes into a risk management conversation about diversification. And we're arguing about diversification. I would hate to be on the opposite side of you shouldn't diversify, because if you're saying you shouldn't buy real assets, you're saying you shouldn't diversify, and I have a really hard time with that.
Jenna Dagenhart: Now, obviously this couldn't be further from the current environment, but Marc, should investors also own real assets during non-inflationary periods?
Marc Dummer: Yes. We looked at if you added real assets to a diversified 60/40 portfolio, and let's say it was a 10 or 15% allocation within a 60/40 portfolio, what did it do to your returns and what did it do to your volatility even when inflation was not a thing? It didn't hurt your returns, the returns were basically the same, but it did lower your volatility because there's very little overlap. A diversified real asset portfolio might have less than a 10% overlap with a 60/40 portfolio.
Inflation emerges, there's a thing called expected inflation and unexpected inflation, and unexpected inflation emerges unexpectedly from unexpected sources with unexpected violence. The only way to really be protected against unexpected inflation is to maintain an allocation of real assets and be diversified across a lot of real assets.
And so, yes, we would argue that you should maintain an allocation throughout an inflation cycle, which might be 30 years that the goal for real asset investing is to maintain the allocation. But you should be deliberate about lowering your allocation if deflation risk is rising. You should be raising your allocation to real assets if inflation risk is rising. The large pension plans, the foundations and endowments will maintain an allocation to real assets, not just because it's prudent portfolio construction, but it better aligns their portfolio with their liabilities. A lot of their liabilities are inflation sensitive. And if you can get your assets and your liabilities to move together, you can immunize your net worth. And so, yeah, we'd argue you should hold real assets through an inflation cycle.
Jenna Dagenhart: David, could you share your views on the inflation reduction act?
David Schassler: The inflation reduction act, as it specifically relates to inflation, is the equivalent of political theater. It as an act is not going to help inflation. If you look at the independent think tanks, they come to the same conclusion, which is effectively, "Interesting but not going to help inflation effectively." What they've done is they've rebranded the Built Back Better, scaled it down a little bit, right? Clever marketing. Came out with it in quality Inflation Reduction act. Effectively, it's the same thing we were doing before, which is energy transition, pushing forward that democratic agenda. Now, this isn't an attack on the Democrats because the Republicans would likely be doing the same thing, just spending the money differently, and then the taxing or trying to tax wealthier Americans and corporations, and then they're going to spend 80 billion on IRS agents to go out and try and find tax evaders. Right? The conclusions from that is likely that this is going to have little to no impact on inflation.
What's going to have an impact on inflation? The money supply excess spending. The government continues to spend more than they take it. They've been doing it for decades, really ramped it up in 2020 and 2021. But the bottom line is until we start spending more reasonably and stop printing to facilitate that spending, we're going to continue to have an inflation problem. And given the amount of leverage in the system, higher interest rates for an extended period of time aren't a reasonable thing without expecting something really bad to happen. We've been saying for a long time now, the idea of a soft landing is a fairytale. There's way too much debt in the system. When they jack up interest rates and stop creating money, what's going to happen and what's happening is you're going to put a ton of strain on the system.
The last time we tried increasing interest rates was 2015 to 2018. We got short term interest rates up to around 2.5%. Things started to break. Fed completely backed off. Lower rates. The expectation has to be given that we've got a lot more debt now than they had back then, eventually bad things are going to happen. People are going to lose their jobs. Go back and look at the 1970s and early 1980s. In the early 1980s, you had an unemployment rate that exceeded the unemployment rate that we had in 2008. The bottom line is fighting inflation is ugly stuff. Given the amount of debt that we have in system, it's very hard to do that in an extended way. You can talk tough and you can act tough in short bursts of time, but the higher we keep interest rates up here for an extended period of time, the more damage it's going to do.
Unfortunately, the Fed got it really wrong at the front part of this by denying that inflation was a problem, and it appears very clear to us that they're getting it wrong in the back half by being too aggressive given how much debt that we have in the system. Again, we said it before, I'll say it again, fighting inflation's a marathon, not a sprint. It's going to take a long time. And if you're super aggressive at it, what's likely going to happen is they're going to have to pivot. Not because they want to, because they have to. When we finally roll over and volatility truly blows out, which is what we expect, at that point, the Fed will be forced to pivot. Once they're forced to pivot, inflation's going to live on. You're going to have these inflationary and deflationary pockets along the way with a higher mean level of inflation. Bringing it back to real assets, that's the environment for real asset investor.
