Although global economic activity remains supportive of the current growth environment and relatively low inflation levels persist, investors continue to grapple with how to think about inflation as they wonder how long it will remain in check.

Concerns about rising inflation triggered market volatility earlier this year, and while equities have generally rebounded, the specter of gradually rising inflation may continue as an undercurrent through the rest of 2018. Given this environment of uncertainty, we believe one asset class – global listed infrastructure (GLI) – remains well-positioned to offer investors some additional protection from inflation, while also providing the potential for attractive risk-adjusted returns and opportunities for diversification in a global equities portfolio.

How GLI Assets May Defend against Inflation

GLI investments typically consist of tangible real assets that are owned, leased, and/or operated by publicly listed companies and backed by revenue structures that are, in many cases, linked to and protected from inflation.

GLI assets include but are not limited to toll roads and bridges, airports, seaports, and facilities that support the generation, transmission and distribution of electricity, oil, and natural gas. In many instances, the revenue streams these assets generate have built-in protections against inflation, such as:

  • Pricing increases linked to inflation,
  • Operating agreements that guarantee returns on assets, or
  • Negotiated fees that are adjusted for inflation.

Generally, these types of arrangements can potentially insulate the owners/operators from the negative impacts of higher inflation.

Many of these structures are underpinned by the fact that the products and services the infrastructure assets provide typically have high barriers to entry and are defensive in nature through the economic cycle. As a result, infrastructure assets typically offer relatively stable long-term growth and real income.

In our view, an environment of higher inflation and increased equity market volatility may be supportive of GLI investments, given GLI’s unique characteristics relative to other traditional global equities.

GLI’s performance relative to inflation is illustrated by the long-term relationship between GLI and the U.S. Consumer Price Index (CPI). Exhibit 1

Exhibit 1: GLIs Annualized Yield Has Outpaced CPI Nearly Every Year for the Last 15 Years

GLI Revenue Protection Tied to Inflation

Revenue generated by GLI assets is typically linked directly or indirectly to inflation by means of negotiated tariff and concession structures that have built-in inflation protections through three principal mechanisms: concession agreements, regulation, and fees.

1) Concession agreements or contracts that explicitly allow for inflation to be passed through to end users. This is the most common of the three mechanisms. Typically, a government agency or regulatory body enters into a concession agreement with a company to operate and/or maintain a government asset for a defined period. In exchange, the company is entitled to collect fees for the life of the agreement. (See toll road example.)

Example: Toll Road Concession Agreement

A government agency or regulatory body enters into a concession agreement with a publicly listed company that will operate and/or maintain a toll road, tunnel or bridge crossing. Under this arrangement, the company is entitled to collect the tolls for the life of the agreement. Regular toll increases are built into the agreement in a defined way, usually through an adjustment or reference linked to inflation.  Consequently, tolls may rise quickly in response to higher inflation, thus protecting the operator’s margins against the potentially negative impact of rising prices.

Traffic on toll roads tends to be inelastic, and toll increases usually have little impact on traffic volumes. Revenue also typically increases faster than inflation as traffic continues to grow.

Another key characteristic of a toll road that has the potential to insulate its operator’s revenues from inflation is the high gross margin (i.e., revenue minus operating costs), which is substantially above other industrial companies’ margins. Once construction is completed, operating and maintenance expenditures are typically very low. Thus, as tariffs grow with inflation, revenue may increase faster than operating costs.

2) Regulation that allows a real return to be earned on the company’s asset base. This is a common practice when it comes to water and regulated electricity- and gas-distribution infrastructure assets.

3) Fees negotiated through “take or pay” contracts that are adjusted for inflation and often include a stipulation that requires payment regardless of whether all capacity is used. In this mechanism, an operator typically receives a fee for handling a product or commodity without taking ownership. These can be long-term contracts that have embedded inflation escalators, which help provide cash-flow stability.

While cash flows are linked to actual inflation (i.e., CPI) through these mechanisms, listed equity prices are typically based on expected future cash flows. Given the forward-looking nature of equity prices, we would expect the performance of GLI companies to be more sensitive to inflation expectations in comparison to traditional global equities. Exhibit 2

Exhibit 2: GLI Has Historically Exhibited a Higher Sensitivity to Inflation Expectations Compared with Global Equities During Both Rising Inflationary Environments and All Periods

When looking at monthly performance of GLI and global equities across various inflationary regimes, GLI has historically outperformed global equities during periods when markets experienced levels of Very High or High inflation.

The chart below shows monthly inflation expectations going back to 2001 (the inception of the S&P Global Infrastructure Index) and breaks out the inflationary levels by quartile. When evaluating the monthly performance of GLI and global equities during those four inflationary regimes, we see that during the Very High and High regimes, GLI outperformed global equities by an annualized 6% and 1%, respectively. Exhibit 3

Exhibit 3: GLI Outperformed Global Equities During Periods of High Expected Inflation

During periods of moderate inflation, global equities outperformed GLI by almost 1% on an annualized basis, as growth tilts tend to perform well in this environment. During the Low inflation regime, GLI outperforms global equities by just over 5%, highlighting the defensive characteristics of the asset class.

All told, since the inception of the S&P Global Infrastructure Index, GLI has outperformed global equities by an average of almost 3% on an annualized basis. This period includes multiple market cycles and numerous inflationary regimes. We believe this outperformance over many market cycles is due to the high-quality nature of GLI companies and their defensive assets, which are underpinned by long-term, stable cash flows.

Rising Interest Rate Risk

One risk to investing in GLI that has gained attention recently is its sensitivity to changes in interest rates. Given GLI’s significant exposure to utilities, which typically exhibit bond-like characteristics, an interest rate increase may result in a negative return. With yields appearing to have bottomed out, the general consensus is that interest rates are likely to increase going forward.

However, when assessing rising interest rates investors should not lose sight of what is driving rates higher. When we think about interest rates we usually focus on nominal interest rates, which are made up of real interest rates plus expected inflation. With an extended low-yield environment becoming the consensus view in many countries around the world, the likelihood of near-term real rate hikes in many regions appears improbable. For the few central banks exploring the possibility of raising real rates, the path looks to be gradual, with near-term interest rate hikes already priced in.

While current expectations for inflation remain relatively subdued in the United States and most of the rest of the world, continued momentum in corporate earnings and spending may trigger an increase that has historically been favorable for GLI. Thus, if nominal interest rate increases are driven by inflation expectations, GLI may perform well. Exhibit 4

Exhibit 4: GLI Performance in Rising Rate Environments

GLI vs. Inflation in Focus

We believe that the inflation-linked revenues that may be derived from investing in GLI equities provide investors opportunities with potential for real growth in earnings and dividends. During periods of rising inflation, we feel these inflation-linked revenue streams can help offset lower valuations of infrastructure assets that may be caused by rising interest (and thus discount) rates.

Further, growing inflation-linked revenue streams may potentially result in higher distributions for GLI investors and, as a result, could help hedge portfolios against inflation and potentially preserve the real value of capital over the longer term.

We caution investors not to rely on historical results to predict future performance. However, we do believe that the GLI sector is well positioned for an environment of potentially rising inflation, based on the unique characteristics of infrastructure investments relative to other traditional global equities.

Infrastructure is a specialty asset class that offers a unique story within the universe of real assets. GLI has the potential to meet the needs of investors who may be seeking attractive risk-adjusted return sources that also offer potential diversification benefits within a global equity portfolio.