Commentary: For investors seeking a hedge against inflation, water could be the answer

As investors look for assets that can hedge against rising inflation, water technology could provide a suitable solution that also makes a positive environmental and social impact.

Equity market investors have experienced a volatile start to 2022, with inflation advancing at the fastest pace in decades in the U.S. and other developed nations, as economies face supply-chain issues while they rebound from the worst of the COVID-19 pandemic. These conditions have been exacerbated by growing geopolitical concerns after Russia's invasion of Ukraine, which, among other things, has highlighted the urgent need for greater infrastructure security, both physical and cyber.

In this context, companies with business models based on preserving supply, enhancing water efficiency and ensuring water quality and water security might give investors a chance to mitigate the impact of higher prices and rising geopolitical risk on their portfolios. These companies can serve as an inflation hedge while water utilities keep margins steady by passing on higher input costs to end users.

Since water is perhaps the one thing that cannot be substituted and remains critical for most things, it should be seen as a key spending priority in any market environment. Aging infrastructure, rising water demand and growing filtration needs provide a predictable demand for more water infrastructure-related spending in this decade, causing the price utilities charge for water services to rise in recent years at roughly twice the pace of inflation.

While water is technically a commodity, its market behavior is different from traditional commodities such as oil and gold; it's not traded and is difficult to transport economically. Unlike other global soft commodities such as soybeans or grain, its value is not captured on trade exchanges and its price remains debatable. Instead, water perhaps has more in common with investing in health care or education, which are typically provided as services rather than as goods. Water itself is typically free, while the infrastructure around it is not.

Therefore, investing in water is typically done by buying equity in firms focused on improving water access with network operations or in improving water-use efficiency, repairing or replacing water infrastructure, or improving water quality by way of filtration systems or wastewater treatment.

Demand for water is growing from its biggest users — agriculture and industrial use. In addition, a rising (and increasingly urban) population increases demand and as income rises, so does agricultural water demand, mainly because more prevalent carnivorous diets require more water than vegetarian food.

Factory demand is also increasing as society becomes more industrialized and the size of the middle-class grows, driving demand for more finished goods, while modern lifestyles are driving greater demand for water-intensive industries such as microchips and data centers.

Amid this accelerating demand, the investment outlook for water is buoyed by global water scarcity. Nearly 70% of the world is covered by water but mostly in oceans. Only 2.5% of water is freshwater and less than 1% is easily accessible. That water must feed and power a global population of 7.9 billion — 70% of water is used for farming, 19% for factories and electricity, and 11% for domestic use.

Making matters worse for investing are endemic problems in aging water systems. For example, 14% to 18% of potable water is lost to leaks in the U.S., where the average water pipe is 45 years old, according to McKinsey & Co. Climate change and ransomware are exacerbating challenges: In 2021, unusually cold weather in Texas froze water pipes, causing the loss of millions of gallons of water, and a ransomware attack on a Florida water treatment plant highlighted the need for cybersecurity upgrades to protect water systems.

After years of underinvestment, the water sector is also buoyed by a growing acceptance that we need to urgently repair creaking, leaking infrastructure. The $1.2 trillion Infrastructure Investment and Jobs Act recently approved by Congress included $82.5 billion for a wide range of critical water investments, from improving drinking water to replacing lead pipes, and could be a tipping point for U.S. water investment. Washington's bipartisan support suggests that municipalities can likewise find political support for investing to upgrade water infrastructure after decades of underinvestment.

At the same time, rising food prices mean that farmers have the much-needed capital to privately invest in improving the efficiency of their water usage through advances like center-pivot irrigation systems.

These tailwinds suggest that the water sector as an asset class could outperform broader indexes for the next few decades. This trend is seen in historic returns: Over the past 20 years, the S&P Global Water index outperformed traditional indexes, such as the MSCI ACWI and S&P 500, producing annualized returns of 11.6% compared with 7.8% and 8.6%, respectively, for the period ended Feb. 28, according to Morningstar. And, as a growing number of investors are drawn to making an impact, investing in water also supports the United Nations Sustainable Development Goals, specifically Goal 6, to promote clean water and sanitation. Together, these characteristics make water an investment that can produce both profits and a positive impact.

Andreas Fruschki is head of thematic equity at Allianz Global Investors, based in Frankfurt. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.