Jenna Dagenhart: If inflation does normalize, David, what's the investment case for RAAX?
David Schassler: Yeah, so I do manage an inflation fund, the VanEck inflation allocation ETF. The ticker is RAAX. Really simply, when you think about real assets, and Marc was talking about this before as well, certain real assets do better during periods of higher inflation, but certain real assets do well during periods of lower inflation. Look at the performance of REITs during a period of lower inflation. They did really well. Infrastructure can do really well. The job is to pivot your allocations and stay dynamic, right? Stay dynamic and adjust based off the inflationary environment.
Inflation's a true anomaly, especially at the magnitudes where it's at right now. Nobody wins with inflation this bad. We think inflation comes down, we just don't think it goes to 2%. But let's say we're wrong. It's certainly happened before. If we're wrong and inflation falls to 2% and stays there, you still want the diversification of real assets, you just want to alter your composition of real assets. That's what we would do as certain real assets continue to outperform and other ones underperform and it became structural and you could see it that's a trend that's going to last or that will likely last, then you pivot the allocations more towards those assets that have less cyclicality that can perform well independent of the inflationary regime. Again, REITs and infrastructure at the top of that list,
Jenna Dagenhart: What's the best way, Marc, or most efficient way to invest in real assets?
Marc Dummer: Yeah, it's an interesting question when I think about it through two different lenses. When I think about the asset class efficiency, so we do an asset class efficiency across all the asset classes that we invest in, and who would be active or passive or some sort of smart beta. Generally, you find that the more liquid the asset class, the more followed the asset class, the more you should be passive. A lot of real assets are less liquid and less followed by a lot of analysts, and so we'd argue in general in real assets, you should be active in the asset class. Now, I completely agree with what David said as far as being nimble. The challenge with real asset investing is that there are some asset classes that are sensitive to inflation expectations and others that are in sensitive to actual inflation, and navigating between those. For example, natural resource stocks and commodities, they're very sensitive to changes in inflation expectations, but while they have great timeliness, they don't have great persistency. We would argue in REITs and infrastructure have better persistency when inflation is more persistent.
The challenge with real asset investing, to David's point, is that it's often an unlivable experience for clients. Natural resource stocks have a volatility of say 25%. A lot of research would tell you that if a client loses more than 15%, they're more likely to call up the advisor and say, "Get me out of this strategy." The key to keep [inaudible 00:28:44] your clients invested in inflation sensitive asset classes is to diversify across a lot of asset classes that may not be perfectly correlated to get that volatility down to a 12 to 15% range. It was just what they might expect out of their equity portfolio or maybe a modest aggressive growth portfolio. I'd argue and support David's notion that the key to investing in real assets is to maintain diversification within a structure so that the line item volatility is hidden from the end client. It's still there, it's just that maybe infrastructure is up while natural resource stocks are down. The clients don't see it, but across the cycle they're still getting that inflation response.
Jenna Dagenhart: In an attempt to reign in inflation, the FOMC has been raising rates by 75 basis points at back to back meetings, and projections show more hikes ahead. However, David, if the Fed pivots, how would the market respond?
David Schassler: The market's going to celebrate that. The market has sustained, the economy has sustained to continue to grow at these rates based off of leverage. The FOMC has been providing liquidity and super low interest rates, and we've had a debt party. That party would then cheer lower interest rates. The expectation would be that you'd see a rally. It would probably happen in anticipation of them while wearing interest rates. We do think that they will pivot, but we're not calling for a pivot tomorrow. I think one of the things that a lot of people don't realize is that because the inflation prop is so bad, they're going to likely continue to be tough with rates, tough with accommodation for an extended period of time, and that's going to mean more volatility. We're not calling for a pivot tomorrow, but we are calling for a pivot, and it'll likely come later than people expect and there'll likely be more pain associated with that pivot, meaning that things will get worse than people expect before the Fed is forced to pivot.
