Brad Bugg
Over the course of 2024, inflation has continued its downward trend, pushing it back to levels closer to the goals of most central banks. Nonetheless, many central banks around the world continue to warn that the fight against inflation is not done yet and they stand ready to respond should the last leg of the inflation fight not go as expected. Accordingly, investors should be contemplating the prospect of inflation remaining higher than expected and potentially look to adjust their portfolios by adding some sort of inflation protection to make it more resilient.
Periods of higher-than-expected inflation often make it difficult for many asset classes as it erodes the real return investors receive. Real returns are important as they protect an investor’s purchasing power over time. Therefore, identifying asset classes which may be more resilient to, or potentially even benefit from, higher levels of inflation can be very valuable to an investor’s portfolio.
All investments are impacted differently during periods of higher inflation, but with Australian and International bonds and equities often making up very large proportions, if not all an investor’s portfolio, introducing other asset classes or investments that are more resilient to high and unexpected inflation can help significantly improve portfolio outcomes. Assets that often fare best are those that see their revenues, cash-flows and/or prices linked to movements in the level of inflation. The most common assets and investments displaying this profile are:
- Infrastructure Assets/ Investments
- Property Assets/ Investments
- Inflation Linked or Protected Bonds
- Commodities, notably Gold.
Infrastructure is an asset class that includes companies or investments which provide goods and services, often essential for the operation of an economy that sees them being highly regulated. Often part of the regulatory arrangements is to link future increases in prices and revenues for the goods and services they provide to the prevailing level of inflation. Therefore, when inflation is high, revenues from infrastructure assets will adjust to compensate.
Similarly, certain property assets can benefit from higher levels of inflation as they have rental arrangements that allow for rents to be adjusted higher in line with the prevailing rate of inflation. It is not just the rents seeing protection, as the underlying value of property has traditionally performed well and outweighing returns from more traditional bonds and equities.
Investors can also seek out protection from more defensive assets, such as bonds that have their coupon payments linked to the level of inflation. These are simply known as inflation linked or inflation protected bonds and are issued by governments and or large companies.
Finally, investors can simply seek out assets whose prices will benefit from the effects of inflation. In this regard, investments which have strong links with commodities have traditionally fared much better than those with no exposure. This exposure can be to explicit commodities themselves, like gold, copper or coffee beans, or to companies which produce/ extract commodities like Energy or Materials companies.
Like any investment, there are factors which investors must consider before taking exposure to any, or a combination of, assets that offer resilience to high inflation. Like any asset, the price at which the asset is being bought should be a key consideration. While the underlying cash flows of the asset may benefit from higher-than-expected inflation, the current price of the asset may already be accounting for, or in many instances overcompensating for the inflation protection benefits, the asset might bring in a high inflation environment.
Investors also need to be aware of how and when cash flows might be adjusted to compensate for increases in inflation. Often the benefits of the inflation linked increases in revenues and cash flows are lagged to when it takes effect. Although the inflation protection benefits will be ultimately realised by the asset, investors need to understand this can often be with a significant time lag.
One final element to consider in relation to infrastructure and property assets particularly is the level of debt or leverage that many of these assets and companies have. With greater certainty around the cash flows these assets can generate, they are able to take on higher levels of debt than what other companies normally might. This element is very important, as it makes the assets much more sensitive to changes in interest rates. This means that when interest rates rise, the negative impact of higher interest costs will exceed the positive benefits that having an inflation linked revenue stream brings.
This last point is the major reason that many infrastructure and property assets have had a difficult couple of years and disappointed many investors in delivering the inflation protection they might have expected. Normally this might be an environment which would be supportive of infrastructure and property performing better than many other asset classes.
However, the period also saw interest rates rise from all-time low levels of near zero, to levels that are now more consistent with long-term average interest rates. Given the magnitude of the move, infrastructure and property were sold down more than other assets due to worries that higher interest rates would impact them more than others.
Infrastructure and property assets were not alone in being negatively impacted by the rising interest rates during this period, as inflation linked bonds also suffered. While they benefitted from the impact of higher inflation, they were disproportionately impacted by the sharp rise in the real yields and the long maturities of many of these types of bonds.
So, in the event that inflation does remain higher than expected moving forward, the big questions for investors is whether inflation linked assets will deliver the inflation protection benefits we would normally expect? Or will there be a repeat of the last couple of years where they failed to deliver the protection expected?
Although no outcome can ever be ruled out, the main element driving the return outcomes in recent years was the magnitude of change in both nominal and real interest rates in a very short period of time. These changes were amongst the largest ever seen in fixed income markets, but probably what distinguishes the period most is the record low levels from which interest rates came. Currently both nominal and real interest rates are at levels which are much more consistent with longer term averages and probably unlikely to move up by the 3% to 4.5% change witnessed in interest rates around the world in recent years. It should be expected that interest rates will likely rise in the event of higher inflation, but looking forward, any adjustments will likely need to be much less dramatic than that seen in the last couple of years.
With the impact of interest rate moves much less pronounced on asset prices, the inflation protection qualities of infrastructure, property and inflation linked bonds will have a much more positive impact on the performance of these assets in the event of high or higher inflation. Such outcomes will allow these assets to play the role normally expected of them in such environments and help deliver the very valuable diversifying qualities to investor portfolios.
In summary, while inflation has made good progress in falling back to central back targets, the fight is not over yet, and inflation could remain elevated or even rise. Given this prospect, seeking exposure to assets which might benefit or offer some protection to higher levels of inflation is likely to enhance outcomes for an investor’s portfolio. However, there are several elements to consider and include issues like how the assets are currently priced, the levels of leverage and the timing of when cash flow adjustments might take effect. Reflecting on more recent outcomes for many of these assets is unlikely to representative of future outcomes with assets like infrastructure, property and inflation having been negatively impacted by one of the largest upward moves, from the lowest level of interest rates in history. A more stable and less volatile interest rate environment will help them deliver the inflation protection and diversification qualities through most other periods of high and unexpected inflation.
By Brad Bugg, Principal Consultant