Inflation has been a tremendous focus for investors over the past few months. Lots of ink has been spilled by the pundits and we would be humble about our insights into a macro issue that is a key focus for fixed income (and equity investors) worldwide.
However, inflation is a key issue for infrastructure investors. First, many projects have inflation linked revenues and so a lift in inflation is a direct boost to cash flows and valuations/returns. Second, higher inflation would usually be expected to be associated with higher long-term interest rates and infrastructure asset valuations are very sensitive to long-term interest rates. Thus, inflation can be a positive and a negative.
The net position will depend on whether what it adds to the cash flows is larger or smaller than the loss from higher rates.
The bond market’s behaviour implies they think inflation is transitory. That is, inflation is high at the moment, but this will pass (and quite possibly these effects will continue for several years – which might seem like a long time for an equity day trader, but isn’t in the context of the 30 year cash flow profile of the typical infrastructure asset). The market is betting either:
• Inflation is actually short lived – that is, it trails off in the next 12 months as the supply chain bottlenecks from the reopening from Covid unwind; or
• Inflation continues for a longer period, but this forces the Fed’s hand so that they substantially raise interest rates through 2022 and 2023 and this rapid tightening in monetary policy (and perhaps an induced recession) results in much lower inflation down the track – such that average inflation over the next 10 years is actually quite low.
The key message from the market is that long-term real interest rates are expected to remain negative. That is, any increase in inflation will be basically matched by nominal interest rates. The market is not predicting a fundamental shift in the inflation/interest rate regime. Provided this is sustained, this is a fundamentally supportive backdrop for infrastructure investors.
Watching long bond rates (both nominal and real) over the months ahead would give an insight to whether the market is changing its view. However, this is not very helpful from an investor’s perspective. If 10 year rates blow out then for an illiquid asset class like infrastructure it is going to be too late to avoid the carnage.
Thus, a key question is whether we can form a judgement today on the likelihood of the market sustaining its view. This is a difficult judgement. Ultimately it turns on what are the key drivers that have caused real interest rates to be so low in the first place and whether there a fundamental change in those drivers.
Global growth has been anaemic since the GFC. Central banks have chosen (or had to) maintain very low interest rates in an attempt to boost growth. This has brought forward consumption and resulted in large debt build ups. High debt means that increases in interest rates will slow growth more rapidly than in the past.
Within this context, it is hard to see the environment that would allow central banks to lift short term interest rates to meaningfully above inflation and sustain that on a long-term basis.