The near-to-medium term path for inflation and interest rates is almost certainly up. While this is usually considered a headwind for equities, including listed Real Assets, we see opportunities for growing the income steam of our Real Income strategy.
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 Australia (MCA) Real Income strategy provides a compelling inflation-protected investment opportunity, as well as meaningful income upside potential.
The MCA Real Income portfolio 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.
We believe that the MCA Real Income strategy provides a compelling inflation-protected investment opportunity, as well as meaningful income upside potential.
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.
Transurban Group’s tolling mechanism provides inflation protection, as toll rates charged are mostly linked to Australian and US CPI, coupled with strong pricing power. Transurban’s higher toll prices remain affordable in the context of inflation-driven price increases; people are more likely to continue paying higher tolls as it is better than the alternative of spending longer on crowded un-tolled roads with worse traffic conditions.
Portfolio positioned for protection and pricing power
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.
Accelerating inflation has been positive for Scentre Group’s regional and super-regional shopping centres. As COVID restrictions have eased, Scentre has seen foot traffic and tenant sales recover quickly. Strong tenant demand/occupancy trends translate to the power to push up retail rents as tenant sales grow. The company’s February 2022 results have demonstrated a strong ability to maintain yields.
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 MCA Real Income strategy in an inflationary world1
The Martin Currie Australia Real Income strategy is 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 strategy 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%.
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Past performance is not guide to future returns.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable
1Source: MCA, FactSet; as of 28 February 2022. Data calculated for the representative MCA Real Income portfolio. Next 12 Months (NTM) Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding – because of this, the returns quoted are estimated figures and are therefore not guaranteed.
Regulatory information and risk warnings
This information is issued and approved by Martin Currie Investment Management Limited (‘MCIM’), authorised and regulated by the Financial Conduct Authority. It does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The information contained in this document has been compiled with considerable care to ensure its accuracy. However, no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained in this document for its own use. It is provided to you only incidentally and any opinions expressed are subject to change without notice.
The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned.
Past performance is not a guide to future returns.
The views expressed are opinions of the portfolio managers as of the date of this document and are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. These opinions are not intended to be a forecast of future events, research, a guarantee of future results or investment advice.
Some of the information provided in this document has been compiled using data from a representative account. This account has been chosen on the basis it is an existing account managed by Martin Currie, within the strategy referred to in this document. Representative accounts for each strategy have been chosen on the basis that they are the longest running account for the strategy. This data has been provided as an illustration only, the figures should not be relied upon as an indication of future performance. The data provided for this account may be different to other accounts following the same strategy. The information should not be considered as comprehensive and additional information and disclosure should be sought.
The information provided should not be considered a recommendation to purchase or sell any particular strategy / fund / security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable.
Risk warnings – Investors should also be aware of the following risk factors which may be applicable to the strategy shown in this document.
- Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment.
- This strategy may hold a limited number of investments. If one of these investments falls in value this can have a greater impact on the strategy’s value than if it held a larger number of investments.
- Smaller companies may be riskier and their shares may be less liquid than larger companies, meaning that their share price may be more volatile.
- Income strategy charges are deducted from capital. Because of this, the level of income may be higher but the growth potential of the capital value of the investment may be reduced.