James Tarry and Luke Layfield assess the impact of recent market volatility across real assets and highlight the wealth of investment opportunities for multi-asset investors that could emerge in 2023.
Read this article to understand:
- How inflation and interest rates have driven real asset markets in 2022
- Why we are now in a period of price discovery to determine fair value
- Why recent volatility and dislocation could make way for sizeable opportunities for investors with dry powder
Winter is coming. The war in Ukraine grinds on, energy prices remain stubbornly high and central banks are hiking interest rates to control inflation.
The UK economy contracted by 0.2 per cent in Q3, with the Bank of England now predicting a “prolonged recession” lasting into 2024.1 The European Union is also expected to slip into recession before the end of 2022 due to slumping output in Germany, the bloc’s largest economy.2
It all adds up to an uncertain backdrop for investors in real assets. Not surprisingly, the number of European real estate deals is falling, with year-on-year transaction volumes down 37 per cent to €53 billion in the third quarter, according to MSCI data.3 Rising construction and borrowing costs are hampering development and weighing on valuations in real estate, although demand remains strong for some infrastructure assets, particularly in the renewable energy sector.
But challenges often give way to opportunities. Investors with the expertise and flexibility to look across markets and asset classes should be able to take advantage of mispricing over the coming months, according to James Tarry (JT), who leads Aviva Investors’ multi-asset strategy for real assets. “2023 could be the best opportunity to invest that we’ve seen in a decade,” he says.
In this Q&A, Tarry and real assets portfolio manager Luke Layfield (LL) explain which markets should stay resilient through a recession and identify the key opportunities likely to emerge as markets stabilise.
How are real assets holding up amid spiralling inflation and rising interest rates?
JT: Inflation and interest rates have been key themes over recent months. The sharp rise in rates – and, in the UK, gilt yields – has been extraordinary, and almost unprecedented in scale and speed.
Rising rates have led to illiquidity. Transaction volumes are down on what we would usually expect for this time of the year, both for debt financing and direct investments across real estate and infrastructure, although we are still seeing some activity.
Different parts of the real assets universe are at different points of the repricing process
We have now entered a period of price discovery, during which buyers and sellers are trying to determine fair value. Different parts of the real assets universe are at different points of this repricing process, depending on their linkage to interest rates. Private debt and amortising leases have an explicit linkage to rates, so repricing has rebased quicker than real estate and infrastructure equity. Going forward, those higher debt costs and a higher cost of capital will feed through into equity pricing as refinancing activity gathers pace.
Liquidity and pricing have been impacted differently across asset classes, with real estate debt transactions more impacted than infrastructure debt for example. We are still seeing strong demand for infrastructure assets, particularly renewables and digital assets, and so expect their valuations to decline less than, say, real estate equity.
It all makes for a challenging investment environment. But there will be opportunities for those with capital who are able to navigate the market and exploit mispricing on high-quality assets.
How could a Europe-wide recession affect the picture?
LL: The UK and many European economies are highly likely to slip into recession. But there is still a great deal of uncertainty around how deep these recessions will be and how long they will last.
A decline in GDP will have a definite impact, the severity of which will depend on the asset
Interest rates will be the more important driver of performance, but a decline in GDP will have a definite impact, the severity of which will depend on the asset. For example, development assets and geared real estate assets are likely to be more exposed to the downturn, while prime real estate should prove more resilient and better able to maintain rents than secondary real estate.
On the debt side, lower-rated and higher-levered loans are going to be more exposed than senior debt, which should be insulated from the recessionary environment.
How do we expect the UK to fare relative to Europe?
LL: Earlier in 2022, we saw a bigger premium to the risk-free rate on UK real assets than in Europe, particularly real estate. Relatively lower interest rates in Europe drove a search for yield and created more demand for alternative asset classes, which pushed up valuations; by contrast, we saw more scope for capital growth on UK assets.
