26 Sep 2022
What a difference a year makes. If in the summer of 2021 consumer price increases were considered a temporary phenomenon and not much to worry about, this year it is hard to ignore the pinch of the rise in the cost of living. Rising inflation has hurt stockmarkets as well, and investors are searching for assets that could potentially withstand better than others the corrosive effect of generalised price rises.
Some context
Historically, investing in infrastructure has sometimes provided shelter from inflation. For example, long-term data from 31 December 2002 to 31 March 2021 analysed by S&P Dow Jones Indices in a report last year[1] shows that the Dow Jones Brookfield Global Infrastructure Index and the S&P Global Infrastructure Index outperformed the S&P Global Broad Market Index by an average year-on-year return of 3.1% and 2.4%, respectively, in high-inflation months. In low-inflation months, the Dow Jones Brookfield Global Infrastructure Index slightly outperformed the S&P Global Broad Market Index, while the S&P Global Infrastructure Index underperformed.
Inflation hedge?
One reason why infrastructure can potentially be seen as an inflation hedge is that many of the income streams coming from these assets are linked to inflation. Contracts may stipulate that regular payments such as royalties should be linked to some measure of inflation or, in other cases, inflation-linked payments may be mandated by law – such as in the case of toll roads in some countries.
Of course, rising inflation also means rising interest rates, which are likely to affect infrastructure assets because of the consequent increase in the rate at which their cashflows are discounted. However, this issue is not confined only to infrastructure assets; it affects virtually all companies’ valuations.
To illustrate this point, while some investors consider utilities – an important sub-segment of infrastructure investing – to be highly sensitive to changes in interest rates due to their bond-proxy nature (as they offer regular cash payments rather like bonds’ regular interest rate payments), in fact over the past 20 years (spanning different interest rate environments) utilities have outperformed the broader equity market (see Figure 1).
In our view, that is partly due to the compounding of the healthy dividends that have tended to be paid in the sector, but also because utilities are increasingly seen as being at the heart of the transition to a renewable energy solution.
Something else to keep in mind is that real (inflation-adjusted) interest rates are still deep in negative territory. Some market observers are saying that central banks are likely to keep real interest rates negative for as long as possible, because this helps reduce debt burdens for both the public and the private sector.
Volatility on the rise
Another issue that is currently worrying investors is volatility. The VIX Volatility Index, also known as the “fear index”, climbed to a year-high of 36.45 on 7 March and although it has come down since then, it was still trading around 34 in mid-June, compared to 17 at the end of December 2021 and around 17 a year ago.
Russia’s war on Ukraine, besides the immense human tragedy that it is causing, is the major factor behind the spike in volatility on financial markets. The risk of over-dependence on Russian gas has been brought into sharp relief, not only because it is a politicised commodity controlled by an unpredictable regime, but also because the gas is transported through pipeline networks in eastern Europe.
One reason why listed infrastructure could display lower volatility could be the higher degree of earnings predictability for companies within this asset class, due to their regular cashflows. This facilitates a more accurate valuation assessment, even during uncertainty.
A pre-pandemic comparison of the evolution of earnings before interest, tax, depreciation and amortisation (EBITDA), a measure of a company’s overall financial performance, for the Global Listed Infrastructure Organisation (GLIO) Index versus global equities shows that infrastructure earnings have held up better in the two decades before the COVID-19 pandemic than those of global companies in general (see Figure 2).
Recovery from the COVID-19 pandemic will most likely require big investment in the asset class globally. In fact, governments around the world have already announced various plans to invest in infrastructure to help support the global economy after the COVID-19 pandemic. In the US, a US$1.2 trillion programme aims to repair, modernise and expand America’s crumbling infrastructure. The European Union has embraced the green agenda and is looking to promote renewable energy and clean transport.
Besides renewable energy, in our opinion listed infrastructure is a potential beneficiary of other long-term structural trends, such as digital connectivity and demographics. These are powerful themes, which we believe will endure for many decades to come. In this environment, we are extremely optimistic about the long-term opportunities in listed infrastructure.
Investing towards a better future
At M&G we believe the investment industry needs to evolve. Rather than short-termism and quick wins, we believe investing requires forward thinking, a long-term outlook and an active approach when searching for investment opportunities. By investing sustainably in a pragmatic and measured way, we can work towards a future that’s better for everyone, delivering positive returns for both investors and the planet.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.