This week, the Bank of England released its updated inflation outlook report for the UK economy. The result was yet another upward revision to expected 2011 inflation, now expected to reach 5%, well above the Bank’s own 2% target.
In 2009 and 2010 the fear was of deflation in developed markets with muted fear of inflation in emerging markets. Through 2011 we have seen the inflation predictions in emerging markets play out (as described in RARE articles The Effects Of Inflation On Emerging Market Infrastructure: 22 Feb 2011 and The Impact Of Higher Inflation On Brazilian Utility Assets: 12 Apr 2011) and now we are seeing increasing signs of inflation pressures in developed markets. Some of these pressures are due to rising commodity prices and will therefore fade with time, however with interest rates at record lows (UK rates remain at 0.5%) it presents a challenge to investors – where to find stable returns when real interest rates are apparently negative?
In this situation the regulated utilities in the UK offer one of the few ways to protect real returns. The regulatory regime in the UK allows for direct pass through of inflation in prices and asset values. As a result the UK utilities are able to offer investors dividend growth indexed to inflation. For example the regulated water companies are offering current yields of between 4 and 5%, growing at up to 3% plus inflation. This compares with UK base rates of 0.5% and 10yr bond yields of 3.3%. As suchRARE notes that in this environment, it is not surprising that these assets are becoming more attractive to investors.