The biggest threat to the global recovery or a transient phenomenon as pent-up demand is finally released into the economy? Inflation is the hot topic of the day and it is splitting market movers right down the middle.
With the ink scarcely dry on the Democrats’ $1.9 trillion stimulus plan, economist and former US treasury secretary Larry Summers predicted rampant price growth and questioned the US government’s ability to bring it under control.
But others are playing down fears of a 1970s re-run, emphasising that the end of lockdown was bound to create a temporary surge in spending – dubbed ‘reflation’. This schism has been mirrored in the headlines of the day. “Everything screams inflation” proclaimed The Wall Street Journal. “The inflation scare doesn’t match reality”, said Forbes. Regardless of the stance, sensationalist photos of Germans in the Weimar Republic wheeling barrowloads of banknotes to buy bread have been circulating everywhere.
“We never want to make ourselves prisoners to any economic scenario and so we apply asset testing scenarios where inflation is higher and remains higher for longer”
What is certain is that no one under the age of 50 in the developed world has had to make financial decisions against the backdrop of significant inflation in their adult life. Equally, an infrastructure industry that grew up in the wake of the global financial crisis has never had to confront an environment of sustained inflation. Inevitably, feverish debate and intensive scenario planning are going on behind the scenes.
“Rising inflation is clearly a concern,” says Anne Valentine Andrews, global head of real assets at BlackRock Alternative Investors. “The economy is waking up and we are seeing surging demand, as well as supply and labour constraints. And there are differing views as to how this is going to play out. Is it transitory or here to stay? Low rates, monetary and fiscal stimulus, and then this reawakening after a global pandemic – these are circumstances we have never experienced before.”
“US inflation has risen to 5 percent,” adds Tina Jessop, senior economist at Partners Group. “But what we don’t know is when the Fed will react and what level it will react at. Our base case is that we will see elevated inflation in the near future, but that after six to 12 months, those rates will come down again and remain at normalised levels – albeit at slightly higher levels than pre-pandemic, at least in the US.
“But that is just our base case. At Partners Group we never want to make ourselves prisoners to any economic scenario, and so we apply asset testing scenarios where inflation is higher and remains higher for longer. Whenever we look at any asset, new or existing, we study the sensitivity of that asset to myriad different situations to ensure we will generate the necessary returns.”
Inflation mitigation is part of the infrastructure sales pitch, of course. As essential assets, some degree of protection is expected. Many assets have natural monopolies, inflation pass-throughs in tariff negotiations with regulators, or CPI-linked revenues.
Valentine Andrews believes that, on balance, inflation is a positive when it comes to infrastructure. “We have gone back through previous inflationary periods to predict what will happen. And, actually, real assets do very well when we have rising inflation and a high growth environment, because there is that inflation protection in place.”
“Moreover, swings in inflation do not tend to affect the infrastructure asset class directly, as the tariff structures for infrastructure operations typically include automatic indexation to inflation or have general cost-recovery mechanisms. In the US, for example, cashflows from infrastructure assets often grow faster than inflation, which offers protection against inflationary impacts.”“Infrastructure as an asset class is often insulated from the effects of inflation,” adds Suzanne Gaboury, director general of the Asian Development Bank’s private sector operations department. “The inelastic nature of demand for infrastructure such as utilities and toll roads, provides infrastructure projects with the power to determine prices.
“The idea that opportunistic or value-add infrastructure is more exposed to inflationary pressures, while core and super core, are not, is distortive”
However, inflation protection is rarely perfect and few of these hedges have ever been put to the test at scale. “You have to look in detail at the mechanisms,” says Vivian Nicoli, managing director of infrastructure in Europe at CDPQ. “Some assets are more protected than others. Infrastructure is an asset class that, in general, has a natural hedge, but that isn’t the case in all situations.”
“There is a degree of protection in the infrastructure space, which differs depending on the type of asset,” adds Jessop. “But overall, the hedge is imperfect.”
Price sensitivity also varies, even within an asset class predicated on its essential nature. “So, there is that counterparty risk to consider as well,” says Jessop. “What’s important is the pricing power of the asset and the elasticity of demand. Just how essential is it? If you are genuinely providing a service that is essential to the functioning of society, it means you have the power to pass on rising prices.”
BlackRock tackles the challenge of ensuring an essentiality inflation hedge by investing behind what it refers to as the ‘four Ds’ – digitisation, decarbonisation, demographics and decentralisation. “Price inflation is one thing, but if you follow those big trends – that societal need – you will ultimately be successful,” says Valentine Andrews. “Those societal needs change, but as long as you change with them, inflation should not adversely affect your returns.”
Yet not all infra assets are equally essential. And inflationary concerns are circulating around some of the newer subsectors that have emerged at the fringes of the asset class. Digital infrastructure, at least, has proved its essential status through the pandemic. However, attempts to align inflationary protection with particular subsectors risks oversimplifying things, says Nicoli.
“The idea that opportunistic or value-add infrastructure is more exposed to inflationary pressures, while core and super core are not, is distortive,” she says. Nicoli cites the example of public-private partnerships in Spain that do not have inflation hedge mechanisms built in: “PPPs would typically be considered as core as you can get. But in that instance, the protection just isn’t there.”
She contrasts this with the healthcare industry, which is typically deemed to be the domain of the value-add investor: “In many cases, there is considerable hedging in that sector, because of the regulatory aspect. You can’t just say that some pockets of infrastructure are protected and others are not, because you have to look at the mechanism itself. Sometimes the hedging mechanism is imperfect. Sometimes there is a delay in how that cashflow is adjusted so that you are exposed for a certain time. It really is a question of case by case.”
