Can infrastructure protect from inflation?
Article4 mins13 April 2022
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 continues to rise above the Reserve Bank of Australia’s (RBA) target range, triggering a lift in the cash rate.
In our view, both these factors pose risks for investors.
Inflation eats away at the value of money and higher interest rates directly lift financing costs, so 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 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 growth-linked assets can provide inflation protection: rising prices tend to be a result of strong economic growth which in turn brings rising employment.
Australia’s real GDP is forecast to grow 4.5% this year1, while nominal GDP growth will come in around 9.5%2. 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 include 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, in our experience, they are usually set at a point that reflects inflation expectations. This means that 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 in response to inflation by central banks can make debt servicing costs rise, although this can be mitigated through hedging.
Regulated assets are 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 a growth-linked asset such as 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 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
The third group are Public Private Partnerships, 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 if the asset is available for use, the owner gets paid — regardless of how many people 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 revenue.
From an inflation perspective, these types of assets often benefit from the ability to pass through incurred costs 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’s inflation is rising, 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.
With a wide variety of infrastructure asset types 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.
1 Econosights: Inflation risks: implications from Russia/Ukraine war and the floods | Dexus (Formerly AMP Capital) as at 7 March
2 Econosights: Inflation risks: implications from Russia/Ukraine war and the floods | Dexus (Formerly AMP Capital) as at 7 March
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