Most infrastructure equity investors adopt inflation assumptions in line with the mid-point of the RBA target band – 2.5% per annum. This is significantly above bond-market implied inflation expectations. If the bond market is right, this implies a material overstatement of expected returns.
History of Inflation Targeting
The Reserve Bank of New Zealand was the first in the world to start inflation targeting in 1989. This was followed by Canada and Sweden, then Australia in 1993. Prior to inflation targeting, most central banks had policies targeted towards control of the money supply.
Inflation was high in the two decades prior to inflation targeting. This was due to a variety of factors including, the 1970s oil shocks, post war population growth, centralised wage setting and floating of the dollar.
Under the inflation targeting regime to date, average inflation has been almost exactly on the RBA midpoint of 2.5%. However, this result is partly driven by two periods of materially above target inflation – in 2000 as a result of the introduction of the GST (which added circa 3% to inflation that year) and in 2008 when the GFC saw the AUD fall sharply(triggering a boost in inflation). Excluding these periods, inflation has tended to slightly undershoot the mid-point of the RBA target range.
Inflation and Infrastructure Equity Returns
Most infrastructure equity investors adopt a 2.5% inflation assumption for Australian projects – in-line with the mid-point of the 2-3% target range. This is significantly higher than current market based estimates of future inflation. For example, the inflation linked bond market is currently pricing implied 10-year forward inflation to be around 1.3% - or more than a percentage point below the RBA target.
What is the impact infrastructure equity returns if there is an inflation shortfall? In the following scenario we assume a stereotypical infrastructure asset with the following characteristics:
a flat real growth profile. That is, revenues and costs are assumed to move in-line with inflation
a 50-year asset life,
gearing of 70%, and
a cost of debt of 4%. For simplicity, this isn’t assumed to change with inflation outcomes. This might reflect that base rates are locked in under interest rate hedges or that inflation outcomes are in-line with bond market forecasts and, hence, lower inflation doesn’t necessarily result in lower risk-free interest rates.
The following is the expected output in various inflation scenarios.
The table above illustrates the significant impact inflation has on infrastructure equity returns. Given the financial leverage, a 1% shortfall in inflation would cut equity returns by around 2%. That is, typical infrastructure equity is levered approximately 2 to 1 to inflation.
Or putting it more starkly, if the bond market is right and inflation over the next 10 years is significantly below the RBA target range, then infrastructure equity returns are likely to disappoint by circa 2%.
Infrastructure equity return expectations – high given base rates
This is potentially linked with another anomaly we have been witnessing. Given the low level of Australian base rates, 1% at the time of writing, we feel that typical infrastructure equity return expectations are too high.
Historically, infrastructure equity has offered similar total returns to listed equity, but with a different composition of risk premia. That is, infrastructure has had a lower correlation with equity markets or the economic cycle (i.e. a market beta significantly less than one) but at the same time offered a significant illiquidity premium.
Typical expectations of listed equity returns are based on the sum of the risk-free rate plus an equity risk premium of 4-6%. When risk-free rates were 4-6% this implied a listed equity return of 10-12%.
Infrastructure equity expected returns were similar, but with a different composition, the same 4-6% risk free plus a market risk premium of 2-3% (assuming a beta of say 0.5) plus a liquidity premium of 1-3%. This results in an expected return for infrastructure equity of 10-12% but with lower market risk than listed equities.
However, the days of 4-6% risk free rates are Long in the rear-view mirror. Now risk free is 1%! This implies a listed equity return of 5-7%.
While return expectations for infrastructure equity have come down – particularly under the influence of offshore investors, who have had to live with low or negative risk free rates for longer – I am not sure whether the average market participant is expecting returns of 5-7% from their infrastructure portfolio. For large, trophy, core infrastructure assets, returns are probably being bid down to 6-7%, but I think a lot of managers are still targeting 8-10%.
This raises an interesting question. At a 1% risk free rate, an 8-10% return objective is a very substantial return premium. In particular, a return premium materially above the standard market risk premium or for that matter historical return premia.
Why is it reasonable to expect these returns?
Is it because investors are taking more risk? Does that mean infrastructure assets will be less defensive? Examples of this would be a move from core infrastructure to non-core infrastructure, or the inclusion of more PE style costs cutting/growth programs (expansion of non-regulated product/service lines) in base case return projections.
Another theory is investors are implicitly adjusting for too optimistic inflation forecasts. That is, an 8-10% return at a 2.5% inflation forecast is more like a 6-8% return on a market implied return forecast. While this is still a high combined market and liquidity risk premium, it is more in line with history.