2023: The Year Of Real Assets

From decades-high inflation and rising interest rates to a downturn in the stock market, 2022 was a challenging year for many investors. As we move into 2023, questions persist regarding the global and U.S. economies.

With heightened uncertainty, even seasoned investors are reassessing their portfolios to manage risk. Let’s review the key economic events of 2022 and consider how investors might approach the upcoming year.

2022: A Tumultuous Year

Inflation

Inflation became a dominant concern for consumers in 2022. Americans had more disposable income as the economy reopened – the result of monetary policy enacted during the Covid-19 pandemic – which placed upward pressure on the price of many goods. Meanwhile, global lockdowns and worker shortages derailed supply chains around the world, further driving up prices. As a result, the Consumer Price Index (CPI) peaked at 9.1% in June, sending prices to their highest levels in 40 years.

Despite inflation cooling to 7.1% in November, key sectors such as food and shelter continue to experience price increases, raising concerns about inflation’s future trajectory. Looking ahead, some experts are wary that easing COVID-19 restrictions in China may contribute to renewed inflationary pressures in 2023.

Tightened Monetary Policy & Rising Rates

In an attempt to deflate price growth, the Federal Reserve increased its trend-setting rate at one of the fastest paces in modern history. In February 2022, the effective Federal Reserve rate was just 0.08%. At the time of writing, this rate has soared to 4.33% – and with further rate hikes expected going forward.

The rise in interest rates had a direct impact on bond prices, with intermediate-term bond prices down nearly 13% through the end of November. The Fed’s reduction of its balance sheet further exacerbated bond market challenges. As a result, companies are increasingly shying away from creating debt instruments; the issuance of U.S. non-financial investment grade bonds dropped 32% in 2021 and 28% in 2022 through October.

As the Fed raises interest rates, mortgage rates have jumped as well. The one-year adjustable mortgage rate has more than doubled to 5.6%, while the 30-year mortgage rate topped 7%, hitting a 20-year high.

Market Turbulence

2022 was a difficult year for U.S. equity markets. Driven by rising interest rates and inflationary concerns, all major stock indexes posted significant losses; the Dow is down 8.15% for the year, the S&P has shed 18.63%, and Nasdaq has plummeted 31.55%. Meanwhile, U.S. small-cap stocks touched a year-to-date loss of 27% in both July and September. As of mid-December, the S&P Small Cap 600 was down nearly 18% for the year.

Corporate earnings growth remained tepid, with year-over-year earnings per share (EPS) growth at just 2.1%, far below the 5-year average of 8.7%. Moreover, just 71% of companies are beating earnings estimates – 6% less than the 5-year average.

Against this backdrop, many experts forecast continued difficulties for equities in 2023.

Global Challenges

Many economies have been hit with rising prices in the wake of the pandemic. U.K. inflation, for example, hit 11.1% in October, a 41-year high, while Germany topped 10%. As a result, many major central banks are rising interest rates at rapid rates, sending global markets into distress. As of mid-December, the EURO STOXX 50 Index was down over 11%, while the Chinese and Hong Kong exchanges were also down double-digits.

Meanwhile, the ongoing Ukraine-Russia war is perpetuating supply constraints around the world. Year-over-year Ukraine grain exports this summer were down 46% (roughly 2.6 million tons). Meanwhile, Russia had been exporting 560,000 fewer barrels of oil per day compared to before the war. As a result, commodity prices remain elevated, with the cost of food up 11.2% from last year and energy up 19.8%.

Navigating Uncertainty in 2023

Amid persistent inflation and market volatility, investors are searching for strategies to mitigate risk. Below are several potential avenues for portfolio diversification and risk management:

1. Diversification

With both stocks and bonds experiencing significant downturns in 2022, traditional portfolio allocations may no longer offer the same level of diversification.

Thus, investors might consider rebalancing their portfolios in 2023 by incorporating assets 0r sectors that have historically demonstrated resilience during economic downturns. Investment vehicles like ETFs or mutual funds, for example, can help reduce the volatility of investing in individual stocks. Stocks within the healthcare or energy sectors, which tend to have reliable revenues throughout the economic cycle, can also help stabilize an investment portfolio.

Additionally, real assets like real estate or farmland can offer diversification benefits due to their historically lower correlations with public equity and bond markets. In the last three decades, farmland, for example, has had a -0.06 correlation to stocks and -0.24 to bonds.

2. Stability

In times of market volatility, stability becomes a top priority for many investors. Historically, high-yield savings accounts, money market funds, and government bonds provided a safe haven. However, recent conditions have challenged the reliability of these assets.

Some investors are turning to real assets, which have shown historical stability due to consistent demand for resources such as shelter and food. For example, from 1991 to 2021, real estate had an average annual return standard deviation of 7.73%, while farmland’s standard deviation was lower, at 6.75%. The S&P 500's standard deviation topped 16%.

Many real assets have proven to be comparatively resilient during market-wide recessions, too. During the 2008 Great Recession, stock prices fell 52%. Though global bonds posted a positive return, high-yield bonds lost 26.2% while emerging market debt lost 12%. During this same time frame, farmland yielded a positive quarterly return of 7.33%.

Today, both farmland and real estate are expected to post net positive gains in 2022. Year to date, the NCREIF Real Estate and Farmland indices have returned around 9% and 6%.

3. Long-Term Fundamentals

Stocks have shown strong long-term growth over the past 30 years, with both the Dow Jones Industrial Average and the S&P 500 delivering substantial value appreciation. However, the performance of individual stocks can be highly unpredictable, influenced by factors such as market demand and company-specific fundamentals.

In contrast, real assets tend to be driven by long-term structural trends that offer more consistent demand. For instance, the global population continues to grow, fueling demand for essential resources like food and housing. Simultaneously, the supply of these resources remains constrained. Over the long term, this stable supply-demand dynamic has supported the appreciation of real assets, including farmland and real estate. U.S. home prices have more than doubled since the early 1960s, while farmland real estate values have steadily increased, averaging $3,800 per acre in 2022, up from $3,160 in 2020.

4. Inflation-Hedge

Real assets, such as farmland and real estate, have historically served as a hedge against inflation due to their inherent ties to physical goods and services. Unlike stocks and bonds, which may experience value erosion during inflationary periods, certain real assets often retain or even increase in value as the cost of their underlying products rises.

Farmland, in particular, benefits from its connection to food prices, which tend to rise during inflationary periods. For instance, as inflation drives up the cost of agricultural products, farmland returns often increase in tandem. However, rising inflation can also impact input costs, such as fertilizers, labor, and energy, which can eat into profit margins for operators.

With food prices 10.6% higher than they were last year, average net farm income increased by 5.2% over the last year. Meanwhile, farmland real estate values topped $3,800 this year, up from $3,160 in 2020.

A look Ahead

Following a year marked by economic uncertainty and market turbulence, 2023 presents both challenges and opportunities for investors. Real assets, including farmland and real estate, may offer diversification, capital preservation, and potential inflation protection in an uncertain economic environment.