Over the last six years we have seen a pandemic, a war in Eastern Europe, and a major conflict in the Middle East.
The pandemic and Ukraine war prompted large policy responses. The Middle East war has not seen major policy responses in the West, but the situation is ongoing and as yet unresolved.
These events have turned the correlation between bonds and equities positive, meaning that bonds have become an unreliable offset for equity risk in investment portfolios.
We are now in a different investment regime to that which existed prior to the pandemic. In the decade before COVID, financial assets outperformed real assets. In annualised US dollar terms, the MSCI World returned 9.5%, aggregate US bonds returned 3.7%, while commodities returned -4.7%. Since the end of 2020, those numbers are 12.5%, -0.3% and 15.4%.
Pre-COVID, the private sector was deleveraging and government spending was relatively contained. Growth was low, inflation was low, and both were stable. In that environment, financial assets thrived, while real assets lagged.
Real world disruption
In contrast, the post-pandemic cycle has been defined by real world disruption. The pandemic hit global supply chains, while wars disrupt the flow of goods, energy and services in ways that are difficult to resolve. Instead of austerity, governments reacted forcefully by running deficits and injecting money into the economy.
Prior to the pandemic there was intense focus on monetary policy. Quantitative Easing (QE), or the central banks buying bonds, was the defining feature of that era. Many saw this as printing money. However, commodities lagged when the Fed’s balance sheet grew substantially, but have outperformed since 2022, when the Fed has hiked and shrunk its balance sheet. QE involves swapping bonds for bank reserves or other risk-free assets so does not increase the wealth of the private sector. It helped boost asset prices but did little for the real economy.
In contrast, governments running large deficits and the private sector spending billions to build AI infrastructure injects money directly into the economy. If this comes at a time of real-world disruption, as it does now, then the impact is magnified.
Real assets play valuable role
In this backdrop, growth and inflation are both higher and more volatile. This has not been a good backdrop for government bonds. Real assets have played a valuable role in investment portfolios in this period.
Real assets are a broad category and may respond differently. Inflation protected bonds can provide protection from high inflationbut may lose money if real yields rise. Gold is a traditional haven from inflation and geopolitical risk. Higher real bond yields have historically been a headwind, but since 2022, gold has risen as the reserve asset demand has outweighed the yield headwind. Gold has struggled in recent months, but remains structurally well supported.
Commodities have performed well so far this year. The oil price has risen due to the Middle East conflict, so oil or oil linked stocks have been a better diversifier than gold.
Within equities, some sectors have more exposure to real assets than others. A popular acronym has been HALO (Heavy Assets, Low Obsolescence), which describes a shift away from “asset-light” businesses under threat from AI, towards businesses that own physical assets, such as industrial companies.
AI is software at the front end, but behind the technology there is a lot of hardware. Building data centres and associated energy infrastructure is very expensive. Large technology firms initially used cash to fund this but now use debt. There is also debt in private markets in various layers of the AI buildout.
The era of QE saw many investors over-index to monetary policy and underappreciated the importance of fiscal policy and private sector activity; especially whether it is deleveraging or increasing borrowing. Now we have governments borrowing a lot of money and the private sector also borrowing for AI. Spending has also risen for defense, public infrastructure and reshoring supply chains. All of this creates a demand for capital, which has put upward pressure on bond yields.
This new regime presents a dilemma for central banks. Whether they respond by raising rates or facilitate loose fiscal policy by holding or cutting is a key variable. The new Fed Chair Kevin Warsh hopes to cut interest rates, but the market is now pricing one hike this year. If the Fed were to cut when the data does not warrant it, real assets would benefit. The bar for Warsh to hike is high, but the tension is real. In this environment, real assets remain a valuable and structurally supported part of investment portfolios.
Nicholas Rilley, CFA, is a senior investment manager and strategy analyst at Butterfield Asset Management.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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