The 5 big growth drivers propelling this asset class (even in volatile times)

You may feel like the current market environment is forcing you to make vastly different choices. Volatile times? Forget the exciting growth-driven investments and stick to consistent quality earnings. Bull market runs? Jump on the big growth, risky plays and the big trends.

Could it be possible to have both, even in volatile times? In short, yes.

Some of the biggest growth trends of our time are the likes of advancing technology, rising middle class across developing economies or the energy transition.

These themes are the key growth drivers for infrastructure – an asset class which also provides consistent stable earnings streams underpinned by regulation or long-term contracts. While it’s often viewed (erroneously) as a bond proxy, 4D Infrastructure’s Sarah Shaw notes that the infrastructure universe is far more diverse than this and that it’s an asset for all seasons.

“There is a view that all listed infrastructure will fundamentally underperform in higher interest rate or inflationary environments, but this is just not true of the entire asset class. It can be true of nominal rate utilities and this is a segment we were significantly underweight in 2023. 

Every other infrastructure sub-sector can perform well in high interest rates and inflationary environments, where there is a positive correlation between earnings and inflation, and/or even interest rates,” she says.

In this Rapid Fire Q&A, Shaw discusses how she is positioning for 2024, why travel is still on the cards and the five big growth drivers of infrastructure. For fun, she also shares which celebrity her strategy embodies – and let’s just say, even 007 himself would respect this choice.

What is your outlook for 2024 and which industries within infrastructure do you expect to perform better?

I think we could have another volatile economic environment in 2024, coupled with quite a few political overhangs. We continue to position to make the most of in-country cyclicals as well as the long-term growth fundamentals.

The beauty of infrastructure is that within the asset class, we have economic diversity, which allows us to actively position for all points of the economic cycle. Even if there’s rising inflation and interest rates (2023), or a recession or stagflation, we can position the asset class to capitalise on this.

Infrastructure has two economically diverse sub-sectors.

1. Essential services or regulated utilities
   These assets are largely immune to shifts in demand because they meet basic needs and the structure of their regulatory environment earns returns independent of volume/demand. Their earnings are more adversely impacted by rising interest rates and inflation and they’re slower to realise the benefits of growth. At the same time, they’re not exposed to economic contraction, and they benefit from lower interest rates. We’re watching interest rates closely coming into 2024.
2. User-pays
   We have been overweight on this sub-sector throughout 2023. These assets capture growth and have explicit inflation protection.

In 2023, we were overweight user-pays and inflation-hedged infrastructure and underweight the bond proxies of our universe – which are the nominal rate utilities. We’ve held these positions going into the start of 2024. 

We’re monitoring the regional economics closely and we will shift our positioning when the signals indicate we can capitalise on a new macro environment.

Inflation is falling but it’s still well above historic levels. Interest rates are expected to fall, but I think the market is over-optimistic on timing. We also have significant geopolitical events next year, with many elections around the world. We’re positioning at a country level for those.

What trends are you seeing in infrastructure investing at the moment?

At the company level, we’re seeing significant growth as companies look to capitalise on really strong key infrastructure investment themes. This growth is supported by strong foundation cash flows and secure balance sheets. We’re seeing positive momentum across the asset class but if you take it to the equity market level, the sector was unfortunately sold off again on the misconception of being a bond proxy.

There is a view that all listed infrastructure will underperform in higher interest rate or inflationary environments and it’s not true of the entire asset class. It can be true of nominal rate utilities and this is a sub-sector we were significantly underweight in 2023. 

Every other segment of infrastructure can perform well in high interest rates and inflationary environments, as there is a positive correlation between earnings and inflation, or even interest rates.

What are the biggest challenges facing infrastructure in the coming 12-18 months?

The biggest challenge over the next 12-18 months is geopolitical noise. We have to separate the resilience, defensiveness and characteristics of infrastructure from the noise. We’ve already seen it kick off in the US with the suggestions that if Trump gets re-elected, he’ll cancel the Inflation Reduction Act, changing the dynamics of renewable investment. It creates a lot of noise and infrastructure names get caught up in that because they can be beneficiaries of government policy and regulatory models.

We prioritise companies with strong management teams, visible strategic goals, strong balance sheets and executing best-in-class in their sub-sector. We’re conscious of economic variables and political noise, but we’re trying to take advantage of the long-term structural opportunities along positioning for the short-term cyclicals.

Data centres and other forms of technology infrastructure are a growing need. Do you invest in these and where are you seeing opportunities on this front?

The rise of technology is one of the five key growth drivers for the infrastructure sector.

There’s no question that the technology boom is happening and it’s very important. Mobile connectivity is emerging as an essential service and the rise of technology is going to increase efficiency and economic growth. 

We tend to favour communication towers for exposure to this theme. Communication towers are the foundation infrastructure for technological advancements. They provide access to data and allow technology to evolve and grow. 

They have very long-term contracts and inflation protection. They meet our core definition of what is infrastructure in terms of long-term visible earnings streams while underpinning a huge growth theme.

Data centres are more competitive and tend not to have long-term contracts with inflation hedges so aren’t the pure-play infrastructure we focus on.

