How the Fed pause affects real assets

In April 2018, portfolio manager Larry Antonatos warned that rising interest rates driven by accelerated economic growth would be a headwind for real asset equities. He added that broad equities with more cyclical upside would outperform.

And he was right.

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“The 10-year U.S. Treasury yield did rise about 50 basis points over the following six months, and broad equities generally outperformed real asset equities over that period,” he said in an interview last month.

Now that central banks are on pause, the risk of rising interest rates is no longer a concern for real asset investors, explained Antonatos, managing director on the real asset solutions team at Brookfield Asset Management’s Public Securities Group in Chicago.

“Both economic growth expectations and interest rates reversed sharply in 2018 Q4, driving a significant correction in broad equities and a more moderate correction in real asset equities—with listed real estate equities and infrastructure equities down approximately half as much as broad equities,” said Antonatos, whose firm manages the Renaissance Real Assets Private Pool.

“This limited downside capture of real asset equities is a component of the defensive characteristics of real assets, where cash flows tend to be relatively stable.”

Why are real asset cash flows stable? They’re generally supported by long-term leases, he said.

Looking to infrastructure, Antonatos pointed to “attractive supply, demand and pricing fundamentals.”

Infrastructure supply is “constrained because many infrastructure assets are monopolies or semi-monopolies,” he said. “Demand for infrastructure services is steady because infrastructure generally provides essential services with limited GDP sensitivity. And pricing for infrastructure services is frequently regulated.”

Real asset risks

Looking ahead at a lower-for-longer interest rate environment, Antonatos said there’s some concern about real estate market risks because the recovery has lasted for the decade since the financial crisis.

But problems in the real estate market have typically been driven by two factors, he said: “either an oversupply of space, or declining demand for space.”

U.S. commercial construction as a percentage of existing supply has been about 2% since 1970, he explained, except for after the financial crisis, when it hit an all-time low of 50 basis points.

“Since then, construction has accelerated,” he said. “It has hit the 2% long-term average. But a great benefit has been that construction has actually declined recently and is now running at approximately 150 basis points of existing supply. This bodes well for the continued real estate cycle.”

Total construction, including private and public residential and non-residential building in the U.S., cost about $1.3 million in February 2019. This is a slight increase of 1.1% from February 2018, notes the U.S. Census Bureau.

So with supply in control, investors can focus on the demand side of the risk equation: Will the economy continue to grow and how will that impact demand?

Overall, Antonatos expects that growth, inflation and interest rates will increase only modestly this year.

“This is a strong environment for real asset equities to perform well,” he said. “While many investors are focused on the risk of an economic slowdown, we believe the defensive characteristics of real assets will shine in that environment.”

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