But it is our base case scenario that eventually the Fed will pivot, and if you want to look at other data points of when they pivot, look at every other time when the market's been down 20%. They jumped in really fast with the punch bowl every time the market went down. The difference then versus now is they did not have inflation. Now we think that they're still going to come to this rescue, the rescue, that lifeline that they throw us, is just going to be a lot later. There's going to be a lot more pain ahead, unfortunately. But a lot of losses have been taken already. The markets are down a lot. The stock markets down a lot, the bond markets down a lot.
One of the interesting things is that people, clients went and opened their statement up this year and they saw their 60/40 portfolio being down double digits and then they thought to themselves, well you know what? I've been here before. We saw it in 2001, we saw it in 2008, we saw it in 2020. But what's very different between now and those other previous regimes was you're experiencing double digit losses on both your stocks and your bonds. Your asset allocation's not working because that diversification's not there. Those other corrections that we spoke about, you lost a lot of money on your stocks, but your bonds were stable if not up. Your asset allocation was working for you, it was diversifying. You're not getting those benefits now, because inflation is attacking both your stocks and your bonds. And unless you own real assets right now, you're just taking those losses and you're accepting the fact that you're not running a diversified portfolio. That's unfortunately the situation that most people find themselves in.
Jenna Dagenhart: Yeah, I see you nodding your head, Marc. Could you elaborate on how real assets have performed compared to a traditional 60/40 portfolio?
Marc Dummer: Yeah, so you see it in the year to date with real assets. Even though they're down, they are dramatically outperforming a 60/40 portfolio. But I agree that the market would applaud a aggressive Fed action. I thought when they first increased rates and they went up by only 50 basis points, they missed an opportunity. The market would've rewarded them. I'll contrast it with Brazil. I think Brazil, their inflation spiked and their central bank increased their equivalent of Fed funds rate from about 4% to almost 14% in a six-month period. Their inflation is coming down, their economy is recovering. The market I believe will reward aggressive Fed action and they have to.
We do some scenario analysis around what's our baseline forecast for the economy, our upside in our downside scenario. In our baseline scenarios that the Fed increases the interest rates to 4.5 To 5%. That's maybe a little bit consensus, with our baseline scenarios that we head into a recession in 2023, that's three quarters long. But what I think is interesting is more the downside scenario. The downside scenario assumes that the Fed blinks, they flinch, they don't get inflation in check and then they have to restart their rate increases and then the Fed funds where it gets to six, six and a half percent. In that environment, you still end up with a recession, but it's just much longer. We are in an environment where not only the US Fed, but the IMF, the ECB, they have all recently commented that they need to get inflation in check and they recognize that it has moved into the stickier areas. Transitory is no longer in their nomenclature, it's not likely to fall down to a reasonable level for an extended period of time. It's going to be glacial in its reversion back to an acceptable level.
Jenna Dagenhart: To follow up on the 60/40 conversation, what would be the appropriate real asset allocation mark if inserted into a 60/40 traditional portfolio?
Marc Dummer: Yeah, well I think about how the consultants have done it, maybe how target date strategies have done it. It depends on how close people are to retirement, but in general, a 10 to 15% allocation to real assets makes your overall portfolio more efficient. Now, some of it depends on whether or not you're allocating to private real assets or public real assets, but either way, a 2% allocation to real assets is just not going to have an impact. You need to have 10 to 15%. If you want to get 10 to 15% and be diversified, you probably need to allocate to one or two or three diversified real asset portfolios versus trying to allocate to a natural resource stock fund or an infrastructure fund.
Jenna Dagenhart: David, what primary factors do investors need to consider this time around in terms of their asset allocation decisions?
David Schassler: Yeah, let me just follow up with what Marc said. I'm often asked the same question on how much do you allocate, and my answer is always 10 to 15%. How do we get there? If you look back at doubts of inflation that look very similar to this, how much would you have to allocate to diversify portfolio of real assets? We use commodities and gold bullion at a 50/50 allocation and then took proportionally from a 60/40 portfolio. We found that to generate a very modest real return of 3%, you really need to allocate to around 15%. We call it 10 to 15%, as well. Our numbers are spot on with Marc's, and I've been agreeing with most of, if not all, of what Marc said throughout today, so I think that that's pretty consistent as well.
