Infrastructure and other hard assets should benefit from a stronger economy and play a defensive longer-term role
The global economy is transitioning from a long period of falling inflation and interest rates to one of gradually rising inflation and interest rates. While we don’t think we’ll see this shift occurring rapidly, we do think the disinflationary forces of the past few decades are now fading or even reversing.
It’s worth reminding ourselves of the reasons given for the long deflationary period. First was central bank independence, concentrating on reducing inflation, which is arguably no longer the case.
Another is globalisation, particularly the rise of China which, given recent talk of trade wars and the growth of wages in China, seems also to be fading.
A further one is the global savings glut, as the baby-boomer generation and the emerging Chinese market drove yields down. This appears to be passing as both cohorts age and move towards spending those savings.
We think the balance of probabilities is that inflation and bond yields drift higher over the coming years, subject to the near term effects of economic cycles.
In such an environment, we think some basic presumptions that investors have come to believe will be challenged: what has been seen as highly valued will become less so, and assets that were previously ignored may come back into favour.
The huge preference that investors have developed for fixed income is likely to fade gradually. Rising bond yields mean that capital losses will become the norm, whereas investors have become accustomed to earning both an income and a capital gain on their fixed income portfolios.
Many years ago, gilts were known as certificates of capital confiscation during the period of high inflation. In that era, capital was eroded by rising yields and further eroded in real terms by inflation. Rising bond yields make decisions around credit selection and duration much harder, as any bond’s yield must be sufficient to offset the potential capital loss from rising rates.
In equities, the period of falling inflation and rates has led investors to prefer asset light, goodwill-driven businesses, particularly those capable of supporting debt, such as mature pharmaceutical businesses and fast-moving consumer goods businesses.
These companies built their assets (brands or new drugs) with revenue investment, while adding further value through taking on debt at falling costs. In a rising inflation environment, the cost of maintaining those assets will be rising, while the debt will provide a further headwind to growth.
In contrast, those businesses with high levels of fixed assets have been out of favour for many years, yet in the future the replacement cost of those assets will be rising and with a shortage of savings, capital to build new steel mills, pipelines or railroads, for example, will be scarce.
We believe the value of existing capital invested will be appreciating as the replacement cost rises and the global savings glut reverses. However, in many cases, this type of business often has substantial levels of existing debt.
So, identifying those businesses that have scarce and attractive physical assets but low debt levels will be the key to benefiting from this new emerging trend, and this has been a key focus of our investing activity.
We have been building positions in US pipelines, airports and railroads globally to complement our existing positions in paper, steel and other hard asset businesses in recent months. These companies appear lowly valued but should benefit both from a strong economy in the short term and, more importantly, position the fund to be defensive against potentially rising inflation and interest rates in the long term.
David Jane is manager of Miton’s multi-asset fund range