Which assets might you consider?
This includes wind/solar farms, hydroelectric, geothermal, energy storage and biomass power-generating facilities. We believe these assets should provide significant inflation protection, as a proportion of their revenues are typically explicitly linked to inflation under subsidy regimes. Others, meanwhile, are implicitly linked as energy prices tend to rise with, and contribute to, inflation.
Social infrastructure refers to a range of services and facilities that meet local and societal needs. These include those relating to health service provision, education, recreation and emergency facilities. Again, given their strategic importance, a significant proportion of revenues are typically directly linked to inflation through concession agreements, regulation and contracts.
Property can potentially provide significant inflation protection as revenues tend to have direct or implicit inflation links. For example, social housing leases can contain high levels of inflation-linkage. Meanwhile, student accommodation usually has one-year rolling rent reviews that typically exceed inflation.
This asset class incorporates a diverse range of investments that have the potential to be relatively resilient in an inflationary environment. Take precious metal royalties. Gold and silver are often regarded as hedges against inflation. That’s because they typically retain their purchasing power over time whereas higher inflation erodes the value of money. Precious metals can therefore offer good protection in an inflationary backdrop. Other royalty streams such as those from music and healthcare might also be unaffected by rising inflation.
An ABS is a security collateralised by an underlying pool of assets that deliver cashflow, such as consumer debt, mortgage debt or corporate loans. They have the potential to provide good inflationary protection depending on the broader macroeconomic environment. If, as looks likely, central banks stick to their inflation targeting approach, then they will continue to hike interest rates to tackle elevated inflation. ABS is a floating-rate asset class (as opposed to fixed rate assets), so income will rise in line with interest rates. Of course, in some scenarios, underlying borrower defaults may nudge up a little, but this shouldn’t materially eat into returns unless there is a significant economic downturn.
Like ABSs, the prospects for equities depends on the broader macro backdrop. Typically, equity revenues rise in line with prices, while inflation erodes corporate debt. That said, weaker economic growth or a dramatic rise in interest rates could cause a fall in equities as company operations, profits and balance sheets come under pressure. Equity valuations are also often linked to interest rates over time with higher rates, all else being equal, a negative for valuations.
Emerging market local currency bonds
Different economies’ interest rate and inflation cycles are rarely perfectly aligned. Many emerging markets raised interest rates during 2021. EM bonds are therefore starting at a different point to developed market bonds. EM bonds usually have higher yields and consequently provide some protection against inflation. Furthermore, low duration bonds will have relatively lower capital losses (compared to higher duration bonds) if yields rise. Currency moves are likely to be the primary source of volatility. However, an approach that expresses its position against a basket of developed market currencies with similar sensitivities to emerging markets, such as from energy costs, should help to mitigate such risks.
Developed market government and corporate bonds
Developed market government and corporate bonds typically do badly when inflation rises. That’s because (a) bond yields rise causing capital losses, and (b) they provide a nominal yield that inflation erodes in real terms.
In our view, one way to navigate an inflationary world is through a broad mix of different assets. That includes those where underlying revenues have an explicit link to inflation and those where history indicates an indirect link. The challenge is to create the right balance of these assets within a portfolio. In doing so, we believe investors can potentially achieve positive returns even during periods of heightened and sustained inflation.