When it comes to discussions surrounding the nature of listed infrastructure, the most prominent and recurring debates that we’ve had with clients over the years would include the following topics:
- Are these stocks simply bond proxies?
- Have infrastructure equities performed well simply because of an era of cheap money?
- Does this trend come to an end with the inflexion in the rate cycle and the end of this era in financial markets?
These are very good questions. Many of our clients have held a broad portfolio of infrastructure funds and investment trusts in an “alternative income” allocation. So, now that so-called risk-free rates are structurally higher, what’s the point in taking this extra risk? If infrastructure stocks generally have higher levels of debt than the wider market, surely they are more vulnerable to rate rises and higher costs of debt leading to depressed earnings?
Fortunately, there is an answer to all of these questions which provides a rationale for owning infrastructure stocks, and even adding into recent weakness, and it is a straightforward narrative which can be summed up in one word – growth. Growth is not ubiquitous across the sector, and the value of stock and investment trust selection will never be as important as it is now. However, we can see the potential for growth, both in returns on and utilisation of existing assets, and in investing in assets for the future, which will drive returns for our stocks, even with a challenging macroeconomic backdrop.
Where does this growth come from? Firstly, it comes directly from elevated rates of inflation across the globe. For many utility networks, renewable generation assets, telecom towers, energy pipelines and other infrastructure assets, returns are either regulated or based on long-term contracts and are explicitly linked to prevailing inflation rates. Therefore, if interest rates rise in response to higher inflation, the returns on these infrastructure assets will also increase. Also, for many regulated stocks, the regulator will also allow higher returns to compensate for rising debt costs, augmenting this inflation linkage.
Secondly, and more importantly, many listed infrastructure companies are absolutely crucial to driving the energy transition – the move away from fossil fuels to renewable electricity generation, the electrification of transportation and the growth of alternative fuels such as hydrogen and of technologies such as carbon capture and storage. The drive for energy security, lower and less volatile prices and overall emissions reduction has intensified through 2022 with the Inflation Recovery Act in the USA and the RePower EU targets in Europe emblematic of the determination to support and accelerate the energy transition. We believe that the secure, visible, long-term, and sustainable growth that utilities and green energy developers can achieve could translate into a very positive dynamic for earnings and dividends, looking out through the next decade and beyond.
The danger in a rising interest rate environment is that investors can be stuck with fixed return assets, where those returns become steadily less attractive as they are eroded in real terms. These assets exist in the listed infrastructure space, and it is our job as active managers to avoid them and instead focus on assets where there is potential to grow returns and provide an attractive asset class for investors in a turbulent financial world.