Geographical distinctions are becoming less important than specific asset-class dynamics
But now the picture is changing. Concerns over the UK government’s fiscal management have prompted a rise in gilt yields, eroding the premium available on real assets. But as macroeconomic uncertainty persists, geographical distinctions are becoming less important than specific asset-class dynamics.
While real estate is re-rating due to a structural shift in interest rates, infrastructure is still attracting strong demand across both sterling- and euro-denominated assets, partly due to thematic drivers such as the accelerating climate transition and the pressing need for increased investment in renewable energy networks.
How do current conditions compare with previous episodes of turmoil?
LL: The current downturn is very different from the global financial crisis (GFC). The GFC resulted in significant deleveraging; the recession was very deep and took a long time to work through because of systemic issues.
2023 could well be the best opportunity to invest that we’ve seen in a decade
By contrast, the current crisis looks more like a cyclical downturn, with high inflation leading to an interest-rate spike. Investors with capital to deploy, and a clear idea of the kinds of assets they want, should be able to look through the short-term volatility and prepare for opportunities on the other side.
JT: We expect the market to stabilise much more quickly than it did in the wake of the GFC. Given the re-rating and repricing we are seeing, 2023 could well be the best opportunity to invest that we’ve seen in a decade.
Where do you expect these opportunities to arise?
JT: As debt-driven buyers struggle to refinance at higher rates, this will lead to financing gaps that need to be covered, either by finding more equity, more debt, or selling the asset.
Investors with dry powder are likely to be well positioned to take advantage
Similarly, on the equity side, daily-priced real estate funds will need to meet redemption requests. These pressures could precipitate a wave of forced selling and investors with dry powder are likely to be well positioned to take advantage.
In a recessionary environment, you typically expect certain lenders to focus on shoring up their balance sheets and being “risk-off” in terms of capital maintenance, and a certain amount of refinancing activity is probable. That will likely create further opportunities for us as a non-bank lender.
How do you weigh up these immediate opportunities against longer-term thematics?
JT: One of the benefits of investing in real assets on a strategic, multi-asset basis is that it enables us to deploy capital where we see best relative value at any particular point in the cycle.
We are still allocating to infrastructure debt and investing in some private placements in the UK
While we have been allocating less capital to real estate debt recently given the slowdown in that market, we are still allocating to infrastructure debt. We have also been investing in some private placements in the UK, which offer long-dated income and a useful pick-up over public markets.
But our approach also gives us the flexibility to invest with conviction on the basis of long-term thematic trends when the right opportunities emerge. For example, we recently invested in Connected Kerb, an electric vehicle (EV) infrastructure specialist.4 This is a good fit for our approach to investing in real assets aligned to the climate transition, as EV-charging networks will be vital in the road to net zero. The key is to combine strong thematic convictions with the flexibility to invest when the time is right.
Many investors are looking for inflation protection. Which markets offer the best prospects of that?
JT: We don’t expect the current rise in inflation to be a short-lived phenomenon. While energy prices may fall depending on the progress of the war in Ukraine, there are longer-term structural issues that may lead to persistently higher inflation, including deglobalisation and ageing populations in advanced economies.
Inflation protection is going to be more important than it was in the benign inflationary environment of old
Governments dealing with high debt burdens following the fiscal interventions of the coronavirus pandemic are also more likely to tolerate high inflation than would otherwise have been the case. All this means inflation protection is going to be more important than it was in the benign inflationary environment of old and real assets continue to offer good opportunities in this respect.
LL: In terms of sectors, real estate long income can offer good inflation protection via investments in long-term leases to strong tenants with index-linked rents, which provide a contractual and credit-backed source of inflation protection. Recent supply constraints – due to a slump in development caused by higher costs and the ongoing economic uncertainty – also look to be supportive of rents on prime real estate once yields reflect the new interest rate environment.
On the infrastructure side, index-linked debt financing can offer inflation protection, particularly where the underlying project has its own inflation linkage thanks to regulation or contractual agreements. Subsidised renewable energy and regulated utilities also offer protection against rising prices.