Swedroe: Infrastructure As Inflation Hedge—Not

June 24, 2013

 

The authors summarized: “We can conclude that on the basis of domestic data there is no statistically significant support for infrastructure as an enhanced inflation hedge. The only exception is infrastructure with high pricing power, which somewhat improves inflation hedging on the five-year horizon, though with very weak statistical validity—all of which is not very comforting.”

The authors offered the following explanations for their findings, which are in contrast to the “conventional wisdom.”

  • Pricing power among infrastructure players potentially is more restricted than often assumed. Effective regulation with independent regulatory authorities and sophisticated regimes prescribing prices, quality and investments are in place across many countries.
  • Deregulation of infrastructure industries over the past 20 years has lowered entry barriers; separated previously vertically integrated firms; and instituted new competition through network access pricing. Consequently, the competitiveness of OECD infrastructure industries has tightened.
  • Though the share of variable input costs is low, some infrastructure companies are exposed to energy prices. For example, merchant power generators rely on energy inputs and might not be able to factor inflationary rises into output prices. Similarly, transport infrastructure firms are indirectly exposed to energy prices, as traffic volumes usually falter when oil prices rise.
  • Even when infrastructure assets themselves generate inflation-linked cash cows, these don’t necessarily materialize for equity investors, as debt financing is a major cost for infrastructure firms. Rising inflation increases uncertainty and therefore debt risk premiums. If refinancing is required during an inflationary period, the inflation hedging characteristics are lost. And if an infrastructure firm finances itself with inflation-linked debt, the inflation hedge properties deteriorate.

 

The bottom line is that if you are looking to hedge the risk of unexpected inflation, the primary investment vehicle should be TIPS; the secondary tool should be short-term high-quality bonds; and commodities are a third option.

 

 

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