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How alternatives can help protect portfolios against inflation

Exclusive research from Nuveen reveals APAC asset owners are more likely to implement inflation mitigation changes in portfolio, through incorporating – or increasing – less liquid investments, than investors from other regions.
How alternatives can help protect portfolios against inflation

As the extreme nature of macro and market events disrupts investment strategies, institutional investors around the world are increasingly re-considering portfolio construction.

This is to be expected amid a more challenging environment of slowing economic growth, increased volatility, upward pressure on interest rates and higher inflation.

More specifically, according to findings from Nuveen’s second annual Think EQuilibrium Global Institutional Study, nearly two-thirds (61%) of investors surveyed are taking steps to increase inflation risk mitigation over the next 12 months.

In particular, this survey of 700 investors and 100 consultants spanning North America, Europe, the Middle East and the Asia Pacific (APAC) region in late 2021, showed that asset owners in APAC are more likely to implement inflation mitigation changes compared with their global peers.

For example, 74% of public pensions and insurance companies in APAC highlighted the need to completely re-think portfolio construction strategies, while 64% of APAC-based insurance companies said fundamental long-term market dynamics have lost relevancy.

“With all the complexity and rapid change now driving communities, economies and the environment, institutional investors urgently need a forward-looking perspective and the flexibility to consider new approaches,” said Simon England-Brammer, head of EMEA & APAC institutional at Nuveen.

Adapting allocations in Asia Pacific

As asset owners in the region strive to tackle inflation risks, they need to look beyond traditional fixed income assets, given these are no longer producing robust income.

Instead, three-quarters of APAC investors in the survey said they plan to expand their reach for yield over the next two years.

In line with this, the majority (62%) are looking to alternative credit. Notably, private credit saw the biggest year-over-year increase in the percent of asset owners who hold the asset class. Now, 72% of institutional investors globally have exposure to private credit, compared with 62% in 2020. Further, 31% said they plan to increase allocation to these assets over the next two years.

“An environment of low yet rising interest rates and high inflation can make middle-market loans, infrastructure debt, real estate debt and other forms of private credit particularly attractive,” added England-Brammer.

Broadly, the productive, cash-flow-generating nature of assets such as real estate and real assets potentially offer long-term inflation protection.

This will be especially important to Australian institutional investors, according to survey findings, as they cast their nets wide in identifying opportunities for yield. Asset owners in Australia also showed significant interest in opportunistic private credit, with 60% expressing a preference for this asset type, compared with 34% of investors globally.

In Japan, meanwhile, although 30% of investors do not own alternative assets, the survey showed that nearly four in every five of them would consider investing in the next 12 months.

Real estate is the most commonly held alternative asset class with 80% of investors currently allocated and 24% planning to increase allocations in the next two years. The areas of interest include industrial, residential and technology-related properties.

Focus on long-term inflation hedges

Alternative portfolio positioning

Despite the fears of asset owners about inflation, Nuveen doesn’t expect a worst-case scenario. While it expects economic expansion to continue contributing to above-average inflation, the firm’s outlook is that demand will soften, supply shocks will dissipate and, therefore, inflation will eventually moderate.

Yet to achieve safe harbour from market volatility, investors should look to shield portfolios by incorporating – or increasing – less liquid investments into their portfolios.

“In our experience, investors tend to overestimate the amount of portfolio liquidity they need, potentially sacrificing better risk-adjusted returns by underinvesting in private assets,” said England-Brammer.

For example, Nuveen’s investment outlook for tactical exposure over the coming months suggests asset owners to consider private investments that align with climate transition themes such as carbon sequestration in natural resources, clean energy, renewable fuel sources and continued strong global demand for healthy foods.

“Infrastructure, agriculture and timber should continue to benefit from high investor demand and relative insulation from inflation and economic cycles,” said England-Brammer. “We are focusing on assets and investments that have the ability to pass through price increases to mitigate inflation risks.”

Meanwhile, real estate can offer capital appreciation and income despite higher inflation; many leases have built-in rent escalators that protect real income generation. In addition, higher nominal wages can lead to bigger budgets for housing, which has been in short supply since the global financial crisis – plus it is a trend exacerbated by Covid-induced migration and higher costs of materials slowing the pace of new inventory.

Geographically, Nuveen’s outlook favours single-family rentals and highly specialised medical offices in the US. The firm is also supportive of suburban housing and data centres in Europe, and senior living and industrial properties in Asia.

From a contrarian perspective, Nuveen identifies idiosyncratic opportunities in distressed retail real estate, especially in the US but also in Europe. “New store openings, increased foot traffic, good leasing activity and compelling prices are all causing us to take a close look,” he added.

“Private real estate investments have been relatively insulated from recent market volatility, and we believe continuing global economic reopening and strong capital flows should provide ongoing tailwinds,” explained England-Brammer.

Learn more about Nuveen’s Think EQuilibrium 2022 Global Institutional Investor Study

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