Jenna Dagenhart: Circling back to the Fed, with the Fed raising interest rates so aggressively, of course the dollar is skyrocketing. David, how is the recent dollar strength affected real assets?
David Schassler: The dollar's a funny thing. By definition, the dollar is week. We know that because every time we try and spend a dollar and buy something with it, we get less and less. Now we've got a situation where we've got people with bigger problems than we have, so relative to somebody else with a bigger problem than us, we look good. That's the dollar situation. The problem with the dollar is once it continues and maintains the strength that it has, it has unintended consequences. Obviously commodities and gold bullion are price and dollars, so it has not been good for any of these assets, specifically gold bullion, which has really struggled with the strength of the US dollar. The hope would be that eventually the US dollar stops going up as much and these assets can perform. But regardless, one of their key reasons why specifically, gold as well, we think gold has not performed as well as it could have, it's really independent of the US dollar.
The US dollar is a powerful force, especially when it comes to commodity prices and gold. But gold is a store value asset. Gold historically performs better in the later part of the economic of the inflation cycle. The expectation would be regardless of a strong dollar or not, if people come to terms with the idea that inflation may not disappear tomorrow and people may have to protect themselves, gold has historically been that key store value asset. That's what the sprawl has been. It doesn't have the utility of other commodities.
The price of oil is not sitting around saying is inflation transitory or not? Maybe I will rally or maybe I won't. It's responding immediately to supply and demand imbalances. Gold doesn't have that luxury. Gold's sitting back and people are saying, "Well, should I allocate to gold?" Well, do I have an inflation problem? Well, no, I don't have an inflation problem because the central banks tell me they're going to fix the problem for me, so I don't have to allocate to gold. If the central banks globally lose their last ounce of credibility and people come to terms with the idea that inflation may not just go away really soon, we expect gold to catch a bid.
Jenna Dagenhart: And I mean, going back to the employment situation, the Fed is projecting the unemployment rate to go up. Who knows if it'll be as bad as in other times, but only about four and a half percent. Anyhow, what about wage inflation? Do you expect that to persist, David, especially keeping in the back of our minds that labor could run into some issues?
David Schassler: Yes. Higher wages are, like other prices, a symptom of higher inflation. Wages are resetting, the problem is it's fueling it. This is what's classically known as the wage price spiral. Costs go up, labor demands higher wages, boss passes that cost onto their customers. Employee now has more money to go out and spend. They spend it. They drive up demand, and this and the cycle continues. You see a huge spike in correlations between wages and inflation during these inflation cycles. You saw it in the 1970s and you're starting to see it now. We think at the end of the day that you're going to continue to see that. You're going to continue to see this period of high inflation, wages try to catch up to them and a fulfilling this. You're going to see this period where you end up with what they call this wage price spiral.
Now, is it the chicken or the egg causing that, meaning is it wages trying to catch up to prices or are wages actually making it worse? That is a huge subject that's up for debate amongst economists. But one thing that's not debatable is that wages are going up a lot, but real wages aren't, because they're not keeping up with the rate of inflation. This is not a good time for the American worker. Because yes, they're making more money, but their spending power continues to go down. That's what periods of high inflation look like. This is ugly stuff. We do think that you're going to get a pickup in unemployment and that'll ease some of the pressures on that because people will be less picky on what they're going to work. But keep in mind as well, COVID-19 was wildly disruptive to society globally. People work in different places. People moved to different locations.
We are having a very hard time understanding what this new dynamic looks like. Work from home, very few people worked from home prior. That is not the case right now. We've got massive changes in preferences and tastes that are then fueling into this pricing cycle. These things were happening before. Again, what COVID did was it pushed the trend forward. We'll see what happens, but we do believe that wages are going to continue to march higher to try and catch up with inflation, and that will in some way continue this inflation, put upper pressure on this inflation regime that we have right now.
Jenna Dagenhart: In turning to real estate Marc, during an elevated inflationary period, what role does an allocation to REITs play?
