Infrastructure as an asset class seems to offer one solution to the ‘inflation hedge’ many investors are seeking in this current environment. Despite this, many investors have little to no allocation in the sector due to lumping it in with property or not seeing the need for it to be part of their portfolio.
The below chart of the S&P Global Infrastructure Index may illustrate another reason why most investors hold a small allocation:
‘Real assets’ were definitely not a winner from the global COVID-19 lockdowns, with the Global Infrastructure Index down -8.18% over 2020. Although this underperformance may have scared some investors off, the drawdown was largely due to market sentiment (“risk-off”) and some sectors facing material revenue declines (airports) – not due to its inherent value to hedge against inflation or as a ‘defensive asset’ allocation.
Looking towards the future, let’s analyse that the underlying qualities of the asset class are and what may drive their road to recovery in the coming years.
Universe and Qualities
The universe of assets that an ‘infrastructure’ investment can hold is vast, so to provide a general definition going forward:
Infrastructure covers investments in ‘real assets’, typically physical utilities or assets which forms part of regular consumer activities including roads, highways, energy infrastructure, railways, ports and sewage systems.
There are subsets, which we will touch on, but this is an over-arching theme as to what the sector comprises. Despite these sub-sectors, infrastructure should hold the following characteristics:
This may seem incongruous given the previous chart showing its collapse in 2020, but infrastructure generally is considered a defensive asset class – modern portfolio theorists like to include it as a means of ‘smoothing out’ volatility from more general equity exposure, whilst aiming to provide income higher than a traditional dividend yield and other defensive assets such as fixed income.
As last year taught us, infrastructure is very exposed to the real economy and the free movement of the general population – but contrastingly it is generally less correlated as an asset class to overall equity markets since revenues are derived from ‘real spending’ rather than capital markets and corporate earning speculation.
Steady/predictable cash generation
Since infrastructure assets generally have long-duration leases (often decades long), the reliability of cashflows is outlined from the very beginning of the investment.
Furthermore, since many infrastructure assets are regulated by government/semi-government bodies, there is a level of certainty around the commitment to maintaining contractual obligations.
Ancillary to this characteristic is also the longevity or ‘shelf life’ of the asset – you would expect a highway or a sewerage plant to have a running life of at least a few decades, whilst rail lines are expected to last decades and even centuries, with only the occasional addition made as population centres expand.
This means that there is a predictable and transparent revenue model established from the beginning of the investment which future investors can tap into at a later date – where cashflows can be discounted (DCF) and readily used to value the assets.
Low Variable Costs
Linked to the quality of longevity is the fact that most infrastructure assets have very low variable costs compared to their revenue. Infrastructure spending is often ‘front-loaded’, meaning that the majority of costs come from the construction of the asset and once it is operational there is only occasional maintenance required to keep it going for its shelf life. A good example of this is a highway; each car that drives over the highway in itself has a very low variable cost, you would not expect a material investment to be made for adding 1,000 more cars to a major highway in Sydney per day, so long as the road continues its scheduled maintenance over its life.
To quote John Julian from AMP Capital:
“Revenues generated by infrastructure assets are often linked to inflation. This inflation linkage can come about because rates of return set by regulators for regulated infrastructure assets are often linked to future inflation, or under the provisions of a long-term contract”
As an example, toll roads are generally run on a government contract which creates the provision of regular increases to toll fees using a formula weighted by the Consumer Price Index (CPI). In other words, as CPI as a proxy for inflation increases, the revenue of the asset should as well.
These characteristics come together to form a robust asset class that, over the long term, should operate on a lower volatility basis than a standard basket of equities, whilst providing the investor with a steady flow of income over the life of the investment.
But as we have established, confidence has been diminished in infrastructure over the last 12 months since the global population was forced into lockdowns and regular use of major infrastructure assets fell away – who, during lockdown, would have been using a toll-road? Or an airport, for that matter?
As infrastructure is a long-duration asset class, with a higher sensitivity to valuations and discounted cash-flow modelling, the underlying assets can exhibit volatility over shorter term basis, as these valuations move with inflation expectations and bond yields, where the asset values later recover as the receipts rise with higher CPI, recovering the value of the valuation-led sell-off.
Like the rest of the market, there are pockets of recovery occurring within the sector, so with that in mind let’s explore ways forward.
The Future of Infrastructure
Infrastructure needs a near-constant supply of private investments, since most governments (especially in the current economic environment) are in a position to completely finance their infrastructure needs – even when large stimulus packages are released to stimulate the economy through projects, this is often in partnership with private operators.
According to Global Infrastructure Outlook (a G20 body), the world will need $94 trillion USD of infrastructure spending by 2040.
At the moment we have $79 trillion USD committed.
From the chart above, you can see that the largest spending is involved in energy, roads and rail. Interestingly, these are also the sectors with the largest spending gap – road alone needs a further $358 billion USD committed in the year 2040.
The upcoming U.S stimulus bill for infrastructure seems to recognise this funding gap; rebuilding ageing roads and bridges is a key item on the agenda, as is building out clean energy infrastructure across the United States. Little is known about the figure of spending, though Goldman Sachs believe it will be in the realm of USD $2 trillion (Forbes).
The short-term recovery of infrastructure will largely depend on how quickly the global economy can recover and populations can return to normal consumption and movement habits; for an insight into this rate of recovery, Jesse wrote an update on the global vaccine effort yesterday.
We will return to infrastructure in a later note – but the characteristics of the investment are compelling, particularly in an area that’s due to see at least $60 trillion USD investment over the next two decades.
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.