Schroders: How does inflation affect the major investment themes?

How will inflation affect the major investment themes of the future? Schroders experts describe how the return of inflation affects some of the major investment themes, such as global cities, digital infrastructure, energy transition, food and water and smart manufacturing.

Inflation higher than the central bank’s target for now

A year ago, many central bankers described inflation as transitory. But they have long since moved on from that, especially now that inflation is hitting not only goods but services as well. Schroders economists forecast global inflation at 7.2% this year from 3.4% in 2021. They expect a slowdown to 4.3% in 2023, but that is still above many central banks’ targets and well above the level which most major economies are experiencing in recent years.

World cities and digital infrastructure

Real estate is an industry where investors can often benefit from rising inflation. This is due, among other things, to rising costs for building materials or labor holding back new construction, which increases the value of existing real estate. But many types of real estate are directly related to inflation.

For example, according to Tom Walker, many leases have clauses for rent increases that are linked to inflation. These ensure that investors’ returns are above inflation. However, not all real estate assets are created equal. Investors should pay close attention to the specific type of property they are investing in. Some types of real estate are essential. Others benefit from strong demand and limited supply. But other segments are not significant and have weaker demand.

The pandemic has accelerated a number of trends, such as e-commerce and working from home. This has weakened the pricing power of owners of real estate such as retail and office space. As a result, the ability to pass on inflationary increases to tenants in these buildings is severely limited. By focusing on locations where economic growth is consistently strongest, investors can maximize their chances of passing on higher costs to their tenants.

Energy conversion

The energy transition is a theme that has had a significant impact on inflation over the past two years. Alex Monk points out that companies are seeing their profitability decrease because their costs have increased. And from a valuation standpoint, the higher interest rates have reduced the value of future cash flows. Companies in some of these higher-growth areas, such as renewable energy, energy storage and hydrogen, have felt the most pain. This is because the value of their earnings lies much further back in time and they are also more exposed to supply chain shocks.

The energy transition theme remains in the spotlight due to the sharp increase in electricity prices in Europe as a result of the reduced supply of Russian gas. Now that energy prices are one of the main causes of inflation, which in turn can cause a recession, it is imperative that more energy supplies be made available. Much more renewable energy, much more energy storage and even hydrogen will be needed to solve the current energy crisis, especially in Europe.

Food and water

Higher food prices have been a major component of higher inflation this year. The war in Ukraine has increased the prices of some agricultural products, especially the prices of wheat. According to Felix Odey, this situation may continue. Higher prices for agricultural commodities may benefit farmers and investors in these commodities, but they lead to food price inflation across the chain of food producers, retailers and ultimately consumers.

Smart manufacturing

The theme of smart manufacturing is about innovation that sparks a digital industrial revolution to produce better goods and manufacture better. Technologies that help improve energy efficiency are part of this. According to Dan McFetrich, industrial energy consumption in Europe constitutes 26% of total European consumption. At a time when gas supply is uncertain and energy inflation is high, the demand for technologies that enable electrification and energy savings is expected to increase.

But there are production trends that are also sources of inflation, rather than solutions. Re-shoring, the tendency to bring production closer to demand, is an example of this. Re-shoring is inflationary. For example, it can lead to higher labor costs or more expensive parts, as companies move production to more expensive regions. But the advantage is a more robust supply chain, lower logistics costs and reduced CO2 emissions from transport.

Automation can ease the costs of re-shoring. The cost of robots is falling due to economies of scale and the increasing adoption of automation across a range of industries. Across all industries, automation can lead to higher productivity, lower labor costs and greater energy efficiency, all extremely attractive at a time of rising inflation.

The inflationary effect is not uniform

It is clear that the effect of inflation on different themes is very different. Even within one theme, investment opportunities are not all affected in the same way.

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