Real Assets Could Be the Alternative

A call for nimble management in Allocation Views and highlighting a perspective on alternatives.

Franklin Templeton Multi-Asset Solutions

In this issue

In broad terms, the global economy is slowing, trade tensions dominate investor sentiment and inflation is subdued. A broad-based rally in global equities since the start of the year has extended a notable divergence against the less optimistic views being reflected in government bond markets and expressed by those central bankers who have pivoted from the planned normalization of monetary policy to offering additional stimulus.

Market disappointment over the delivery of rate cuts could renew pressure on equities. The alternative scenario, where growth continues to disappoint, might lead to additional rate cuts, but this is hardly an optimistic outcome for stocks.

Major themes driving our views

  • Slower global growth remains a concern
    Growth is slowing as contagion from manufacturing threatens resilience in the services sector. Trade disputes are only a symptom of broader tension between the United States and China. With profit margins having peaked, this is likely to present an ongoing headwind for business investment intentions.
  • Subdued inflation across economies
    Inflation expectations remain close to historical lows, and various central banks are struggling to engineer a revival. Corporate fundamentals generally remain relatively strong despite the moderation in global growth. At the same time, the ability of corporations to pass costs on to consumers appears limited, increasing pressure on margins.
  • Approaching the limits of monetary policy effectiveness
    The global economy is slowing, and policymakers may be reaching the limits of conventional monetary policy. Various markets and their participants appear to be discounting different degrees of support from central banks, some of whom are constrained in their ability to act decisively. Any failure to manage these expectations could result in a loss of confidence among investors.

Practical positioning

  • Nimble management required
    Over recent quarters, we have highlighted a return to long-run levels of market volatility rather than the muted levels seen for much of the past 10 years. This indicates that we have entered a new volatility regime. We have taken a more cautious stance on risk assets and believe the challenges that current markets present will require nimble management.
  • Real assets could be the alternative
    Market-based expectations for inflation, derived from the yields of nominal and real return bonds, have fallen sharply. In an uncertain environment, holding a diversifying asset such as US Treasury Inflation-Protected Securities (TIPS) might enhance return potential and lower portfolio volatility.
  • Alternative assets that aren’t really alternative enough
    Other alternative assets such as real estate might show uncorrelated return potential. However, listed alternatives such as real estate investment trusts (REITs) would be more vulnerable in a correction due to their equity-like characteristics. We retain a less optimistic view of commodities, despite their potential diversification benefits.

Major themes driving our views

Slower global growth a rising concern

The global economy continues to show downward momentum, with many of the themes discussed in our Allocation Views over the past year remaining pertinent. Trade in goods has been the transmission mechanism for declining sentiment; the big question remains whether contagion from manufacturing threatens the more resilient services sector.

Stress in the traded goods sector of the economy has been broader based than just the flows directly impacted by tariffs imposed by the United States, or the retaliatory measures enacted by China. Indeed, threats to expand the theater of this trade dispute continue to pose a direct threat to European automakers. This hit to confidence has already started to impact manufacturing employment, and with factory orders in Germany showing little sign of a rebound (see Exhibit 1), the risks to growth remain skewed to the downside.

ORDERS REMAIN DEPRESSED IN GERMANYExhibit 1: Germany, New Manufacturing Orders (Year over Year Change) August 2010–July 2019

Exhibit 1: Germany, New Manufacturing Orders (Year over Year Change) August 2010–July 2019

Sources: Franklin Templeton Capital Market Insights Group, German Federal Statistical Office (Statistisches Bundesamt), Macrobond.

However, it is the seeming intractability of the conflict between the United States and China that has become a bigger concern. We view trade disputes as only one symptom of broader tensions between an incumbent global power and its challenger for supremacy.

The political pressure on US President Donald Trump to secure a deal may see some progress in coming months. He likely has at least one eye on his forthcoming re-election campaign. However, the hardened rhetoric that Chinese officials have adopted more recently suggests that President Xi Jinping is willing to take a longer view of this conflict. For now, his Chinese counterpart appears to have more levers to pull than President Trump.

