For many income investments, rising inflation can spell bad news. But that's when infrastructure truly shines.
The outlook for inflation is one of the most important factors for financial markets, currencies and economic growth. Although inflation risks currently appear skewed to the downside, it is impossible to predict when prices may begin to rise more quickly. Rising inflation would erode the purchasing power of wealth, and the value of investments.
No asset is perhaps better poised to weather – even benefit from – inflation than infrastructure. History shows that when inflation strikes, infrastructure doesn't just protect. It outperforms.
During Inflation, Infrastructure Outperforms
Research shows that global infrastructure investments have delivered historical returns well in excess of inflation.
For the fifteen years ending December 2018, global listed infrastructure gained 9.7% per annum. This was 7.7% higher than the US Consumer Price Index (CPI), a key inflation indicator, which averaged 2.0% pa over this period. In contrast, the MSCI World Index only delivered returns of 6.6% per annum, or 4.6% higher than the CPI.¹
That should sound rather enticing to pensions and insurers, who generally target long-term portfolio returns of 5% above CPI, on average.
"The higher the inflation rate is, then the better infrastructure tends to outperform equities."
Interestingly, the higher the inflation rate is, then the better infrastructure tends to outperform equities. Over the same 15 year period, when the inflation rate was between 3-4%, global listed infrastructure outperformed global equities by 6% per annum. And that outperformance increased to almost 7% per annum whenever inflation rose above 4%.
¹ Source: Bloomberg First State Investments; FTSE Global Core Infrastructure 50/50 Total Return Index in USD from inception in 2006; prior to that the Macquarie Global Infrastructure Index 100 USD TR, MSCI Daily TR Gross World USD, US CPI Urban Consumers SA.
Infrastructure performance during inflationary periods
Source: Infrastructure: FTSE Global Core Infrastructure 50/50 Index (from its base date in 2006 until 31 December 2018), prior to this infrastructure data for this comparison utilizes the Macquarie Global Infrastructure Index
Equities: MSCI Daily TR Gross World USD
CPI: US CPI Urban Consumers SA
Bloomberg, First State Investments, Quarterly time series from 2003 - 2018
What explains this outperformance? Essentially, inflation protection is baked right into most infrastructure pricing models. Rates, rents, tolls and other pricing schemes are often explicitly linked to inflation, whether through government regulation, concession agreements, or contracts. Even those assets that aren't regulated are often monopolies in their industry, meaning they have total discretion to keep prices in line with inflation – or even outpace it, to their investors' benefit.
Either way, infrastructure operators usually can pass through higher operating costs to their customers by hiking tolls, rents, rates and so on. Neither demand nor earnings will be meaningfully impacted by the increase, since infrastructure provides services that society considers essential. All things considered, it's a good spot to be in when inflation comes knocking.
Ranking Infrastructure's Strength in Inflation
Not all infrastructure assets are alike, of course; nor do all assets protect against inflation equally well. The degree of inflation protection a given infrastructure asset provides will vary by sector, geography, regulatory regime, and so on.
Some of the better defensive plays include:
- Toll Roads
Toll roads offer some of the strongest protection against inflation available, since their pricing formulas are often explicitly hitched to inflation increases. For example, the terms of Australian toll road company Transurban’s concessions allow it to increase prices on many of its roads by the greater of inflation or 4% pa. Similar concession agreements where tolls are explicitly linked to inflation exist in Brazil, Canada, Chile, Italy, Portugal, Spain, UK and the US.
- Regulated Utilities Water, gas and electric utilities often keep pace with inflation through regulated pricing. UK water utilities earn a real return on regulated assets, with prices linked to inflation. US electric and gas utilities operate within regulatory frameworks which enable them to earn an allowed rate of return on money spent maintaining or improving their asset base. While this rate is fixed for each regulatory cycle (which usually lasts between one and three years), the allowed rate of return of the next cycle can be adjusted upwards if needed, to reflect a higher inflation environment.
- Cell Phone Towers U.S. telecoms typically lease cell tower capacity for hardware for their wireless networks over 5-15 year periods, with multiple five year renewal options. But zoning requirements and community opposition make it hard to find additional sites, so tower companies tend to have high contract renewal rates for existing sites. As such, U.S. tower companies have agreed contracts that automatically raise prices 3% per year.
But not all infrastructure offers a safe port in an inflationary storm. Assets with a low degree of inflation protection include:
- Integrated utilities
Integrated utilities combine transmission and distribution networks with energy retailing, power generation, even gas production. With so much exposure to so many different markets, it's tough for these companies to align revenues with inflationary pressures
- Ports Port operators generally negotiate their prices directly with shippers. Overcapacity in some regions has led many ports to drop their prices to attract more volume.
- Passenger Rail Though U.S. freight rail has strong pricing power and can pass through rising operating costs as needed, passenger rail (such as Japanese passenger rail operators) have a limited ability to raise fares.
How to Evaluate Infrastructure For Maximum Inflation Protection
When evaluating individual infrastructure assets for their defensiveness in inflationary periods, investors should ask a few key questions, including:
1) How is the asset regulated? How explicitly are the asset's earnings linked to inflation? Is the process transparent? How much lag time exists between inflation increases and the asset's recovery from those increases?
2) How vulnerable is it to political interference? How easily can politicians impose new rules, regulations and taxes on the asset without compensation?
3) What competition exists? Is the asset a monopoly or duopoly? If prices rise, will customers opt for substitutes instead?
4) What are the asset's variable costs?
How sensitive is the infrastructure asset to higher operating costs, like labor or fuel?
5) What's my duration of investment?
Can you hold the investment for a long enough time to ensure that its returns reflect the characteristics of infrastructure assets, rather than the volatility of the broader stock market?
