Global Matters: 2022 outlook
2022 is shaping up as potentially another challenging year, with the combined effects of the ongoing COVID crisis together with evolving inflationary pressures presenting governments and central banks around the world with some challenging policy decisions.
However, the two key factors dominating economic discussions and providing some near-term threat to a generally robust outlook as we enter 2022 are COVID-19 (again) and evolving inflationary pressures.
While the ongoing COVID saga keeps pressure on equity markets, we continue to believe it represents a unique buying opportunity for infrastructure investors. The infrastructure investment thematic has not been derailed by COVID, but rather has been enhanced by the pandemic - huge government stimulus programs are fast-tracking infrastructure investment (in particular the energy transition), increasingly stretched government balance sheets will see a greater reliance on private sector capital to build much-needed infrastructure, and the interest rate environment remains supportive of infrastructure investment and valuations.
Global inflationary forces
Broadly, the price increases are being driven by a combination of supply chain disruptions, causing critical supply shortages of key items (such as computer chips), together with the huge global monetary stimulus pushing up the amount of money in the global economy, with inflationary forces being the consequence (e.g. Australian house prices). Importantly, we are also seeing real wage pressure in certain industries and markets as a result of the combination of COVID disruptions and job rotations as stimulus flows through. This is compounding near-term inflationary pressure.
Central banks are already beginning to tighten monetary policy in an attempt to curtail these inflationary forces. After its January 2022 Fed meeting, Chair Jerome Powell said the Fed is ready to raise rates in 2 months. He spoke after the FOMC communicating that it would hike 'soon' and then shrink its bond holdings. Mr Powell declined to rule out tightening at every meeting this year, said officials may have to move sooner and faster on shrinking the central bank's US$8.9 trillion balance sheet, and warned there's a risk of a prolonged period of surging prices.
The risk now is that if the Omicron variant continues to spread, this may itself lead to a crimping of global growth just as central banks take their feet of the stimulus pedal, compounding the slowdown.
Ultimately, we believe central banks will act prudently and cautiously in easing policy. We are also of the belief that they may let inflation run somewhat ahead of target over the short to medium term to assist in the reduction of headline nominal government debt to GDP levels.
But just at the present, uncertainty prevails and caution is warranted. In this regard, infrastructure is an asset class that can do well in an inflationary environment and we believe it is a sensible portfolio allocation at the current stage of the economic cycle. As discussed in a number of our previous Global Matters articles, many infrastructure stocks have built-in inflation protection, either directly linked to tariffs or indirectly through their regulatory construct.
As such, in an inflationary scenario some parts of the infrastructure universe, namely User Pays, may enjoy the perfect storm over the short/medium term -interest rates supportive of future growth, economic activity flowing through to volumes, and explicit inflation hedges through their tariff mechanisms to combat any inflationary pressure they may experience.
In contrast, Regulated Utilities can be more immediately adversely impacted by rising interest rates/inflation because of the regulated nature of their business. The flow-through of inflation is dictated by whether the Utility's return profile is 'real' or 'nominal'. If the Utility operates under a real return model, inflation is passed through into tariffs much like a User Pay asset. This model is more prevalent in parts of Europe and Brazil, for example, and limits the immediate impact of inflationary pressure - and in fact can positively boost near-term earnings. In contrast, if the Utility is operating under a nominal return model, it must bear the inflationary uptick reflected in certain costs until it has a regulatory reset, when the changing inflationary environment is acknowledged by the regulator and approved to be incorporated in new tariff/revenue assumptions. This nominal model is the standard model for the US Utility sector. As such, those Utilities in a real model will weather inflationary spikes a little better than their nominal peers.
However, in terms of interest rates shifts, the issues for both real and nominal models are consistent. For a Regulated Utility to recover the cost of higher interest costs, it must first go through its regulatory review process. While a regulator is required to have regard for the changing cost environment the Utility faces, the process of submission, review and approval can take some time or can be dictated by a set regulatory period of anywhere between 1-5 years. In addition, the whole environment surrounding costs, household rates and utility profitability can be highly politically charged. As a result, both the regulatory review process and the final outcome can be quite unpredictable.
The differences between User Pay and Regulated Utility assets should see certain sub-sets fundamentally outperform during a rising inflation/interest rate period due to a more immediate and direct inflation hedge. At 4D we remain overweight User Pay assets and, within the Regulated Utility sector, favour those with real returns. However, should the market overreact to the economic outlook we would use it as a buying opportunity across all sectors.
Key ongoing macro themes
However, in summary, current investment forces that we at 4D find particularly interesting include the:
What could derail our outlook?
We continue to monitor the near and long-term trends and will actively position accordingly as events unfold.
Funds operated by this manager:4D Global Infrastructure Fund, 4D Emerging Markets Infrastructure Fund