Taking a broader perspective of the major economies, the United States remains better placed than some in Europe. However, both regions show high levels of employment, and the relative confidence of consumers remains intact. This provides some cause for optimism.

While we continue to see few signs of latecycle imbalances that typically foretell recession, and the probability of recession remains moderate, the risks are rising. The deeper the trade slowdown and the longer it persists, the harder it is to see the global economy escaping some form of contagion. Our dominant theme remains “Slower Global Growth Is a Rising Concern.”

Subdued inflation across economies

Subdued inflation expectations remain the main concern of key central banks. At this late stage in the business cycle it is unusual to see such limited pass-through from tight labor markets to higher wages and ultimately broad measures of inflation (see Exhibit 2). When combined with the headwinds facing global growth, an inability to generate the targeted level of inflation starts to feed concerns that inflation expectations might become “un-anchored.”

It is well observed that inflation expectations are a large determinant of actual inflation, through the actions of wage bargaining and company pricing power. Survey measures of longer-term inflation expectations in the United States remain close to historical lows, matching levels last seen in late 2016 (see Exhibit 3). As a result, it is unsurprising to see the US Federal Reserve’s (Fed’s) continued focus on this issue.

Corporate fundamentals have remained relatively strong, despite the moderation in global growth. With labor markets tight in many economies, wage inflation has been picking up to some extent. However, the ability to pass this cost on to consumers appears limited. After a long period of expansion, profit margins have peaked and are likely to slow the pace of earnings growth.

Together with cyclical drivers of inflation that are weakening, commodity price declines since the middle of 2018 have put pressure on headline measures of inflation. Underlying disinflationary forces from demographics, technology and globalization have not been reversed, although some of their impact might be offset by growing protectionism and the impact of populism. However, on balance our analysis leads us to continue to reflect a theme of “Subdued Inflation Across Economies.”

CHANGING NATURE OF THE PHILLIPS CURVEExhibit 2: Unemployment Gap vs. Change in Average Hourly Earnings (January 1990–August 2019)

Exhibit 2: Unemployment Gap vs. Change in Average Hourly Earnings (January 1990–August 2019)
Source: Franklin Templeton Capital Market Insights Group, U.S. Bureau of Labor Statistics, U.S. Congressional Budget Office.
*ST NAIRU = Short term Natural Rate of Unemployment

INFLATION EXPECTATIONS REMAIN SUBDUEDExhibit 3: Market vs. Household Expectations for Inflation (January 2004–August 2019)

Exhibit 3: Market vs. Household Expectations for Inflation (January 2004–August 2019)

Franklin Templeton Capital Market Insights Group, Bloomberg, Factset, Macrobond, University of Michigan, St. Louis Fed. Important data provider notices and terms available at www.franklintempletondatasources.com.

Approaching the limits of monetary policy effectiveness

Policymakers are facing a challenging few months. Investors’ expectations, in broad terms, appear to be discounting continued interest-rate cuts from the Fed, which are being mirrored in a range of developed and emerging economies. However, given the low levels of current official rates, many central banks may be running out of ammunition. Growing concern that conventional policy measures are nearing the end of their effectiveness puts more pressure on alternative policy measures and leaves investors worrying about policy impotence. This is reflected in our theme “Approaching the Limits of Monetary Policy Effectiveness.”

In Europe, heightened fears of recession have prompted calls for fiscal policy to be used to complement monetary policy. Although Christine Lagarde, incoming president of the European Central Bank (ECB) supports policy coordination, we do not underestimate the challenge of making progress in this area. The ECB may struggle to achieve the political consensus required for an early adoption of these measures until a deeper slowdown raises the fears of a renewed crisis in the eurozone.

At the same time, stock market resilience in the face of slower global growth appears to reflect ample liquidity more than corporate earnings expectations. We are concerned that central bankers will collectively fail to meet the full extent of market expectations. When combined with political pressure on the Fed and the complex interaction between trade rhetoric, market sentiment and monetary policy, we would not be surprised to see continued sharp moves in asset prices.

