The safe havens often quoted in the financial world are in demand, inflation is back. If the safe havens are taken literally and find their way into portfolios as the basic infrastructure, they can be useful as inflation protection and profiteers. A guest contribution by Robin Jakob, Managing Director of LPX.
“Transitory” was probably one of the most used words by central bankers in the past few months. In the expectation that inflation rates will only rise temporarily, they have so far only tightened the reins of monetary policy a little, at best verbally. There are increasing signs that inflation is likely to persist longer than expected. In the United States, for example, it was above five percent in October for the sixth month in a row and, at 6.2 percent, it was as high as it was in 1990.
For investors, the question of suitable inflation protection for their portfolios is therefore becoming more and more urgent. Most of them are less concerned with protecting themselves against hyperinflation and shifting substantial parts of their assets into gold or similar “safe havens”.
Rather, wealthy private customers as well as institutional investors are asking themselves which investments are best positioned for a sustained phase of moderately increased inflation without having to switch to niche markets such as precious metals or crypto currencies.
Stocks are widely considered to be one of the instruments that provide effective protection against inflation. Unlike bonds, they offer direct participation in companies and thus their value creation. They are thus a kind of real asset. This line of reasoning is extremely holey, however, because some industrial sectors of the stock market face significant problems during periods of heightened inflation. Growth companies in particular can be used as an example.
The valuation of these companies is based in particular on future profit expectations. However, these are currently being dampened by increased inflation. Even companies from particularly competitive industries, in which price increases are not so easily passed on to customers, do not cope with increased inflation – one example is consumer goods manufacturers.
Inflation as a tailwind
Investors may be able to solve this problem by investing across different countries and industries, such as in ETFs on broad stock indices. And in fact, the MSCI World has achieved a performance of 6.9 percent per annum since 1999, around five percentage points above the average inflation rate as measured by the US Consumer Price Index. However, there is one sector that dwarfs this performance when compared to inflation. Infrastructure stocks, measured by the NMX Infrastructure Composite, achieved a plus of 10.0 percent per year in the same period, around eight percentage points more than the average rate of price increases.
Well, infrastructure stocks’ excess return versus inflation – and versus the broader equity market – may have fundamental reasons that are not directly related to inflation. In fact, however, it can be shown that infrastructure stocks only show their full strength in times of significantly increased inflation. For example, if the average annual inflation rate is above three percent, the average excess return on infrastructure stocks versus the MSCI World is 7.2 percentage points. With inflation rates between two and three percent, there is still 3.7 percentage points of outperformance per year.
It is implicitly shown that company shares represent a kind of real asset, but therefore do not serve as a good protection against inflation per se. In contrast, infrastructure stocks can serve as an effective hedge against high inflation rates. That makes them particularly interesting in the current environment.