Can infrastructure protect from inflation?

It’s an important question as prices rise around the world fuelled by soaring energy and commodity costs, supply chain constraints and a geopolitical retreat from globalisation.

In Australia, headline inflation is expected to reach 5 per cent by the end of the year. And while that’s still low from an historical perspective, it is above the Reserve Bank of Australia’s (RBA) target range and could likely trigger a lift in the cash rate to 0.75 per cent.

Both of these factors are in our view negative for investors.

Inflation eats away at the value of money and higher interest rates directly lift financing costs, so in our view it is critical that investors find a way to protect the value of their investments.

Is infrastructure the asset class that can provide the hedge that investors are looking for?

The broad answer is yes — but the devil is in the detail.

Infrastructure is not a homogenous asset class. Assets that look similar on the surface can have very different drivers of risk and return and it is important that investors consider each individual asset’s specific characteristics.

At a high level, infrastructure assets can be grouped into three categories. Each has a slightly different and nuanced relationship with inflation, and each provides investors with a different level of protection from price rises.

Let’s look at each in turn.

Growth-linked assets

Growth linked assets are infrastructure assets where revenue is linked in some way to the health of the economy — like airports, ports and toll roads.

In some way, each of these businesses enjoys revenue linked to economic growth and this is the core of how in our view growth-linked assets can provide inflation protection: rising prices tend to be a result of strong economic growth which brings rising employment.

Australia’s real GDP is forecast to grow 4.5 per cent this year, while nominal GDP growth will come in around 9.5 per cent. This kind of economic growth lifts the usage of many infrastructure assets.

Typically in a stronger economy, more people fly, more goods are imported, and more cars and trucks are on the move. This can result in rising revenues for these growth-linked infrastructure assets. In addition, these types of businesses can often lift their prices to keep pace with inflation.

Airports may have escalation factors built into their agreements with airlines that provide for annual price increases, while their retail tenants are under individual tenancy agreements that often come with regular rental reviews. Similarly, toll road concessions usually provide for annual price rises.

And while agreements to lift prices are not always directly linked to inflation, they are usually in our experience set at a point that reflects inflation expectations, meaning they offer protection in rising price environments and can even help drive earnings when actual inflation undershoots.

Still, there are downsides for these businesses. Operating costs often rise as input prices escalate which can impact earnings. And higher interest rates as central banks respond to inflation can make debt servicing costs rise, although this can be mitigated through hedging.

Regulated assets

Regulated assets are the infrastructure associated with essential services like water and electricity.

Demand for essential services also rises as an economy expands and more people are employed, but generally in our view it does so to a lesser extent than for a growth-linked asset like an airport.

Importantly, these assets operate under regulated pricing models where their revenue is determined under a regulatory framework. In many jurisdictions these revenues are in most cases explicitly linked to inflation.

Again, there are downsides. Operating costs often rise in an inflationary environment for an essential utility just like they do for other businesses, which can put pressure on earnings. And they also face the challenge of higher interest rates which may need to be mitigated through hedging.

Public Private Partnerships (PPPs)

The third group are PPPs, a category that includes assets like schools and hospitals built and owned by the private sector and provided for use by the public sector.

These types of assets usually have fixed, availability-based revenues. This means that as long as the asset is available for use, the owner gets paid — regardless of how many people actually use the asset.

This provides a high level of certainty and consistency around the cash flows the asset generates but comes with less scope to increase revenues.

From an inflation perspective, these types of assets often benefit from the ability to pass through costs as incurred to the end user, insulating the asset owner from input price rises.

Another positive is that the revenues are often explicitly linked to inflation, but with little scope to lift prices, the inflation protection is generally limited to the extent of this inflation-linkage.

As the world is seemingly heading into a new bout of inflation, in our view investors need to seek out assets that can protect their savings from rising prices.

In many cases, infrastructure assets can provide this hedge through a combination of mechanisms.

But with a wide variety of different types of infrastructure assets available for investors, each with its own unique characteristics, we believe that taking an asset-by-asset approach is important to understanding how effectively the sector may provide a hedge against inflation.

Let’s talk about minimising the impacts of inflation on your finances, reach out to the team at ADR Wealth to discuss your needs. 

Source: AMP Capital