by Stephen Bonnyman, MBA, CFA® Director of Equity Research and Portfolio Manager, AGF Investments Inc.
Steadying rates and peaking inflation could generate a positive tailwind for much of the Real Assets complex.
Notwithstanding the outperformance of Real Assets versus broader equities in 2022, the outlook for the group continues to appear positive into 2023.
Granted, the market continues to struggle to define a clear outlook for next year. But a consensus appears to be forming that a peak in inflation is within sight, and with it the potential for a cap in rate hikes (and maybe even rate cuts later in the year) and a rebalancing of the global economy. Steadying rates, continued inflation (even after it moderates), a peak in the strong U.S. dollar and the first signals of a China re-opening could generate a positive tailwind for much of the Real Assets complex.
Aside from the specific fundamentals of each industry/commodity, many of the sectors in Real Assets are benefiting from underinvestment in new capacity over the past cycle, leaving inventories low and supply constrained and inelastic to demand.
While the exceptional outperformance of energy will be challenging to repeat in 2023, the sector remains well positioned to deliver positive returns next year. Supply remains largely inelastic, with risk skewed to shortfalls rather than excesses, and demand is not entirely elastic to global GDP (for instance, in the event of a shallow recession). We view this energy cycle as secular rather than purely cyclical, in large part due to the discipline and supply constraints of OPEC+, as well as the capital discipline of U.S. producers. From an equity perspective, we expect to see multiples rise for the group as the market comes to accept the sustainability of the sector’s current very high cash flows.
Like energy, a declining U.S. dollar and Chinese restarts should be positive for the commodity materials, but any outperformance will likely occur through the later half of next year. China’s steadfast commitment to its “Zero COVID” policy will make the timing of any reopening uncertain and continue to overhang global demand. Still, while the threat of global recession looms large for Materials, China provides a huge potential catalyst for outperformance in commodities – if and when its economy fully reopens.
While the exceptional outperformance of Energy will be challenging to repeat in 2023, the sector remains well positioned to deliver positive returns next year.
We remain cautious on processed materials (chemicals, packaging), at least until inflation begins to wane and interest rates pause or reverse; when that occurs, they should outperform the market as margins widen. For now, we are more positive on extractive materials (mining, fertilizers).
While Precious Metals have performed better than our earlier expectations, in the near term we are cautious on gold. The combination of slowing inflation and rising rates will create a violent inflection in the cost of carry trade, potentially triggering inventory reductions and pressure on pricing. Gold’s recent outperformance is largely tied to an abrupt decline in the U.S. dollar and a breakdown in the cryptocurrency markets.
Meanwhile, continued high market uncertainty has supported the outperformance of Utilities, but we remain cautious in the medium term. Rising recessionary risk could be supportive for the group, but historically, higher rates have provided an impediment to outperformance. We believe this will be the case through the first half of 2023.
Finally, Real Estate, which underperformed the broader markets in the later part of the year as real rates quickly accelerated, is likely to continue to struggle until interest rates stabilize. While limited, private market Real Estate transactions suggest that public valuations remain discounted, and as interest rate and economic clouds fade, this value gap should narrow.
While uncertainty remains a dominant phrase in the individual sector outlooks, Real Assets as a group should continue to provide solid protection against rising inflation and weaker economic growth, while setting the base for strong potential performance in an economic recovery.*****
Stephen Bonnyman, MBA, CFA®Director of Equity Research and Portfolio ManagerAGF Investments Inc.
