Keeping positive

Financial markets have a tendency to focus on bad news rather than looking for the positives. Hence some sharp setbacks in recent days in investment company sectors focused on “real assets” such as property, infrastructure and renewables. Funds in these sectors are particularly vulnerable to rising gilt yields, which spiked in the wake of the government’s “mini-budget”. But it’s important to recognise this is only part of the story.
 

First, the bad news. Gilt yields are a critical factor when investors are calculating the value of a portfolio of real assets. One way to explain that is to recognise gilts offer risk-free yield, because the UK government is highly unlikely to default on payments; when investors buy assets other than gilts, they therefore expect to earn a premium on those assets to compensate them for the risk they are now taking – if gilt yields rise, so must the yields on other assets in order to protect that premium. By definition, that means asset values must fall.
 

The more complicated version of the story is that analysts use gilt yields to calculate the value of the cash flows that real assets promise to produce over time – and therefore the value of the assets themselves. They discount those cash flows to reflect the reality that investors have to wait to receive them; the higher gilt yields go, the higher the discount rate used – and the lower the valuation of the assets. (Note that this discount rate is not to be confused with the discount or premium at which an investment company trades relative to its NAV.)
 

This is why we have seen shares in many investment companies fall back since the mini-budget. The Chancellor’s intervention prompted gilt yields to soar – and the market adjusted its assessment of the fair value of these funds’ assets accordingly.
 

Here’s the thing though. As a number of investment company analysts have pointed out in recent days, there are counterweights here that markets do not appear to be taking into account. One is that the mini-budget also included measures that will directly support these funds. “One short term sugar rush”, points out the team at Jefferies, “is the reversal of the planned corporation tax increase”; that will deliver a significant and unexpected windfall for many investment companies with real assets.
 

A second crucial consideration is that some real assets deliver an income with a contractual link to inflation; this is particularly common in the infrastructure sector where that contract is often with the government or a public sector body. If the mini-budget is inflationary, as expected, it will drive inflation higher, increasing the cash flows of those funds that hold inflation-protected assets, and compensating for higher discount rates.
 

Investors appear to have overlooked this, says Mick Gilligan of Killik & Co. As he told Investors Chronicle magazine this week, “the market tends to adjust share prices quickly for the discount rate element of the net asset value calculation but to be slow to readjust for any inflation-related benefits.”
 

A third positive is that real assets remain in real demand – and short-term valuation weakness could be seen as an opportunity in this respect. As the analyst team at Numis argues: “There are few other places to gain exposure to long-dated, predictable, inflation-linked cashflows…  where discounts appeared in core infrastructure several years ago, it prompted M&A activity.”
 

None of which is to say that investment companies are somehow immune to the volatility we are seeing in the economy and in markets right now. But investors do have a bad habit of throwing the baby out with the bathwater – they get over-excited in bull markets and too depressed when the bears arrive. The bottom line is that real assets – and the investment companies that provide mass market access to them – continue to have much in their favour.