Why focus on inflation?

Inflation has remained benign in the last two decades but in 2022, it has shown rapid, meaningful growth, particularly in the US where the data to March 2022 showed an annual increase of 7.9%, a sharp increase to the rate of 1.4% as of 2020 year end.[1] While there has been a similar trend across developed markets, the rate of increase has not been uniform. In Europe it has been growing over the last year at 7.5%, in Australia 5.1%, while Japan it is still low at 0.3% in line with past 10-year average. These data reflect the highest point since the early 1980s.

Milton Friedman is famously quoted as saying that the cause of inflation is “always and everywhere a monetary phenomenon.”[2] In a macro sense, the monetarists contend that inflation is not caused by short-term shifts in costs and demand but growth in the money supply and increased velocity or circulation rate of money. Similarly, keynesians are concerned that inflation risks lie in the potential for a sharp economic recovery to quickly absorb excess capacity.

Today, in a post-COVID environment, both monetarists and keynesians would recognise the potential for earlier strong COVID-related fiscal stimulus for businesses and households to push demand beyond available supply, fanning inflationary pressures. Measuring the extent and duration of these pressures and arriving at a correct policy response has been made more difficult in the midst of rising geopolitical risk and its impact on commodity price and energy supply and prices.

From a micro perspective, that of investors in individual infrastructure assets, it is important to understand the mechanisms through which inflation affects the asset class returns. In turn, it is up to investors to assess how well managers protect their returns from inflation volatility.

This Stafford Diary looks to provide a framework to understand these mechanisms across a diverse range of sub-sectors within the infrastructure asset class. We do this by following the course of rising prices through the cash flow statement for various types of infrastructure assets and observe that while core infrastructure assets boast the strongest claim to offering infrastructure protection, the asset class overall is a net beneficiary of rising inflation. We have tested these assumptions with a modeling of the individual assets within Stafford’s SISF infrastructure secondaries portfolios and indeed find a positive inflation link to the investment lifetime returns of our portfolio asset.

Inflation has followed other macroeconomic factors trending upwards. Developed market GDP is recovering from the COVID lockdowns but also an extended period of loose monetary policies across developed markets together with more recently, massive COVID related fiscal stimulus, resulting in sustained growth above levels of the last decade, with the exception once again of Japan.

Inflation pressures have been evidenced in both a “demand pull” and “cost push” formats for the private sector.

Demand-Pull Inflation describes a scenario where prices rise in response to excess demand relative to the existing supply of goods or services. Demand-pull inflation might be caused by an increase in money supply so that prices are “pulled” upwards by the continuous upward shift of the aggregate demand function. The spike in GDP in calendar year 2021 in the above chart illustrates the impact of both strong fiscal and monetary support despite the continuing impact of rolling Covid lock downs.

Cost-Push Inflation describes a scenario where inflation is induced by the general increase in raw materials or wage costs. Accordingly, cost-push inflation occurs when the increase in costs is passed on to buyers and not absorbed by producers. Cost-push inflation is usually discussed in the context of actual and expected inflation being built into costs. In the present context, it also includes rising commodity and energy prices which are responding to post Covid supply chain disruptions, exacerbated by more recent supply chain uncertainty related to the present geopolitical turmoil from the invasion of Ukraine.

Built-in Inflation occurs where expectations of continued future inflation, for example in wage claims leading to higher costs, helps realise the expected increase in inflation. The expectations of increased inflation that produce built-in inflation tend to increase the momentum of either persistent demand-pull or significant cost-push inflation in the past but are not, by themselves, a cause of inflation.

The above Figure 2 GDP chart shows a strong upward trend with a first peak driven by the COVID recovery, but also sustained growth above levels of the last decade, with the exception once again of Japan, showing that we are transitioning from cost-push inflation (with the initial supply chain issues of covid) to demand-pull inflation, driven by strong demand (with cost-push perhaps appearing again in the context of oil and gas supply chain issues).

Post COVID, demand is growing at a pace that has created supply chain and inventory issues leading to a strong inflation push on the cost side. Central banks had generally responded to this with talk of accelerating plans for higher interest rates after a continuous and gradual decrease over the last decade. Actual rate increases attributed to inflationary pressures only started in early 2022. Once again, the response varies per country/region with the US and Australian interest rates inching towards 2.5% whereas Eurozone is picking up and Japan is still close to rock bottom.

In our analysis we will look at the inflation mechanics, i.e. how inflation affects an asset in different ways, then we will focus on the various protection levels that infrastructure assets have against inflation in theory, while we will also provide explicit examples of inflation sensitivity based on proprietary data.

[1] Note that the data and charts used in this paper are as of March 2022 unless otherwise noted.
[2] https://youtu.be/6LfUyML5QVY