portfolios for inflation

How to reposition portfolios for inflation with listed infrastructure

Ken Baumgartner, CFA, Investment Director
Tom Levering, Global Industry Analyst
2023-01-31
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The post-COVID recovery has been accompanied by a sharp rise in inflation around the world. To a large extent, this spike in global consumer price indices has been caused by temporary supply-chain disruption and is therefore likely to be temporary. However, underpinning this surge is a structural shift towards higher inflation as several key drivers that dampened price rises over the past 30 years — such as globalisation, supportive demographics and energy costs — have gone into reverse.

Preparing for structurally higher inflation

The potential change in the inflation regime, coupled with less accommodative monetary policy, suggests investors may need to reposition their portfolios. As well as revisiting traditional inflation hedges such as inflation-linked bonds, this may involve exploring alternative avenues to bolster portfolio resilience against persistent price rises. Targeted exposure to global listed infrastructure is, in our view, one area that warrants closer attention as these businesses are often well positioned to cushion the impact of inflation on their returns. This is particularly true for what we call enduring assets. These are long-lived physical assets, such as electricity grids, with stable income flows and a degree of regulatory or contractual protection. The companies that own these assets tend to benefit from strong competitive positions.

Explicit or implicit inflation mitigation

Sometimes these companies enjoy explicit protection from inflation. That is the case for many regulated European utilities which, under inflation-indexed regulation, are allowed to maintain returns at a given spread above that region’s inflation. In other instances, the link between inflation and the tariffs charged by the company is implicit: as costs increase, the company is able to maintain an agreed-upon level of return by moving prices higher. For instance, US utilities tend to earn nominal returns, but US utilities are still able to pass on to customers any increase in operating expenses caused by inflation. Moreover, if inflation were to stay persistently high, regulators may adjust tariffs at their rate reviews, which typically occur every two to five years.

What about other assets? While few, if any, airports have inflation-linked regulation, most toll roads are able to increase tariffs by some percentage of inflation. Owners of storage and transport logistics for oil and gas — so-called midstream assets — tend to correlate well with inflation due to their energy-related exposure, while cable and data infrastructure providers often have competitive advantages that allow them to pass higher prices on to their customers.

In summary, while these enduring assets do not protect portfolios from inflation surprises in the same way as a commodities portfolio might, they potentially offer some mitigation over the medium to long term, which, in our view, makes them an attractive addition to an inflation-aware portfolio.

Rising interest rates

One of the concerns often raised about utilities and other listed infrastructure assets is their sensitivity to rising interest rates. There is no question that, in line with most other risk assets, these stocks would struggle in the face of a sharp, unanticipated rise in rates. However, to date, central banks are taking a cautious approach towards gradual normalisation. Longer term, these companies should be able to pass on the associated costs to the consumer or be allowed to earn a higher spread. An active manager may also be able to select companies with strong balance sheets that focus on growth and reinvestment rather than dividend payouts, meaning they are relatively less sensitive to interest-rate rises. Finally, utilities’ underperformance over the past couple of years implies that the market may have already priced in the potential impact of higher rates, offering scope for these stable assets to surprise on the upside.

Authored by
baumgartner-ken
Ken Baumgartner, CFA
Investment Director
Boston
levering-tom
Tom Levering
Global Industry Analyst
Boston

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