The problem, McKinsey says, is that the world needs annual investment of around US$3.3 trillion through to 2030 just to support current projected global economic growth, effectively resulting in a cumulative US$49.1 trillion gap in infrastructure investment by 2030.
This underinvestment in a burgeoning and somewhat unstoppable demand for infrastructure, driven by economic growth and pure population growth, has become a significant opportunity in an asset class that is relatively young and increasingly in focus for investors.
What are the characteristics of essential infrastructure?
Essential infrastructure refers to the assets that are essential for the basic functioning of a society. Essential infrastructure is typically monopolistic, regulated or long-term contracted essential infrastructure assets and companies in sectors such as regulated utilities (such as electricity, gas, and water), transport (for example, toll roads and airports), energy (like regulated or contracted pipelines and renewables), and communications (such as mobile phone towers).
From an investment perspective, the key investment characteristics of classic infrastructure are typically described as being:
- High barriers to entry with monopolistic characteristics.
- Earnings growth and stability through the economic cycle, with less volatile cashflows.
- More stable long-term returns.
- Naturally hedged for inflation.
- Less correlated to equity markets.
Essential infrastructure should offer a compelling mix of yield, relative stability, and long capital growth in the returns it offers investors.
How does yield in infrastructure compare to global equities?
The unique cash-flow nature of infrastructure is such that equity investors in this sector forego some elements of growth, compared to what is on offer in global equities, in return for a higher relative yield. With essential infrastructure, yields are typically backed by large, real assets that hold dominant or allowable monopolistic positions in their respective economies.
For most essential infrastructure assets, there is little to no competition or substitution and yields are underpinned by long-term contracts and concessions. These are agreed with regulators, governments, and customers and generally allow for steady increases in revenue streams to cover operating and capital costs, and inflation rises. This stability in revenue and earnings can be seen in the EBITDA growth for essential infrastructure assets compared to that for global equities.
One of the strong themes that can be seen in infrastructure earnings growth is that it is consistently positive through economic cycles, compared to the boom-and-bust pattern that can be seen in the earnings growth of general equities. While global equities can enjoy periods of superior earnings growth, a lot of the benefit is given away in market drawdowns or when the earnings cycle goes into major contraction. In contrast, the steady positive earnings growth shown in essential infrastructure compounds over the long term to significantly outperform the far more volatile earnings growth of general equities.
How does infrastructure perform in inflationary environments?
Turning to inflation, essential infrastructure should demonstrate a high degree of inflation protection because in a tight definition of essential infrastructure, inflation protection is one of the key characteristics.
At an absolute level, essential infrastructure has historically performed best under a moderate inflation backdrop. This has been the case as the moderate inflation typically translates into healthy cashflow growth through contracted or regulated CPI escalators (adjustment clauses in contracts that allow for CPI to pass through the charging structure for users), while not causing significant changes to nominal base yields.
Importantly, we think that active management can lead to better outcomes when managing inflation impacts on the portfolio. Infrastructure sectors are heterogeneous and offer the opportunity for active allocation towards sectors that hedge well for inflation and those that thrive in inflationary environments.
For example, transportation tends to lag in high inflationary environments as these companies typically have long duration in cash flows, and relatively high gearing which makes it more sensitive to increasing bond rates. Energy infrastructure (oil and gas pipelines), by contrast, has historically performed strongly as high inflation leads to higher commodity prices and therefore increased exploration, drilling and capex activity, which ultimately leads to higher volumes carried by pipeline infrastructure.
However from our perspective, downside protection is more important than upside capture, and pleasingly, the downside capture of essential infrastructure has been around 83 per cent of the downside that global equities has suffered during down months. COVID-19 lockdowns significantly impacted global infrastructure, listed and unlisted, in 2020 and 2021, however, downside capture was still superior to that of global equities. Importantly, it is the asymmetry of the upside and downside capture that is important, and it’s important to seek to control the downside, and capture most of the upside in rising markets, in order to increase the potential to outperform over the long term.
What does all this mean for investors?
Not all infrastructure is the same. Definitions of unlisted infrastructure are being continuously stretched as the asset class grows and higher allocations are made. As a result, index definitions can extend along the risk curve and increasingly include assets that are not, by definition, essential or even core infrastructure. As we have seen, this has significant consequences on the risk and return characteristics of a portfolio.
Our belief is that investors allocate to infrastructure in order to access a unique combination of characteristics. This includes downside protection, inflation protection, low cyclicality, low commodity risk, lower correlations with other asset classes, and access to long-term secular growth.
In our view, it is crucial that investors seeking the true investment benefits of the infrastructure asset class look to essential infrastructure to replicate these benefits. By having a very tight definition, only those companies and assets that are able to demonstrate true infrastructure investment characteristics are included.
What is the outlook for global essential infrastructure?
As we approach the remainder of 2023, two prominent factors continue to dominate the market landscape: inflation and interest rates. While inflation has been gradually decreasing in most countries, it has not been declining at the pace desired by central banks. Consequently, central banks have been raising interest rates in their pursuit of achieving price stability. We think inflation and interest rates will remain higher for longer, and we do not see any interest rate cuts by the Fed until at least 2024.
Essential infrastructure is well positioned to navigate this current environment. When evaluating essential infrastructure stocks, one of the characteristics we prioritise is cash flow protection against inflation. This can be achieved through regulatory mechanisms (like with utilities), or contractual escalators (like with energy infrastructure). Moreover, when interest rates reach their peak, it is likely to be favourable for infrastructure assets, particularly those with longer durations that have underperformed across the rate-rising cycle.
Historical data suggests that infrastructure tends to outperform broader equities once interest rates reach their peak because the secular growth prospects for infrastructure remain relatively stable in a high-interest rate environment. This consistent growth trajectory is a significant advantage of essential infrastructure, making it an appealing investment choice in the years to come compared to other sectors.
Tim Humphreys, head of global listed infrastructure, Ausbil Investment Management