Extreme weather risks, like US wildfires and Australian bushfires, are an increasing risk. How does this affect infrastructure and how do you manage the risk of this in your portfolio?

Fires are a real risk to utility companies. It does look like the issue is going to intensify going forward with extreme weather events on the rise. There have been several examples in the US where electric utility company assets have ignited wildfires and they’ve gone on to cause loss of life and significant third-party damage. Unfortunately, the utility company has then faced billions of dollars in litigation liabilities. While they do have insurance protection, these far outweigh the level of insurance protection.

The way we think about this is we need to understand the utility’s operational preparedness and investment plans, along with hardening their networks against wildfires. That is – what are they doing to make sure they aren’t causing these wildfires and to ensure that they aren’t negligent should a wildfire start?

We’re closely following legal and regulatory developments. California was a global case study. If utilities do everything they need to do, harden their network, and mitigate the risk of fire ignition, then they’re not held liable anymore.

We will rule a stock as un-investable if there’s a real risk of unquantifiable liability as a result of wildfires or weather events.

Airports are one of the bigger holdings. We’ve had some contributors suggest that travel will die off in the coming year. Do you agree and what role will China’s sluggish reopening have?

The ongoing post-pandemic traffic momentum continued through 2023 despite big question marks over affordability and rising inflation. Around the world, we’ve seen some areas back to or above pre-pandemic levels. Places like Mexico, Spain, Brazil and Greece. For others, the anticipated timeline for recovery has been significantly brought forward. This momentum has been strong without Chinese travellers and continues to be driven by leisure passengers.

There seems to be a real fundamental shift in the way travellers think of their discretionary spend and they want to invest more in travel and associated experiences than things. 

That’s true of the Chinese as well. What we’ve seen in their reopening is that they were previously the big spenders on luxury goods and the like but after being locked up, they’re looking to go out and do things. It’s a focus on the services industry. This has started small, but we anticipate Chinese travellers will come back and boost traffic in 2024.

We remain travel-starved and people will continue to spend on holidays despite the cost-of-living headwinds. One operator described it to me as, even if your budget is more limited, you still want a holiday but you might change how it looks. It might be close to home instead of overseas, or you might shorten the duration of your trip. For an airport operator or tourism business, that might give you more seats and the ability to work with more people, because more people are travelling for shorter periods.

We don’t think travel is going to halt, but I expect it will slow into 2024. China will see strong traffic trends starting across Asia and then moving into Europe. It might not be the same traffic growth levels as 2023, but we’re not expecting a big contraction either.

Can you discuss what you are particularly excited about in the infrastructure space?

What is continually under-appreciated from infrastructure is the growth opportunity and there are five key and integrated growth dynamics long-term. They are significant, growing and immune to short-term economic events – if they don’t happen, we go backwards.

1. Developed market replacement spend: upgrading old and inefficient infrastructure. If we don’t upgrade, there are social and economic consequences, like causing wildfires, bridges collapsing, pollution in water supplies.
2. Global population growth and changing demographics: the West is getting older, the East is getting younger and both dynamics require significant infrastructure investment. For example, new infrastructure to support the older generation or infrastructure to support absolute growth.
3. The emergence of the middle class in developing economies: infrastructure is the biggest driver of the emerging middle class and it’s also the first beneficiary of it. If you have improved living standards, you want clean water, gas/electricity for cooking and heating, and roads to move about. We play this theme across the emerging world with core exposure in Indonesia, Brazil, parts of China and Mexico. In Mexico, the airport is 12% above pre-covid passenger levels, partly because the middle class is travelling.
4. The energy crisis and transition: the goals for net zero across the developing and emerging world make this a huge investment theme. It’s a multi-decade opportunity but it needs to be done in a socially responsible way. We prefer to play it by the grid network along with some of the big integrated companies like Iberdrola (BME: IBE).
5. The rise of technology: this has been across a few things we’ve discussed today and is critical to the other themes as well. One position we have in this space is Cellnex (BME: CLNX), a European leader in tower deployment.

What is an insight you’ve learned from your experience in investing in infrastructure?

You can’t use blue-sky thinking to value the asset class. We don’t value investment pipelines as an infrastructure investor – our asset class is all about long-term visible and resilient earnings streams. For example, it has been hard to find value in pure-play investments in the renewable space because the market attributes value to their investment pipeline - for us, we can't value the 'desire' to build 10GW of renewable generation, rather we can only value the 3GW in operation or at FID (final investment decision). 

In a rising interest rate environment and with supply-chain issues pushing capex budgets up significantly, we’ve seen some of the renewable builds decline in value or become uneconomic. If you had valued these pipelines, you’re now having to re-value them down, or there have been impairments against the new assets meaning a loss incurred.

Fun question: If you had to pick a celebrity to embody your strategy, who would it be and why?

We’re going with Dame Judi Dench. 

She’s had a long-lasting career. She has enduring talent and quality and that aligns with the long nature of high-quality infrastructure. She’s had huge diversity in her roles across her career and that’s the beauty of infrastructure as well. She’s had critical acclaim around the world and that’s where infrastructure looks to sit in that high-quality, long-duration diverse space.