Now that inflation seems poised to rise during the next several years, an interesting question is, how will infrastructure portfolios respond? No one has a crystal ball, of course, but UBS and Oxford Economics have published a white paper that provides a look at how infrastructure investments could perform in different inflation scenarios.
“This is not a straightforward question to answer,” UBS’ Infrastructure and the Economy report states. “It depends on whether we refer to the performance of the cashflows; i.e. absolute performance or the attractiveness of the sector relative to other asset classes.”
Investors add infrastructure assets to their portfolios in part to help hedge against the risks of inflation eating away the value of their investments. But as with most things, details matter, and in this case, investors seeking inflation hedging have to carefully construct a portfolio of the right infrastructure investments to get this benefit.
This task is easier said than done, especially in an infrastructure market with a lot of capital bidding on a limited number of investments that provide inflation hedging. But for those investors with that objective, one of the most important steps in this process is defining the infrastructure investment universe in such a way that assets with inflation-hedging capabilities land in the portfolio.
The UBS report helps explain how this could be accomplished. The analysis focuses on cashflow drivers for each infrastructure subsector, the historical performance of listed and unlisted infrastructure from 2004 to 2017, and an evaluation of the drivers of investor appetite for infrastructure, i.e., demand elasticity as economic conditions change. According to the report, the subsectors with the greatest potential for inflation hedging capabilities are telecommunications, water and airports.
But UBS also notes that how and when inflation is measured can make a substantial impact on the performance of infrastructure investments as an inflation hedge — another important detail. The UBS/Oxford data found that inflation measures often were “accrued” at the end of the year, which affects inflation’s impact on a portfolio.
“The correlation between infrastructure returns and inflation is relatively weak and does not appear to have a meaningful impact on absolute returns. Given revenues are contractually linked to inflation for many infrastructure assets, the results were somewhat counterintuitive.
“We believe this is due to the timing impact of inflation. Where contractual, regulatory mechanisms exist within infrastructure assets, most adjust for inflation at the end of the year, with a year’s lag. Therefore, we adjusted the test by lagging earnings by one year. This resulted in a stronger correlation and the results better reflect our understanding of how the asset class should behave.”
The fees and tolls many infrastructure assets and companies charge are linked to measures of inflation — when inflation rises, asset owners can increase what they charge. Investors seeking inflation-hedging investments have to identify these assets and then acquire them in a competitive market. If they can do this, it is possible to add inflation-hedging benefits to a portfolio.
