To say inflation has been one of the themes of the year might be putting it mildly, considering we’ll be in a very good place if it doesn’t turn into the theme of the decade.
While it is now giving signs of some easing, creeping inflation in 2021 – seen by many then as a temporary blip – erupted into record-high levels this year, putting a definitive end to the Great Moderation, a golden era of benign investment conditions, which arguably peaked over the past decade, with its lower for longer interest rate environment.
All of that has now forcefully changed. As Oaktree Capital Management co-founder and co-chair Howards Marks put it in a recent Financial Times article: “We’ve gone from the low-return world of 2009-21 to a full-return world. Investors can now potentially get solid returns [without having] to rely as heavily on riskier investments to achieve their overall return targets.”
Our new full-return world, as Marks put it, is impacting the entire spectrum of private markets, including infrastructure, one of the asset classes that emerged as a clear winner from the global financial crisis. As we wrote in November, infrastructure – with its low-risk profile and stable, long-term cashflows – was presented as the perfect alternative for investors unable to get yield via traditional fixed income investments post-GFC.
These days, understandably, it’s the asset class’s inflation-hedging characteristics that are placed front and centre. But while the jury is still out on whether high inflation will prove to be a defining moment for infrastructure, our new environment is capable of causing plenty of headaches for infrastructure investors.
The asset class as a whole is, of course, not immune to inflation. Case in point: the knock-on effect high-energy prices are having on digital infrastructure, with consumers not necessarily willing to pay for digital services if these were to increase in price in line with inflation, as we wrote recently. Or the way high energy prices – combined with supply-chain issues and higher interest rates – are threatening to derail US offshore wind projects which, all of a sudden, have found themselves with inadequate PPAs. Or the fact that high inflation raises the risk of regulatory resets, already evident in the price caps/windfall taxes proliferating across Europe.
It’s hard to underestimate how much higher interest rates – a direct result of higher inflation – have changed the game. Marks argued he would “be surprised if 40 years of declining interest rates didn’t play the greatest role of all” in this long period of stock market outperformance. Not coincidentally, much has also been made of the role played by low discount rates in infrastructure’s strong performance over the past decade.
Having said all that, it’s not wrong to argue the asset class is well-positioned for this new world we find ourselves in, especially in a wider private markets context. While inflation pass-through is not magically available to all infrastructure assets – and there is arguably some optimism bias about its effectiveness even when it is – there is no doubt that many core infrastructure assets possess this ability. And LPs know it, as the increasing popularity of core funds attests.
There are also very strong secular tailwinds propelling the asset class forward – chief among them the energy transition, but also digital infrastructure – as we’ve covered often throughout the year.
Which is another way of saying that, while there are different schools of thought as to how well infrastructure will fare in our new world, we don’t expect interest in it to fall off a cliff. Whether fundraising in 2023 will be quite so buoyant as this year, well, that’s another matter altogether.