Following March 2020 world-wide lockdowns, global inflation collapsed only to rebound once COVID-related restrictions were gradually lifted. While inflation (and the increase in interest rates it triggers) could spell bad news for stock markets in the short term, rising prices are normally positive for infrastructure companies, as most enjoy price escalators embedded in their contracts.
Following March 2020 world-wide lockdowns, global inflation collapsed only to rebound once COVID-related restrictions were gradually lifted. This was driven by a confluence on factors including a rapid global economic recovery, a strong rebound in consumer spending, supply chain bottlenecks driven by the pandemics and restocking and a tightening of global energy markets.
As a consequence, year on year inflation skyrocketed from -0.3% in December 2020 to 5.0% in December 2021 in the Eurozone. Over the same period, CPI jumped from 1.4% to 7.0% in the US. Although some would rather focus on a narrower measure of inflation adjusted for the most volatile items (mostly energy and food), it should be noted that headline inflation is a better gauge of the impact of inflation on companies and consumers.
For one year now, these higher levels of inflation have been qualified as “transitory” by most central banks. However, as the higher rates persist, the Fed has recently changed its stance and not only decided to reduce the amount of bonds it purchases every month, but quickly guided to a doubling of that reduction and hinted towards rate hikes as soon as March 2022. Whilst most FOMC members expect three hikes in 2022, the market now prices closer to four. The ECB, however, is maintaining its position and a European rate hike is not expected prior to 2023.
The Fed’s change in narrative prompted a sharp sell-off across markets in early 2022. This was especially true for growth stocks whose valuations are more sensitive to higher rates.
Longer term however, this is not necessarily bad news for stock markets. Stock markets can perform when the US central bank hikes, as seen in most of the previous instances and the last time the Fed shrunk its balance sheet. Looking at previous periods of rate hikes, it seems likely that equity markets generally will experience short-term periods of consolidation, while still performing relatively well longer term.
Nonetheless, what is different this time is the pace of the reversal. Between 2013 and 2017, the Fed announced tapering bond purchases almost two years before hiking and four years before actually shrinking the size of its balance sheet. This time, it seems that the tapering will take place less than a year after announcing it. The key will therefore be whether the Fed is able to manage the imminent rate hikes better than it did in 2013-2018 when it generated a sharp selloff, with the S&P plummeting 20% in the last quarter of 2018.
Rising inflation is normally positive for infrastructure companies. A key feature of this sector is that these companies enjoy price escalators embedded in their contracts which are either linked to CPI or a sector-specific measure of inflation. Therefore, earning prospects for 2022 should improve for these businesses as contracts are repriced at the start of the year
In this context of rising rates and unpredictable short-term inflation, we have reduced our exposure to expensive growth stocks such as telecom tower and data centre companies. We have shifted the portfolio allocation towards more cyclical companies which can deliver the earnings growth we require, adding new positions in the midstream energy and multisector categories. These should benefit from higher inflation, and their valuations are less sensitive to higher costs of capital than typical growth stocks.