Marc Dummer: Yeah, I think I want to contextualize it relative to an inflation cycle. Going back to what David said, the huge amount of money out there in the system, it is like the fuel that's been ... inflation is ever present. It's like a pile of your winter tinder for keeping your house warm and we keep pouring fuel on this unlit fire. So, what was the spark? Inflation cycles usually emerge this way that you have a commodity shock, whether that's through cut in supply, like we saw during the early phases of the pandemic, or surge in demand like we saw in the early stages of the pandemic recovery, or Russia's invasion of Ukraine. You have this commodity shock, and if it lasts long enough and you're at full employment, then people can go out and command higher wages, higher wages turn into higher prices, higher prices turn into higher wages, and you end up with this wage spiral that David highlighted.
During that cycle, there are various asset classes that are going to better than others. What you typically find with REITs is that they sell off when inflation expectations first emerge because some people view them as a bond equivalent to equity. The same thing can happen with infrastructure they, sell off. But ultimately when inflation becomes a little more persistent, first to recover would be infrastructure. These are the companies that are price setters, not price takers. They have monopolistics so they can go out and increase their revenues when their input costs are high, when their wages are high. The next to recover is REITs. There's an 18-month lag between when inflation first emerges and when REIT prices start to accelerate because it takes a little while for their rent rolls to roll over. So while REITs are not very timely, they have a really great persistency if inflation is persistent. Because of this wage spiral that we are in, we think that inflation will be long lasting, it'll be a little more persistent, and REITs will now have a chance to catch up.
I remind people that commercial real estate is really there for one reason, is to bring people together. And the pandemic basically said you can't come together, and so people had to work from home. As the market digested that and reprice is sold off, and for the quarter, I thinks REITs were down over 11.5%. A lot of that gets priced into the REIT market. I think that as soon as the Fed path has more and the terminal level of the Fed seems more defined, then people will start to come back to REITs, and REITs can start to play their role in the inflation cycle.
Jenna Dagenhart: What about you, David? What's your current view of the housing market and what impact might it have on inflation?
David Schassler: Yeah, so the housing market. Affordability obviously is going way down. Here's the issue, we've structurally under invested in housing since the housing bubble burst in 2006, so we've got a significant supply-demand mismatch. Now we with higher commodity prices and soaring costs of labor, it costs a lot more money to build houses. You've got this situation where you've got a supply-demand mismatch, the inability to affordably build new houses, and then something else happened, which was hugely dramatic, and I think even more profound than the other two things. What happened was increasing interest rates. If you want to go out and get a mortgage, it's going to cost you 7%. If you're sitting there in your house and you were planning on upgrading it or buying a house the first time, if you own a house, how are you going to get rid of that mortgage at 3% and then trade into one at 7%?
What we've effectively done is we've stuck the market. We've taken most of the inventory in the housing market and we've locked it in, because people don't want to get let go of those 30-year mortgages at 3.3%. Why would you trade out of that and go to a 7%? It doesn't make sense. We've got trapped inventory. So, supply-demand imbalances, trapped inventory, and a problem with affordability. Do we think that housing prices particularly in certain areas are going to come down? Yes. Do we think they're going to come down nearly as much as they did in 2008? No, because of the structural supply-demand mismatch. We think you're going to see a softening, and you're already seeing it, but there's going to be limited downward mobility because that's supplied demand mismatch, which is a lot worse now given the surge in interest rates. The expectation would be that affordability's going to continue to be a problem, and I really feel bad for first time home buyers and people who are trying to enter the market right now because of the way that they're being locked out of it.
Now, how does that relate to REITs and how we invest in real estate? Marc was spot on. Listen, during periods of higher inflation, property values go up. Eventually the yields off those properties go up, those properties do better. At first not so much. As a landlord, you can't go in there and just flip the switch and Jack everybody's rents. Doesn't work that way. It takes time. People have leases. It takes time to roll that over. But eventually you do and you do well. And there was a lot of interest rate sensitivity, which is another thing that we should talk about.
REITs have retail interest rate sensitivity, especially when interest rates were so low. People were going out and buying investment properties, sub five caps. Why would you go out and buy an investment property at a four or five cap when you could just go out and buy a bond with a yield the same and not deal with all those headaches associated with ownership, the operational headaches, et cetera? There needed to be a repricing at a certain point. You saw that with higher interest rates. The expectation would be now that you're building in a bigger yield cushion, that REITs, other yielding assets, and fixed income would start to do better as we move forward here.
