How infrastructure can defend against inflation

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How infrastructure can defend against inflation
(Alex Azabache/Pexels)

It is the Fed’s most aggressive cycle of monetary tightening since 1981 and is likely to be followed by other central banks, including the Bank of England.

The inflation problem worldwide is glaringly obvious – at the time of writing, the UK consumer price index is 9.4 per cent and expected to go higher. The International Monetary Fund has raised its forecast for global inflation to 8.3 per cent from 7.5 per cent and cut its global growth prediction to 3.2 per cent. Recession worries, resulting from action taken to cut inflation, are building in major economies.

Soaring inflation, rising interest rates and slowing growth with the risk of recession make portfolio decisions tougher for advisers, clients and fund managers. Identifying investments that can perform and protect investors globally from the impact of inflation, which varies from country to country, is crucial.

The impact of inflation for investors

For many investors, and admittedly fund managers, rising inflation is a new phenomenon that may have been read about but not experienced.

In recent years, discussing inflation protection was met with mild interest but quite often indifference. Benchmarks of CPI +3 per cent for funds such as ours have sometimes been seen as nice to have but not critical for portfolio construction.

This has changed now that inflation is surging. Investors are facing a major devaluation of their cash assets in real terms when inflation is at 9.4 per cent while rates on savings accounts struggle to beat 2 per cent.

The longer the inflationary period lasts, the worse the impact on their investments and advisers, and their clients are looking for investments that provide a level of inflation protection.

Traditional portfolio mixes are not guaranteed to keep pace with inflation, particularly when they are invested in companies unable to pass on price rises to consumers. 

Some companies are more resilient than others during rising inflation, including those focused on consumer staples and non-discretionary spending.

These firms tend to hold up well as demand for their products and services is less affected. Traditional fixed interest securities can also have inflation protection but they tend to be far less widely held. 

Infrastructure builds a balanced portfolio

Infrastructure and real assets, however, can play a significant role in providing inflation protection.

Renewable energy infrastructure assets are generally multi-decade in nature and contracted to governments and other highly credit worthy institutions that are unlikely to default.

Most importantly, they typically have mechanical inflation protection built into the contracts – usually based on the rate of CPI in the region where the asset is located. This benefits investors as inflation automatically increases the revenues they receive from the assets. 

Holdings we believe exemplify these qualities include International Public Partnerships Limited, a UK closed-ended investment company investing in public and social infrastructure with strong environmental, social and governance credentials globally. It estimates that every 1 per cent rise in inflation increases its cash flow by 0.75 per cent.

Another example is Transurban Group, which owns and operates toll roads in North America and Australia. It includes embedded CPI escalation across 68 per cent of its revenues with quarterly to annual toll price increases generally linked to inflation.

Infrastructure as a general asset class can help with inflation-linking, but we believe there is added benefit to focusing on real infrastructure assets, as they generally have a higher level of mechanical inflation linkage and lower sensitivity to market and economic cycles.

Within real infrastructure, it is important that investors take advantage of the themes that are correctly aligned with the current macro environment.

Sub sectors such as renewable energy, core, social and digital infrastructure are all appealing in that sense. The most ironclad opportunity however, is within the subsidised renewable energy generation space, where government sponsored schemes provide mechanical escalation in line with local inflation. 

Investors need holdings within their portfolio that provide services which are required during an inflationary environment and recessionary periods. Real infrastructure assets fit the requirement.

It is physical infrastructure that is keeping the lights on, providing the medical, education and transport services required for society and communities to function during periods of inflation and recession. As part of a balanced portfolio, real infrastructure is well positioned to deliver returns for advisers and their clients.

Nick Scullion is a partner at Foresight Group