Real assets are not what they were.
Just as those of us in the West were starting to get our lives back after the pandemic, Russia invaded Ukraine, provoking a dramatic and unified response from much of Europe and the USA. At the same time, China rolled out widespread and severe lockdowns in many major cities, further exacerbating the supply bottlenecks that were helping fuel inflation that was certainly not transitory.
Consequently, real assets investors are facing not just the radical behavioural change triggered by the pandemic, but also seismic shifts in the geopolitical backdrop against which they invest. The TL:DR of all of this is that the next 10 years are going to be far more challenging than the past decade and bring many long-run tailwinds.
In retrospect I think the decade from 2009 to 2019 will be seen as a golden period for real assets investment. We had it all in our favour:
Many institutional investors were raising their allocations to private market real assets from circa 5% to circa 15%. This gave us massive capital inflows.
On top of that, newly wealthy emerging Asian individuals and sovereigns, with few domestic investment options, were also exporting excess savings into Western treasuries and real assets.
Even better, major global central banks were enacting a deliberate policy of shifting investments from safe to risk assets through their policy of deliberately suppressing bond yields, aka Quantitative Easing,
So we had three major factors driving capital into real assets. Added to this, it was also an incredibly favourable period for moving capital around the world to wherever the most attractive relative value was to be found. After the Cold War, we had seen much of Eastern Europe reintegrated into the global economy, and with the entry of China into the WTO, the same was true of her massive labour force. Underpinning all of this was the creation and expansion of international laws and regulations that governed the smooth globalisation of the trade in goods, services and underlying financial flows. In short, one could move capital to the most attractive investment opportunity, assured of property rights, in most major markets. And the entire system was lubricated by the US dollar as an international reserve currency.
Sadly, many of these factors have now gone into reverse.
Many institutional investors have successfully built up their real assets allocations to the desired level. To be sure, there may still be some radical changes within those allocations to come – most urgently from legacy office and retail toward logistics, residential and the ‘next generation’ sectors. But more or less, a lot of the work has been done. And with fixed income experiencing its sharpest sell-off in 30 years, and equities teetering on the brink of a bear market, many investors now find themselves the victims of the denominator effect. Private market real assets could well be punished as a result, victims of their own success – or at least – more sluggish valuations.
Our second factor is also likely to go into reverse, on the back of the West’s rapid action to cut Russia out of the global payments system and seize not just the government’s assets, but those of individuals perceived to be adjacent to the regime. Whatever the moral merits of this action, what it did was undermine the perception of the rule of law and property rights, and create assets that were now stranded. So, if you were previously of a mind to export capital from China, for example, to the USA or Europe, you might rightly need to demand a risk premium for potential expropriation risk.
I also suspect that we are on the verge of seeing the world’s payments and currency system split from one that was more or less unified under the US dollar, into more regional blocks, with the renminbi seen as the settlement currency of choice in Asia and the dollar in the West. This was always potentially going to happen in the long term, as China opened up its capital and currency controls, but I would argue that it has been radically accelerated by the removal of Russia from SWIFT. One corollary of this is that if countries that used to settle trades in US dollars no longer need to, then they no longer need to run large US dollar current account surpluses and so no longer need to export those surpluses to buy US treasuries. This potentially puts upward pressure on US bond yields and brings to a close a long period where the budget deficits of the West were effectively subsidised by the savers of the East.
“The decade long era of incredibly supportive monetary policy is at an end”
Finally, and most obviously, excluding China and Japan, the world’s central banks are no longer pushing investors into risk assets such as real estate. The impact has been swift. Deals that were previously attractive based on cheap financing costs and risk-free rates are now being re-traded, price chipped or done with lower bidder pools and prices. The decade long era of incredibly supportive monetary policy is at an end, and we are all having to reassess relative valuations and pricing.
Where does this leave us? In a global economy grappling with a radical and completely unexpected de-globalisation of the payments system, more persistent than expected inflation, a faster than expected normalisation of policy rates and central bank liquidity conditions, and a much faster than expected decarbonisation of energy, particularly in Europe, for both climate and military reasons.
No wonder equity and fixed-income volatility has spiked and no wonder liquid assets are selling off. The question is what this all means for private market real assets? To some extent, they are perfectly positioned to thrive in a world of higher inflation, given some of the inflation protection built into their cash flows. And logically one would expect credit and infrastructure strategies to look particularly attractive as we enter a cyclical downturn.
But I suspect that net, this is going to be a tricky year or so. The denominator effect, higher financing costs, and the fact that our tenants are feeling the impact of higher prices on their balance sheets and profit margins do not add up to an easy time in leasing and capital markets. Added to this we now face a world where being regime agnostic and seeking the best relative return globally has an added political risk dimension. We can already see this in deal volumes in some of the CEE and Baltic markets.
And what happens when we come out of the other side of this adjustment? I cannot see trend inflation or interest rates settling to where they were before the pandemic. Just the higher frictional costs of doing business in a deglobalising world where the movement of labour, capital and goods is more difficult than it used to be seems – coupled with the absence of QE – to argue for less favourable monetary conditions.
So, if there’s one phrase or big theme that you take from this essay it should be ‘turning point’. Not just in the obvious sense that we are now at a cyclical turning point in terms of monetary policy and growth, but that we are also at a structural turning point for global capital markets and geopolitics. The good news is that – with the GFC, the Greek sovereign debt crisis, Brexit, the pandemic and now war – we are more than capable of adapting.