Jenna Dagenhart: To your point on mortgage rates, they've doubled in a year. I mean, wow. But spending a little bit more time on commodities, Marc, some advisors include tips and commodities in their models and then simply toggle between those two. Are there any flaws with this approach?
Marc Dummer: Yeah, I think there's two flaws with the approach that come to mind. One is the investor behavior risk, the abandonment risk, when clients call up their advisor and say, "Hey, tips are down year to date by 11%, and I see commodities are up 20%, sell my tips and buy my commodities." And then in the third quarter, when commodities give some back and tips off of the protection that the rising recession risk brings, they don't get back into their tips and they stay invested in their commodities. The challenge is both managing client behavior risk, that line item statement risk that they point out the one red item on their statement, and it's also the timing. It's really hard to time perfectly when commodities are going to do well and when tips are going to do well. We'd argue have commodities, have tips, have infrastructure and REITs, and modestly lean in or lean away from those, but maintain an allocation to them because those reversals are really hard to time.
I point out 2015. Tips were down 1%, but MLPs were down 40%. 2016, MLPs metals and mining were up 60%. Getting that timing right is really hard for individual clients and getting your clients to invest in metals and mining at the end of 2015 when they just offered you a 40% [inaudible 00:48:53] is going to be really hard, so they're not going to get back in and capture the plus 60%. I think just there's a lot of ways to add alpha, and the primary way in real assets is just through prudent portfolio construction. Construct in an ability to outperform, and then add a little bit of value through either manager selection or technical allocation views, but constructing just an ability to deliver CPI plus three over a market cycle. And then add a little bit on top of that through your allocation and manager selection decisions.
Jenna Dagenhart: David, could you discuss the current environment for commodities and anything you'd like to add about how that impacts commodities equities?
David Schassler: Yes. There are structural supply-demand imbalances across the commodity complex. We are moving very aggressively towards energy transition. The problem is we're still reliant on the thing that's most hated, which is traditional energy. So we're under investing in the thing that we need the most right now, and then redeploying resources and then some to renewables. Renewables are super intensive when it comes to minerals and metals. What's happening is these structural supply-demanding balances. Once you factor in that a lot of these emerging markets, specifically India and China, they're becoming more wealthy. And what happens when you become more wealthy? Your diet changes. People are moving towards a more protein-intensive diet, so we're ending up with grain shortages. Eating the grain directly uses a lot less grain than the cow. Right? The cow that has to be killed for you to eat the cow ate a lot more grains than you did.
You end up with this situation where countries, as they develop, are changing their preferences, and it's looking more like a western diet. When I look at the entire commodity complex, I see a situation of elevated commodity prices. That's even before I factor in the valuation or what these commodities should be priced at, given the massive devaluations of fiat currency, specifically the US dollar. When I put all this together, I see a period of extended elevated commodity prices. Then I say to myself, "Well, how do I best play it?" I want to have exposure to commodities, and we do in our fund. We think it makes sense to have a core allocation to commodities, specifically commodity futures. But natural resource equities are very attractive. These are companies that make more money. Their revenues go up a lot when commodity prices are elevated. Their cost structures are rising with everybody else's. They're not immune to that. But their revenues are going up a lot more.
You've got the rest of the S&P 500 with declining revenues because they're struggling with inflation, and then you've got these gem segments. Look at how traditional energy's doing year to date. You've got these segments to the market in natural resource equities that are making a lot more money, and their net profit margins are a lot fatter. You're getting double digit free cash flow yields off a lot of these segments, and we think eventually that's rewarded. For us, we think commodity prices, they're going to stay elevated. We think natural resource equity companies are going to continue to make money. We think when you pair those together in a portfolio allocation, you'd end up with a mix that should outperform both stocks and bonds as we start to think about the next three to five years out.
Jenna Dagenhart: Marc, how do real assets produce a steady income stream?