Jessop goes further, claiming that a value-add strategy is a hedge to inflation in itself. “The best defence against rising inflation is an entrepreneurial, bottom-up value creation approach, because it means you are making yourself less susceptible to macro changes,” she says. “By creating growth, you are taking outcomes into your own hands. That is different to the core space where investors take a more passive approach. With a value-add strategy you can protect returns.”
“It is pretty clear that real assets outperform bonds and equities in both high growth and low growth inflationary environments and so, investor appetite is soaring”
Anne Valentine Andrews
Valentine Andrews agrees that the trick to weathering an inflationary environment is to control what you can control. “Prices will go up,” she says. “We are already seeing the cost of building materials spiralling and, in the long run, I do think things will get more expensive. The answer is to focus on those things that lie within your power – the types of assets you invest in, the location of those assets, the essentiality of those assets. And then gain as much protection as possible by structuring the best deal that you can.”
In addition to a hands-on approach at an individual asset level, Jessop believes proactive portfolio management is key. “Flexibility is important in any period of uncertainty,” she says. “Being able to pace commitments, or increase diversification by vintage year or strategy, means money can be put to work at the best relative value at any point in time, including periods of higher inflation.”
Where in the world?
Of course, the inflationary landscape and the means to tackle it will vary depending on where in the world you are. Concerns in the developed world currently centre on the US. “Market analysts are coming around to the idea that there will be a very strong spike in
inflation, which will then ease back closer to long-term averages,” says Nicoli. “In Europe, the situation is expected to be less pronounced.”
The situation is different again in developing markets, many of which have experienced significant and sometimes recurrent inflationary periods in the past. Here, the drivers behind inflation tend to differ from those in developed markets. Gaboury says triggers might include supply shocks, fiscal policy and cost-push factors, rather than the pent-up demand we are currently seeing in more mature and well-vaccinated markets.
“Higher inflation expectations in developing markets could translate to even higher interest rates for infrastructure financing than in developed markets. Higher interest rates for infrastructure financing in developing markets may lead to challenging project economics.”
There is also the danger that attempts by central banks to subdue inflation could trigger slowdowns in those economies. But experience in itself could prove an advantage, according to Nicoli.
“Inflation has always been a hot topic in developing markets, and investors are extremely diligent in covering inflationary risk,” she says. “When you are investing in Latin America, you are going to be ‘diligencing’ that mechanism incredibly carefully, probably more so than in Europe. Our own investments in Latin America are well protected because of a history of extreme cases, which has made us more sensitive to that risk.”
“Although infrastructure assets may not be directly affected by swings in inflation, they may be sensitive to changes in interest rates due to changes in inflation expectations as prices fluctuate”
On the other hand, in regions where inflation has historically been stable, such as Europe, there has been a greater degree of flexibility about the level of hedge required. “There is more appetite for imperfect hedges, and some exposure to inflation has been viewed as acceptable,” Nicoli explains. “If it is an asset where the investor would need to adjust contracts to increase pricing, the investor would take into account that inflation could increase operating costs, for example, and the commercial contracts would reflect that. That approach can have a place in portfolios.”
However, Nicoli adds that if there is an inflationary spike it will make investors more conscious about the hedge mechanisms they have in place, even in markets that have historically been less impacted by extreme inflationary volatility. “It will become a higher priority in due diligence, certainly,” she says.
Infrastructure valuations are also likely to be impacted by inflation, both as market comparables rise and as investors flock to what would be deemed to be a relative safe haven. “It is pretty clear that real assets outperform bonds and equities in both high growth and low growth inflationary environments, and so investor appetite is soaring,” says Valentine Andrews. “We have seen that during the pandemic, but demand is being exacerbated by the inflationary concerns that are the topic du jour.”
Inflation is rarely a standalone phenomenon. Some degree of interest rate rise from protracted historical lows seems inevitable.
“Although infrastructure assets may not be directly affected by swings in inflation, they may be sensitive to changes in interest rates due to changes in inflation expectations as prices fluctuate,” says Gaboury. “The market value of infrastructure investments will then be affected by changes in the interest rates as the term structure of cashflows from the investments is discounted. Often this is done through an equivalent term structure of interest rates to which a risk premium must be added.
“This creates a channel through which infrastructure assets can become sensitive to inflation risks: an increase in the discount rate would reduce the fair value of infrastructure equity investments. This is the reason why fixed rates are favoured by infrastructure projects when such rates are available in the market. In many jurisdictions, interest rates as a component of the tariff structure, are also fully passed on to end-users as part of the cost-recovery formula.”
Nicoli believes that although interest rates could have a negative impact on valuations, the overall attractiveness of infrastructure, and the growing recognition that the asset class provides a natural hedge, will result in an overall upward movement in pricing. That will be likely to create additional demand for private sector capital to fund the world’s infrastructure needs as public sector purse strings are tightened.
“The increase in valuations would impact the public sector,” says Nicoli. “PPPs have been rare in Europe in recent years, as the public sector has sought to take advantage of low interest rates and relatively cheap debt to realise its infrastructure ambitions. If those interest rates change, I think there will be greater interest in PPPs which, at the end of the day, are expensive, complex and time-consuming.
If interest rates go high enough, I think public authorities will find PPPs become attractive options once again.”
The situation may be similar in the US, which has previously relied heavily on the municipal bond market to finance its infrastructure. “Given that a lot of municipalities are strapped for funds, I do think that demand for private capital will increase,” adds Valentine Andrews. “And there is a lot of private capital sitting on the sidelines, waiting to be put to work, so we may see an increase in PPPs and other arrangements.”
“National debt levels have only increased as a result of the pandemic,” agrees Jessop. “Private capital has a very important role to play in building the infrastructure that the world desperately needs.”