QD view – Inflation Scare

With inflation rates much reduced, investors became convinced in October that interest rates had peaked. Share prices in the renewables and infrastructure sectors began to rise while yields began to fall and there was a sense that as we entered 2024 we had passed the worst of the sell-off in those sectors. However, as the slide in Bluefield Solar’s (BSIF’s) share price from £1.20 on 4 January this year to 99p on 14 February demonstrates, the worst was not yet over. BSIF is tackling the problem with a new £20m buyback but our feeling is that January’s wobble in confidence may have been just that, although it could take a couple more months for nerves to settle.

The hotter than expected US CPI data, which came out on Tuesday, provides a timely reminder that it pays not to get too far ahead of oneself. Ever since the back end of 2023 when inflation started to fall, markets have been pricing in a significant period of easing in the UK and US, to the point where 10-year yields fell as low as 3.8% and 3.4%, respectively. The almost 150pb repricing kickstarted a global equity rally, requiring policymakers to step in to temper expectations as looser financial conditions and wealth effects from benchmarks closing in on all-time highs risked erasing the progress made over the past year. Tuesday’s announcement reignited those fears and, with the benefit of hindsight, perhaps it should not have been such a surprise after all.

Despite the rate of inflation falling dramatically, some measures such as in the service sector have remained elevated (indicating pricing pressures may be more imbedded in the economy than a falling headline rate would suggest), while wage growth across both economies continues to run hot. Notably, GDP growth in the US has actually been accelerating, recording its fastest pace in over two years.

Equivalent data out of the UK, which was released on Wednesday was less dramatic, at least in terms of expectations, although it hardly paints a benign picture, with the headline rate still running twice the target while services inflation continues to travel at more than triple the 2% rate deemed by the Bank of England as ‘low and stable’.

Unlike the US, however, the BoE has very limited room to manage any reacceleration, having recently slipped into a technical recession and with growth expected to remain stuck at around 0.5% over the next two years. With stubbornly high living costs, weak external demand, and necessarily hawkish monetary policy, it is difficult to see a positive inflection on the horizon. This goes some way to explain why the bank’s latest monetary policy report predicts that inflation will remain above target until 2027 (although anyone aware of its track record in this regard knows to take these forecasts with a large grain of salt). Concerningly, the threat of external influences such as rising oil prices and supply chain pressure stemming from an increasingly volatile geopolitical environment may take inflation outcomes out of the hands of the BoE altogether, risking a scenario where growth remains stuck while inflation becomes untethered once more. Such an outcome certainly isn’t guaranteed; however, it remains a very real risk which at present appears to be underappreciated considering the level of rate cuts still priced in over 2024.

Mispricing tail risks has been commonplace over the last few years. In 2022, positioning was overwhelmingly favoured towards a recession which never materialised, while the almost universal expectation of a post pandemic rebound in China has led to a dramatic period of underperformance. Investors looking to avoid being caught wrong footed once again should give at least some consideration to the potential that inflation reaccelerates.

Unfortunately, positioning for such an outcome is not exactly straightforward considering the aforementioned growth outlook in the UK (with the Eurozone similarly afflicted), while valuations and index concentration in the US make any investment there a challenging proposition. A contrarian view on China and related emerging markets has some merit given the situation is, by some accounts, less dire than it appears especially considering lower levels of realised inflation. However, there remain myriad concerns and any investments in the world’s second largest economy are at constant risk of political overhang.

Closer to home, one sector that appears well positioned as a hedge against the deteriorating economic climate in the UK is, perhaps counterintuitively, renewable energy infrastructure. The prevailing view is that rising interest rates have an outsized impact on the capital-intensive nature of the sector, however with discounts collapsing to record lows, it’s clear that the sell-off has gone well past the mechanical impact of rising rates.

The sector continues to generate stable NAV growth, and in many cases, increasing earnings thanks to a structural increase in energy prices. Long term, inflation linked contracts provide reliable, and highly visible cash flows regardless of the economic cycle, limiting the typical threat of margin compression, and allowing companies to maintain impressive dividend payouts. These utility-like characteristics are crucial during periods of rising inflation and stagnant growth and have historically delivered the best returns during similar periods of economic stagnation.

As always, there remain risks, and a number of current discounts in the sector accurately reflect the struggles of those companies unable to adjust to the dramatic increase in financing costs. However, BSIF and other examples such as Ecofin Global Utilities and Infrastructure (EGL), JLEN Environmental Assets (JLEN), Pantheon Infrastructure (PINT), and GCP infrastructure (GCP), all highlight the structural resilience of the renewable energy infrastructure sector and the ability to generate stable returns no matter what happens with the economy.