Scott Thompson, senior investment analyst at Morningstar Manager Selection Services, analyses whether listed real investors should be concerned about inflation and its impact on markets.
Inflation, having been off the menu for so long, now seems to be the hottest of topics. How worried should investors be given recent inflation fuelled market wobbles and how can they protect themselves if it does become a problem in reality?
One answer could be found in real assets, which generally benefit by economic growth that causes inflation. Certain types of real assets, like property and infrastructure, can also rise in price when their input costs rise, as the replacement cost of building similar buildings or structures rises. However, for most investors infrastructure or commodity investments can be too niche or volatile, and the liquidity mismatch of direct property funds throws up additional risk. As such many investors look to REITs (real estate investment trusts) or funds of REITs for long term capital appreciation, a robust income stream and inflation protection, as rental incomes general include inflation uplifts. Most investors would invest in REITs that focus on commercial property, but more specialist REITs and residential REITs are available.
REITs do exhibit a much greater short-term correlation to equity markets than direct property, but over the long term the property like characteristics are much more apparent, and drawdowns can provide buying opportunities to pick up REITs at a discount. They are more economically sensitive than the wider stock market however, so in times of severe market distress they witness deeper sell offs as we saw in Q1 2020 where in USD terms the Global REIT index fell 8% more than MSCI World index. Over the long term however, they act more as a hybrid between stocks and bonds, with income producing capabilities being especially prominent in the recent low-rate environment.
This year however, as inflation has become more prevalent REITs have performed strongly across all geographies, but in particular in the US, with the index being 10% ahead of the S&P 500 and 12% ahead of MSCI World. It has also benefited from the fact that they are also more value orientated and smaller cap than the wider US market, an area of the market that has attracted attention as part of a reflation trade.
Looking forward REITs can provide a good option for inflation wary investors or those who like the income producing characteristics of property without the liquidity burden of owning direct property. Potential investors should be aware that despite being technically an equity, over the long-term it is likely that REITs will underperform the broader equity market whilst delivering equity like risk in the short term. Another risk is that the inflation they protect against also leads to rising interest rates. As interest rates go up yields on REITs can look less attractive and the bond like characteristics that make them attractive also brings with it some implicit duration risk. Finally, REIT selection is also important. Making sure underlying exposures match risk tolerances can be difficult, and some of the top performing REITs have sector specialisms (e.g. healthcare) that may not be appropriate for many investors.
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