Real Assets Can Prosper in Inflationary Times

Growth and inflation are on the rise

The reopening of the global economy has been gathering momentum as COVID-19 restrictions continue to be eased. This has led to a spike in inflation across major economies and expectations of monetary policy tightening from historically low levels. Following a prolonged period of below-trend growth and extremely low interest rates, rising inflation is naturally front-of-mind for investors.

Throughout the recent February 2022 Australian reporting season, inflationary pressures were a consistent theme emerging from our company discussions. Many of the Real Asset companies we spoke to told us about the impacts of inflation across their supply chains and their labour forces. Those that have not yet seen a direct impact are reporting clear expectations of an acceleration throughout the year.

The real asset opportunity in an inflationary world

Equity markets, including Real Assets, can be sensitive to movements in global interest rates, with changes in prices typically inversely related to movements in bond yields. This means that a tightening of monetary policy, which would be expected in response to accelerating inflation and would see an increase in bond yields, would generally put downward pressure on equity values.

Despite what might be perceived as a challenging landscape, we believe that the Martin Currie Real Income Fund provides a compelling inflation-protected investment opportunity, as well as meaningful income upside potential.  

The Real Income Fund has been positioned to benefit from accelerating inflation since early last year. We have been focused on owning Real Assets with inflation protection mechanisms and strong pricing power, that should exhibit meaningful cashflow growth as inflation rises. These characteristics are discussed in greater detail below.

In-built protection from accelerating inflation

Real Assets, such as shopping centres, toll roads and regulated utilities, can benefit from inflation pass-through mechanisms. As inflation increases, they often can increase their prices, grow their levels of income, and thus the dividends they pay to investors.

For example, many have rents, tolls or charges that directly reference the Consumer Price Index (CPI) or have rents that are closely correlated to tenants’ sales. This means they are less impacted in the long run by rising inflation as they will also see higher cashflows as prices rise and revenues are boosted.

The power to raise prices

With accelerating inflation, companies will likely see increases in the costs which can naturally place pressure on profit margins. A company with strong pricing power will be able to pass through these cost increases to consumers, allowing them to more effectively control their margins.

An element inherent in pricing power is the ongoing affordability of the end service; ultimately a pass-through mechanism or pricing increase will not be of benefit to the company if the customer is subsequently unable to afford to pay the increased rate. As such, our assessment of company pricing power also extends to understanding how much customers are able and/or willing to pay for the services provided by a Real Asset in an inflationary environment.

Portfolio positioned for protection and pricing power¹

Generally, Infrastructure and Utilities names will typically fare better with accelerating inflation than REITs, however we note that some REIT segments, such as Retail, can provide solid inflation protection, highlighting the importance of searching for the ‘right’ Real Assets to invest in.

One of the key portfolio positioning decisions that we made was to skew our exposure away from less inflation-protected CBD-based office assets, offshore retail and energy generation, in favour of suburban-based, every day needs assets such as toll roads, energy transition network winners, storage, daily needs retail and childcare REITs.

These portfolio adjustments saw us reduce exposure to stocks including Mirvac Group and Dexus Group, in favour of allocations to stocks like Atlas Arteria and Charter Hall Social Infrastructure.

The Martin Currie real income Fund in an inflationary world²

The Martin Currie Australia Real Income Fund focused on growing the long-term dollar value of its income stream. This income stream is well placed to deliver benefits from inflation, while being well-shielded from negative impacts such as margin pressure.

Including the stock examples above, the portfolio holds 38 stocks, which have 2,000+ underlying asset leases. Approximately 80% of these reference CPI. This diversification limits concentration risk and ensures no individual asset will impact our ability to provide a growing income stream.

On a forward-looking basis, the Fund is expected to provide a dividend yield of 5.3% over the next 12 months, with forward income growth exceeding the latest inflation peak. This compares very attractively to the 4.0% S&P/ASX 200 expected yield and S&P/ASX 300 A-REIT expected yield of 4.0%.