ARTICLES

Inflation has for a long time been the dormant passenger in the trunk of most investors’ risk factor vehicles. The last time it had the wheel was back in the Volker era of the late seventies, early eighties when Paul Volker brought down the hammer and snapped the back of inflation to around 2%. Since then, inflation has been kept in its cage, only out on occasions on a very tight leash.

Shortly after the pandemic struck in March of 2020, the Fed opened its dam wall and flooded the system with liquidity that unbeknownst to them would roughly coincide with several other forces nourishing the feral inflation and radically altering the economic landscape. Now the Fed sits with the problem of 6.28% core inflation and investors are dealing with a new type of regime which is considered a novelty by those that only entered the game in the last three decades.

There is a scenario where inflation can be found in the driver seats of the upcoming three cars on investors’ highway: the short-term, the medium-term, and the long-term.

The short-term has very little need for explanation beyond the current level of inflation in the US, fuelled by structural deficiencies in the supply of shelter and labour for which there is no easy and quick fix. The medium to long-term can see a myriad of factors play out, all of which seem to be back in the trunk of the investors’ risk factor vehicle, with the 5y US breakeven inflation rate at 2.35% and the 10y at 2.28%.

Prospective Inflationary Forces

The world is on the cusp of a great infrastructure overhaul which will require an unprecedented amount of spending and resource utilization. To keep global warming at no more than a critical 1.5°C, emissions need to be reduced by 45% by 2030 and reach net zero by 2050. The degree of such a trajectory leaves a jumbo question mark hanging over its achievability in a world where many of the necessary natural resources are set to come under pressure.

Exhibit 1: Metals in a Net Zero Scenario

The inevitable acceleration of the clean energy transition could lead to several supply crunches that are highly inflationary, especially in the subterranean metals group, where there is a significant lag between demand and supply owing to large investment requirements, and long periods between exploration and production.

The International Energy Agency’s Net Zero by 2050 Roadmap calls for up to sixfold increases in the demand for certain natural resources such as lithium and cobalt. The pace required to meet the 2050 target could result in a derailment of the transition itself. The longer it takes the world to complete the transition to net zero, the more damage the earth’s atmosphere will take, resulting in further expansion of climate extremes and weather events disrupting crop yields—phenomena which will cascade through into the global economy as food inflation.

Many of the necessary natural resources for the transition are concentrated in the hands of only a few nations. Centralized resources don’t help the issue. It can cause supply security issues and in the worst of cases, an abuse and weaponization of resources—Russia’s natural gas to Europe being a prime example of this.

The baby bust is another risk yet to be given its rightful attention. It works in two channels: (1) women deferring pregnancy to less fertile years owing to their evolution in the workplace and (2) the toxicity of food and certain consumer products which significantly curtails sperm count (to roughly two thirds of pre-industrial levels) and damages chromosomes of the fetus in utero. These drivers have sent current fertility levels below replacement level in most of the developed world. The inter-generational effect of compounding, where damaged chromosomes are carried over from offspring to offspring, is exacerbating the problem. Jørgensen et al. (2017) found that from 1973 to 2011 the loss of sperm count compounded at 1.9% per year.

Exhibit 2: Sperm Concentration in the Western World

Fertility phenomena of this kind is set to augment the aging of the global population, putting severe pressure on resources and systems, and resulting in inflationary supply-demand imbalances.

Inflation prospects hardly end with resource crunches and labour shortages. Heightened rhetoric among companies to reshore production from cheap labour economies like China as a response to the events of recent years could lead to increasing manufacturing costs. New Chinese policies like dual circulation paired with common prosperity signals the end of cheap Chinese goods flooding the global market.

Any escalations in geo-political tensions in an increasingly polarized world between autocracies and democracies through wars, the prospect of war, countries forced to pick sides (and condemned when they don’t), dollar weaponization and subsequent de-dollarization, could all lead to the loosening or cutting of trade ties and thereby…more inflation.  

Real Estate Haven

It is important for investors to start thinking about these inflationary prospects. There is no surety on how or if they will develop, but they are important considerations in a world of accumulating risks for which it is sapient to build portfolios best able to absorb as much of the prospective impacts as possible and preserve wealth by, at the very least, matching inflation.

One of the most effective inflation hedges is real estate. It sits at the unique intersection of inflation pass-through (through rental contracts) and inflation cultivar (land and building materials)—making it an asset class with the ability to capture a great deal of the inflation that permeates in an economy. Other assets have shortfalls in hedging inflation that real estate circumvents, such as return being capped at inflation—as is the case with treasury inflation-protected securities when held to maturity—or running the risk of being used as the wrong inflation hedge, which can be the case with commodities, and the risk of staying relevant and competitive which are prime considerations for equities. In essence, real estate can be seen as the asset class that comes the closest to being structurally linked to inflation with still the potential for outsized returns.  

Real Estate’s ability to hedge against inflation is buoyed by its relative scarcity which makes it a viable store of value. Its scarcity is magnified when rising building costs and interest rates result in certain construction becoming financially infeasible, putting a damper on supply. However, its store of value aspect only really comes to the fore when in a desired location for which there is a finite amount of land available.

Real Estate correlates strongly with inflation and GDP over the long-term—interrupted by market forces, interest rates, and real estate idiosyncrasies over the short to medium term.

Exhibit 3: Changes in Real Estate Value and Consumer Prices 1951-2021

Long criticized implications of real estate investment such as illiquidity, management intensity, and large initial capital investment have been eradicated by the advent of real estate investment trusts (REITs) that provide investors with a seamless way of bootstrapping into and out of real estate. However, not all REITs are of equal merit and still require the right analysis to separate the winners from the losers. Although still a relatively niche practice, fund managers that provide these services have emerged in recent years.

In Conclusion

Whether inflation will persist in the short-term and continue into the medium and long-term is almost an aside. There is rarely any certainty around something as uncertain as inflation, but there does seem to be a current underappreciation by the market for certain future inflation carriers.

The best way around uncertainty is building a resilient portfolio that is ready for anything, not least of all inflation. And while Real Estate is not the only way to hedge against inflation, it is one of the most effective.