Practical positioning

Nimble management required

Over recent quarters, we have highlighted continued divergence between various financial markets and the global economy. Although we recognized the longer-term return potential for stocks, we continued to point to shorter-term concerns that have tempered our enthusiasm. A return to long-run levels of market volatility since early 2018, rather than the muted |evels seen for much of the past 10 years, indicates that we have entered a new volatility regime.

The decline in bond yields that accompanied the prospect of tariff increases makes the next move even harder for the Fed. Markets now appear to anticipate a succession of rate cuts through year-end, at least in part to offset the impact of trade concerns, as well as any hit to market confidence. Increasingly, it looks like the Fed is being pushed toward actions that it is less able to justify on the basis of its dual mandate of stable prices and maximum employment. This has driven an inversion of the US Treasury yield curve, as the 10-year note’s yield fall below that of Treasury bills (see Exhibit 4). Such a development is often a signal for impending recession, though we maintain a somewhat more constructive view of the US economy.

Against a backdrop of slower growth, global equities as a whole are not cheap, in our analysis. Any market disappointment over the Fed’s delivery of potential rate cuts might hurt market stability. Having taken a more cautious stance on risk assets in the first half of the year, we continue to believe navigating the challenges 2019 presents will require nimble management.

TARIFF UNCERTAINTY CAUSING INVESTORS TO PREFER LONGER DATED ASSETSExhibit 4: 10-Year Treasury Note Yield Less 3-Month Bill Yield (December 1999–August 2019)

Exhibit 4: 10-Year Treasury Note Yield Less 3-Month Bill Yield (December 1999–August 2019)

Sources: Franklin Templeton Capital Market Insights Group, Federal Reserve, NBER (National Bureau of Economic Research) Macrobond.

Real assets could be the alternative

By a significant margin, energy has been the most important factor driving consumer prices over recent years. The cost of a barrel of oil rebounded strongly and then corrected again. Despite its relatively modest weight in the overall Consumer Price Index (CPI), oil has accounted for a large part of the volatility in headline CPI inflation. That energy is considerably more volatile than most other components of CPI is not new or surprising. Indeed, this is why central bankers and market watchers tend to look at underlying “core” inflation, which is the headline reading minus the volatile food and energy segments.

Although we may have an interest in core inflation from a macroeconomic perspective, headline inflation increases have a direct impact on the return from certain real assets. Inflation-linked bonds’ capital value and income stream rise in direct proportion to the increase in the headline CPI (or other price index that certain countries’ bonds follow), delivering explicit inflation protection. Today, unless oil prices rebound, the rate of headline inflation is likely to continue slowing during the next few months. Similarly, an increase in prices that comes about because of import tariffs may have an immediate impact on inflation. However, the longer-term impact (on a sustained basis) is dependent on changes to consumer behavior. For now, longer-term inflation expectations remain relatively well anchored.

In contrast, market-based expectations for inflation, derived from the yields of nominal and real return bonds, have fallen sharply. These so-called breakeven inflation rates (where the prospective return on nominal and real-return bonds are equal) have responded directly to recent commodity price declines. Looking more deeply, the level of breakeven inflation over the five-year period starting five years from now (5-year/5-year forward rate) has also fallen (see Exhibit 5). This largely reflects a re-rating of nominal bond yields and a decline in the risk premium for inflation uncertainty.

Some further modest decrease in this market-based measure of long-term inflation rates could occur, but to see it move appreciably lower would require consumer expectations to become less well anchored. Such an event would likely be a catalyst for an acceleration in the pace of monetary easing by the world’s leading central banks and may see broader market changes—weaker stock markets or, in the longer term, higher bond yields. It is this combination of “shocks” that provides the environment where holding a diversifying asset such as TIPS might enhance return potential and lower portfolio volatility.

