Private markets assess the impact of inflation

Alex Leung, Infrastructure Analyst

The infrastructure sector is resilient by nature. Given it provides services deemed essential in today’s society (such as electricity, heating, high speed internet, mobility), demand is generally steady and reliable, as we saw during the Global Financial Crisis or the recent COVID-19 pandemic. Historically, governments have implemented infrastructure-friendly policies during periods of economic weakness, which has also made the asset class less tied to the economic cycle.

A Preqin survey from November 2021 showed that 47% of global institutional investors planned to increase their long-term allocation to infrastructure, as opposed to 7% intending to reduce their exposure. We believe here are many reasons why investors are interested in increasing their allocation. For example, infrastructure’s resiliency and low correlation to other asset classes has helped investors further diversify their portfolios, which is a particularly important attribute in the current market volatility.

In addition, infrastructure investments offer a relatively strong cash yield, which makes it well suited for certain investors such as pension funds that are looking for cash flows that can match their liabilities. Also, the asset class offers attractive risk-adjusted returns; for example, both infrastructure equity and debt have historically experienced relatively low volatility, while infrastructure debt historically had lower levels of default risk and higher premiums compared to corporate debt.

One important characteristic of private infrastructure is its performance during periods of high inflation (Chart 1). Based on historical data, perhaps it is not surprising that private infrastructure equity and public equities both perform well when GDP growth is strong. However, where infrastructure has really shone is when there is above average inflation, a time in which infrastructure equity has outperformed public markets. This outperformance is even more apparent when high inflation is combined with low GDP growth.

Chart 1: Developed markets investment performance in different GDP/CPI environments (1Q05 – 3Q21)

Finally, looking at the current geopolitical scenario, the war in Ukraine has forced the world to refocus its attention on traditional energy sources such as natural gas and nuclear power in the near term. However, high energy prices have historically been a driver of innovation in clean technologies. The current crisis could therefore accelerate the global energy transition in the long term – a secular trend that the private infrastructure sector is highly exposed to.

Manisha Bicchieri, Sustainability and Research Analyst and Alejandro Tapia, Research Analyst

Investing in food and agriculture through farmland provides a balance of current income and long-term capital appreciation while also providing diversification as it typically has a low correlation to other asset classes. As a natural inflation hedge, many investors are considering farmland now in times of high inflation and rising interest rates. How does inflation impact this sector and how does the future of this asset class look given the current global situation?

In 2021, the Consumer Price Index (CPI) for all food, a component of the all-items CPI, increased an average of 3.9%. Comparably, the United States Department of Agriculture (USDA) predicts food prices to increase between 5.0%-6.5% in 2022.

However, retail food prices only partially reflect crop prices, with the latter being more volatile.

In general, higher crop prices bolster farm incomes which result in greater farm revenues and, ultimately, increased land values. As such, farmland assets provide an inflation hedge for those investors looking to protect their investment returns, offering capital preservation in addition to current income.

Historically, there has been a strong correlation between rising inflation and farmland performance.

An analysis conducted by the US Department of Agriculture shows that during the period 2017-2021, food inflation has been hotter than all segments outside of housing and transportation, due to the pandemic situation and imbalances in the supply chain.

When annualized from 1991 to 2021, the NCREIF Core Farmland Index (CFI) has generally shown positive returns, 9.8% nominal or 7.4% real. With the exception of some periods (such as the post Global Financial Crisis period from 2008), the association between farmland returns and inflation has been positive, and is further represented by a correlation coefficient of 0.24 between CFI returns and CPI inflation rates during the same period (1991-2021) (Chart 2).

Chart 2: US farmland in a real estate portfolio, annual returns 1991-2020

On the other hand, the relationship between interest rates and farmland returns hasn’t seemed to be following a linear path, with farmland returns showing a stable performance in a volatile setting.

When comparing the current inflation scenario with the last major one registered in the US between 1979 to 1981, we can spot different drivers. Back then, there were many factors contributing to inflation (various energy sectors, commodities, food items), whereas today the main drivers are the spike of gas prices, utilities (such as chemicals and vehicles), rising energy costs, and unbalance in the supply chain.

All this is exacerbated by Russia’s invasion of Ukraine, which is provoking a surge in food prices (especially grains and oilseeds) and utilities (where Russia is a major fertilizers exporter).

Still, we believe that farmland keeps being an asset class worth investing in, especially for investors looking for natural climate solutions.

James Pilkington, Multi-Managers Private Equity Portfolio Manager

Private equity momentum has been good following 2021. According to McKinsey Global Private Markets Review 2022, private equity outperformed all other private markets asset classes. We believe the current scenario looks reassuring despite the current high interest rates and price-volatility.

We believe inflation to be a manageable challenge for private equity-backed companies. This is because the private equity structure allows companies to be managed with a longer-term view, in contrast to public companies which face external pressure to report stable quarterly earnings. This gives management at private equity-backed companies greater flexibility to problem-solve, which can be a significant advantage in an uncertain environment. For example, the strategies and companies of our private equity portfolio are carefully selected. Often, they are market-leading companies with differentiated products that enjoy greater than average pricing power and the ability to pass costs through to their customers.

Inflation can have outsized effects on a particular sector or region so private equity portfolios which are well-diversified by geography, investment stage, company size and industry provide the best protection.

So far, we have not changed our investment thesis, which is cycle tested, and we predict good prospects for investing in privately held companies over the long term.

Joe Sciortino, Head Multi-Managers Private Credit

Private credit, also known as private debt, can help investors secure high yields and diversify their portfolios. Particularly in these times of high interest rates and inflation, many are starting to look away from the high volatility of the stock and bond markets.

Inflation can be a double-edge sword to private credit, creating both headwinds and tailwinds across the corporate, real estate and consumer segments.

A large portion of private credit strategies are floating rate, and therefore they generally provide some protection to investors against inflation. As a result, many strategies will benefit from rising interest income and the underlying deals should ultimately generate higher yields. This exposure should serve as a complement to a traditional fixed rate bond allocation.

However, rising inflation and interest rates will ultimately increase credit risk as borrowers contend with higher input costs and rising debt service requirements, creating substantial tailwinds. While consumer and corporate balance sheets are in good shape, there will likely be greater dispersion in fundamentals and the credit selection will be more important.

Amid this backdrop, our private credit strategy focuses on floating rate, short duration strategies whose yields should increase as interest rates rise. Furthermore, we are targeting asset classes where credit fundamentals are strong, and we ultimately expect there to be minimal deterioration in credit performance by focusing on sectors and borrower groups that have the ability to withstand and/or pass through inflation.