Spoilt for choice in infrastructure
As the COVID-19 pandemic enters its third year, many challenges continue to face investors. Omicron is the most recent variant but unless vaccines can be distributed fairly globally, it is unlikely to be the last.
Amidst this we have growing global inflationary pressures, which are expected to prompt interest rate hikes in the US imminently.
More recently, we have conflict in Russia-Ukraine which is creating a great deal of uncertainty.
Despite these not-insignificant challenges, which are playing out in equity markets around the world, we believe there are still unique buying opportunities for infrastructure investors.
Huge Government stimulus programs are fast-tracking infrastructure investment, and governments are expected to increasingly rely on private sector capital to build much-needed infrastructure assets as government debt rises.
ECONOMIC OUTLOOK
The key issues facing the global economy currently are COVID-19 (still), inflationary pressures and ongoing conflict.
The Omicron variant, and Delta before that, slowed the emerging global economic recovery. We expect that further variants will emerge and the battle to fight it will be ongoing but, ultimately, we all need to learn to live with COVID-19.
Once COVID-19 moves from pandemic to endemic stage, infrastructure, in all its forms, will be essential to a sustained economic recovery. There is no global growth recovery without roads, railways, pipelines, power transmission networks, communication infrastructure, ports and airports.
Since last year, global inflation has also been emerging as a key economic risk. In the US in December 2021, consumer prices accelerated at the fastest pace since 1982, hitting 7% annualised.
Price increases are being driven by supply chain disruptions along with the vast amounts of monetary stimulus global governments have pumped into economies during COVID-19 economic disruptions.
The Federal Reserve is expected to raise rates in March with other countries, such as the UK and Brazil, already moving on monetary policy.
The Russian invasion of the Ukraine dominated headlines and markets in February, continuing into March. The world has united in opposing Russia’s actions, introducing a large and diverse suite of sanctions designed to punish Russia economically and isolate them internationally. However, it is worth noting that these types of invasions, involving a motivated, dug-in, homeland defender, can run for years.
In the face of this, the global economic recovery continues, although the most recent events have pushed out the timing of the full recovery. Investors may need to be cautious as events unfold, but they should also be aware of some of the strong opportunities on offer.
INFRASTRUCTURE AS AN ASSET CLASS
Infrastructure is known as a defensive asset class. It has monopolistic market positions or positions with high barriers to entry. It has earnings that are underpinned by contracts or regulation. It’s a very long dated asset which has high upfront capital costs but reasonably low maintenance costs, which also provide inflation hedges within the business model. All of these characteristics can provide long-term visible and resilient cash flows.
There are also two very distinct and economically diverse sub-sectors within infrastructure – User Pays and regulated assets (or essential services).
Regulated assets include things such as regulated utilities in the power and water space – for example AusNet in Australia or NextEra in the US, while ‘User Pays’ assets include toll roads, airports and ports, where the user pays to use the asset.
Regulated infrastructure assets are largely immune to economic shifts, as they function as a basic need and are usually regulated by government with returns calculated independent of volumes. However, prices for these goods can be slower to respond in an inflationary cycle, due to their regulated nature and the time it takes for government to respond.
On the other hand, ‘User Pays’ assets can offer a real inflationary hedge during times of inflation and tightening monetary policy.
User Pays infrastructure investments may actually be about to enjoy a ‘perfect storm’ in the short and medium term, with interest rates supportive of growth, explicit inflation hedges through their tariff mechanisms, and improving economic activity flowing through to volumes.
Long-term drivers Infrastructure investments can provide an inflationary hedge when needed but are also a responsible addition to any portfolio due to some major underlying economic themes that will drive this sector for years to come.
Two themes we have liked in the infrastructure space for a long time are growing global wealth and an emerging middle class, especially in Asia.
Growing global wealth
Global wealth tripled in the last two decades – from US$156 trillion to US$514 trillion – with China experiencing the biggest increase, ahead of the US and Europe.
The 10 countries in Chart 1 represent more than 60% of world income:
Bloomberg forecasts that the world will average annual growth of around 3.2% in the decade ahead, which is slightly down on the average of 3.5% for the 2010-2019 decade. However, the composition of that growth is expected to change, with emerging economies outperforming more advanced economies that are burdened by ageing populations.
This is a clear positive for the infrastructure asset class as growth will drive necessary investment in the sector. A growing economy needs more roads, power, ports, airports and other essential services.
Although this economic growth is being accompanied by increasing global debt, that should be a positive for privately funded infrastructure, as governments increasingly rely on the private sector to fund much needed infrastructure assets.
Emerging middle class
More than 1 billion Asians are set to join the global middle class by 2030, with India and China adding about three quarters of that growth. A larger middle class drives consumption patterns that will require more infrastructure. More affluent consumers, for example, will be seeking out more opportunities for international and domestic travel.
As just one example, passport ownership in China is still below 10%, meaning there is huge opportunity set for global travel in coming years. Aerospace company Boeing’s forecasts include an additional 8,700 new aircraft for Chinese airlines over the next 18 years. All those airplanes need to land somewhere, which means an increase in the number and size of existing airports. COVID-19 may have delayed these trends in the short term but they will persist in the longer term.
A growing middle class is also expected to push for cleaner energy, and combined with global government decarbonisation efforts, this represents a significant opportunity for infrastructure investors that understand the real threats of climate change.
POTENTIAL RISKS
There are risks to any outlook, and while we are generally optimistic, the past few tumultuous years have taught us to be very mindful of factors that could adversely affect our views.
For instance, if we cannot achieve fair, timely distribution of COVID-19 vaccines around the globe, the pandemic will continue to adversely impact economic growth.
The conflict between Russia and the Ukraine is a clear concern. Global growth will likely be weaker as a consequence while inflation higher driven principally by a higher oil price. Global tensions between China and the
US, are also a concern, along with the timing of expected interest rates. Central banks need to act prudently and cautiously in easing monetary policy in order not to derail emerging economic growth.
Notwithstanding the above risks, there are many opportunities for the infrastructure investor in this environment, and we feel we are spoilt for choice.
The ongoing pandemic has only highlighted the need for more of these essential infrastructure assets and the potential for private sector investors to step in where governments are unable to meet demand.
Our portfolio remains diversified, with a strong bias to attractively valued investments with solid balance sheets and superior management teams.
In the current inflationary environment we are overweight User Pays infrastructure and real rate utilities and will continue to position the portfolio for the significant long-term themes.
Sarah Shaw is chief investment officer at 4D Infrastructure.
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