Management of risk profile—duration considerations

How would we take exposure to inflation protection? If we buy inflation linked bonds out of our short-term bond holdings, we will take additional exposure to the level of interest rates (duration1 or interest-rate risk as well as the term premium seen in longer-dated yields). This might help to diversify against equity risk. However, we may not wish to add further to this exposure given historically subdued yield levels.

If instead we sell other bonds to fund this position, we would be reducing exposure to the defensive component of a multi-asset portfolio and not adding to overall duration. However, in our analysis, the overall portfolio would be more correlated to equity markets and more cyclical in nature, which runs counter to our defensive posture overall. Any reduction in overall diversification needs to be considered in deciding how to fund an investment in inflation linked bonds.

Alternative assets that aren’t really alternative enough

We anticipate that certain other alternative assets might show uncorrelated return potential. Real estate is widely viewed as providing some protection against a general rise in inflation. However, as global growth slows, this would impact the ability of tenants to continue to cover rent and risks falling occupancy rates.

Similarly, any rise in bond yields could put pressure on property valuations through the current relatively subdued yield. While directly held property might weather this storm, and even potentially benefit from a modest rise in inflation, listed alternatives such as REITs would be more vulnerable to a correction due to their equity-like characteristics, in our analysis.

Broad commodity prices typically perform well in the latter stages of a business cycle, but they have been weak over the past year. They would benefit from any increased demand, driven by a renewed capital investment cycle. Commodities often see prices rise as a result of supply constraints, but this has been offset by demand concerns as China rebalances its economy toward domestic consumption. We retain a less optimistic view of real assets such as commodities, despite their potential diversification benefits.2

More specifically, certain commodities may offer alternative diversification benefits. Precious metals such as gold may not follow the same trend as industrial metals or broad commodities (see Exhibit 5).

At times of financial market or geopolitical stress, they can offer perceived safe haven benefits and are viewed as a hedge against the debasement of fiat currencies.3 Our analysis of the drivers of precious metals shows that they would tend to fare better if the US dollar were to depreciate. Also, as an asset that generates no income, they compete better in a falling interest-rate environment (see Exhibit 6). Currently, we find the specific attractions of gold somewhat more compelling than those of commodities more broadly.

 

COMMODITY CYCLES ARE NOT PERFECTLY CORRELATED Exhibit 5: Growth Comparison Between Industrial Metals, Gold and Commodities (January 2002–August 2019)

Exhibit 5: Growth Comparison Between Industrial Metals, Gold and Commodities (January 2002–August 2019)

Sources: Franklin Templeton Capital Market Insights Group, Bloomberg, Macrobond.

GOLD PRICES RISE AS US TREASURY YIELDS FALLExhibit 6: Price of Gold vs. 2 Year Treasury (January 2015–August 2019)

Exhibit 6: Price of Gold vs. 2 Year Treasury (January 2015–August 2019)

Sources: Franklin Templeton Capital Market Insights Group, LBMA (London Bullion Market Association), Macrobond.

 


Franklin Templeton Thinks: Allocation Views
Our research process monitors a consistent set of objective indicators and screens them to identify signals that help our analysts to make better recommendations. By doing this we aim to filter out the daily noise to reveal the underlying trend.

Our macro-economic research group aims to challenge the consensus forecasts for growth and inflation by digging deeper into the data. Just as important, we aim not to be swayed unduly by topics that are dominating current market debate.



Editorial review

Ed Perks, CFA Chief Investment Officer,
Franklin Templeton Multi-Asset Solutions

Gene Podkaminer, CFA Head of Multi-Asset Research Strategies,
Chair of Investment Strategy & Research Committee,
Franklin Templeton Multi-Asset Solutions

ENDNOTES

  1. Duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.

  2. Diversification does not guarantee profit or protect against risk of loss.

  3. Fiat currency is money that is not backed by a physical commodity. Most modern paper currencies, such as the US dollar and euro, are fiat money. They are issued by a government, which guarantees the validity of that currency for use in economic trade.