Marc Dummer: Yeah, so normally what you find in, let's first talk about public real assets, so infrastructure or REITs. Public real assets produce an income stream because most of their or a good portion of their total return comes from just the revenues that they're collecting off of their utilities. Think about a toll road or an airport, they're leasing out the space, so their lease income is contributing to their income. A utility, a lot of the total return comes from just the dividend. An infrastructure index is probably yielding three and a half percent right now. Our REIT index is probably yielding 3.5%. When you look at their historical drivers of total return, maybe 40% comes from the dividend and 60% comes from capital appreciation.
When you shift into the private real asset space, it becomes even higher. So, when we buy a forest land through a fund, they can go in and say, "Hey, we're going to buy this land. You as the timber manager, the forest land manager are going to pay us rent. You're still going to participate in some of the commodity return from those trees, but pay us a lease." When we buy a farmland in Indiana, for example, we'll go in and say, "We're going to bring you capital improvements. We're going to make your water usage more efficient. You'll pay us a lease. We're buying your land, you'll pay us a lease and we'll help make your farm more efficient," and so that lease rate can drive even a higher portion of the total return. Even though real assets seem like they are purely growth commodity related, the underlying investments can generate nice steady income, and the more private you are, the higher the income typically out of real assets.
Jenna Dagenhart: Well, before I let you both go, I'd love to just go around the room and have everyone share final thoughts. A few, I guess, key takeaways for me have been be nimble with real assets, inflation, marathon not a sprint, but I'd love to give you the final word. David, why don't you kick us off?
David Schassler: Sure. The biggest takeaway is risk management. It's diversification. You may have a view that's exactly opposite of minor inflation. And truthfully, I actually hope that you're right and I hope that inflation goes away tomorrow. That may be your view. The reality is that nobody has a crystal ball. We don't know the way that this is going to pan out. We can look at history and say that it's all likely going to go away for some time and expect a lot of pain. That's why it's our base case.
But economics, it's about setting probabilities, and assigning a probability of zero for inflation, extending for an extended period of time, doesn't make any sense at all. Not owning real assets during a period of really high inflation doesn't make sense at all. Periods of volatility are expected during periods of high inflation. Commodity prices zig and zag on their way northbound. You saw it in the 1970s, you saw it in other previous inflation regimes. During periods of high inflation, corrections and real asset prices are typically buying opportunities, not confirmation that inflation was transitory. So, regardless of your view on inflation, put diversification first, because if inflation goes away tomorrow, then you're all covered. Your stocks and your bonds are going to do just fine. But what if it doesn't? And if it doesn't, you're going to wish you owned more real assets, and 10 to 15% in our view is the right number.
Jenna Dagenhart: Marc, anything you'd like to leave with our viewers?
Marc Dummer: Yeah, so I would echo what David said. It's about prudent portfolio construction and having an allocation to real assets, a 10 to 15% allocation to real assets, will lower the volatility of your overall portfolio, increasing the risk-adjusted returns for your clients regardless of the inflation environment. But let's not forget there's an opportunity right now as well. People will sometimes ask, "Did I miss it?" Valuations are not a good predictor of next year's returns on anything, but they are a pretty good predictor of the average returns over the next 10 years. The example I'd give is if you take the S&P 500, and as a PE ratio of 20, you flip it on its head, it becomes the earnings yield, and that's a 5% earning yield, one over 20. That's a pretty good predictor of what people can expect to earn out of the S&P 500 over the next 10 years. If P ratios are 20.
Well, natural resource stocks, REITs, commodities, they are all fairly cheap relative to their long-term averages, so you did not miss it. With the recession risk that climbed, all of that commodity-sensitive equity, portfolio sold by pretty dramatically. As I said, I think the S&P 500 is still priced a little bit above fair value, where metals and mining, agriculture, timber, water, that all sold off pretty dramatically with [inaudible 00:57:14], and now is a good time to get some of that cheap portfolio construction, diversification risk management that should stay in your portfolio for a market cycle.
Jenna Dagenhart: Well, David, Marc, so great to have both of you. Thanks for joining us.
Marc Dummer: Thank you.
David Schassler: Thank you so much. It was a pleasure.
Jenna Dagenhart:And thank you for watching this Real Asset's Masterclass. I'm Jenna Dagenhart with Asset TV.