Why infrastructure is made for a world of low growth and rising costs

The ongoing inflation threat, and the risk that central banks overreact in their monetary tightening, continues to be the key concern in the 2023 outlook for equity markets – although some green shoots may be emerging. US inflation metrics look to have improved slightly in November while Federal Reserve Chair, Jerome Powell, has signalled that the Fed will slow the pace of interest rate increases.

I am often asked how infrastructure is likely to perform in this environment, and in responding I always highlight two of the asset class’s unique characteristics that position it relatively well – investment returns that are underpinned by regulation or contract; and inflation hedges inherent in the assets’ business models.

What then becomes relevant, in positioning for the current environment, is how quickly inflation and changes in interest rates can be passed through to earnings profiles.

To illustrate this, let’s take a look at infrastructure’s two economically diverse infrastructure subsectors, user pay assets and regulated utilities, and how an infrastructure portfolio can be tweaked to take advantage of the current growing long-term structural opportunities, as well as the short-term cyclical macroeconomic outlook.

User pay assets: built-in inflation protection mechanisms

User pay assets are those where a customer pays for the service provided, such as toll roads. These stocks have a direct positive correlation with growth (volumes) and often have built-in inflation protection in their business models via mechanisms to increase their tariffs in line with inflation. As inflation and interest rates increase over time, these protection mechanisms positively impact earnings and improve valuations due to the compound effect. This should then ultimately be reflected in the relevant stock price and performance. These types of assets should represent a core portfolio holding in an inflationary environment.

Regulated utilities: timing of inflation pass-through is key

In contrast, regulated utilities, such as electric or gas companies, can be more immediately adversely impacted by rising interest rates/inflation because of the regulated nature of their business.

The speed at which inflation flows through to tariffs is dictated by whether the utility has an annual cost pass-through or not. If the utility operates under a ‘real return’ model, then inflation is quickly passed through into tariffs, much like a user pay asset. This model is more prevalent in parts of Europe and Brazil, for example, and limits the immediate impact of inflationary pressure – and in fact can positively boost near-term earnings and long-term values. Iberdrola is listed in Spain, but with utility operations around the globe, the company is a net earnings beneficiary of inflation.

In contrast, if the utility doesn’t have this inflation pass-through, it must bear the inflationary uptick reflected in certain costs until it has a regulatory ‘reset’, where the regulator is expected to have regard for the increased costs borne by the utility as a result of the inflationary forces. This model is the standard model for the US utility sector.

Overall, certain utilities, depending on their tariff structure, will weather inflationary spikes better than their peers.

Rising interest rates and infrastructure assets

When it comes to interest rates shifts, however, all utilities are the same. For a regulated utility to recover the cost of higher interest rates, it must first go through its regulatory review process. While a regulator is required to have regard for the changing cost environment the utility faces, the process of submission, review and approval can take some time, or can be dictated by a set regulatory period of anywhere between one to five years. In addition, the whole environment surrounding costs, household rates and utility profitability can be highly politically charged. As a result, both the regulatory review process and the final outcome can be quite unpredictable (as we’re seeing in the USA at the moment, with rate cases being denied or significantly amended to avoid ‘rate shock’).

What this means for investors

These differences should see certain infrastructure subsets outperform during a rising inflation/interest rate period due to a more immediate and direct hedge or flow through of inflation.

At 4D, we remain overweight user pay assets and, within the regulated utility sector, favour those with inflation pass-through. 

However, should the market overreact to the economic outlook and selloff in 2023, we would use it as a buying opportunity across all sectors.

We’re conscious of the economic backdrop and are positioning to make the most of in-country cyclicals, but we do also remain optimistic about the long-term fundamentals underpinning the infrastructure investment case:

• The re-opening trade, capturing the stimulus and pent-up consumption around the world (2023 should be China’s year)

• The global need for infrastructure investment across every country

• The emerging middle class offering a significant opportunity with infrastructure, as both a driver and a first beneficiary of improved living standards

• The global population growth, but with changing demographics – the West is getting older, but much of the East younger

• The energy transition, with environmental and climatic challenges underpinning the need for even more spend on infrastructure globally.

We believe that infrastructure as an asset class can always play a vital role in portfolio construction via the provision of stocks with inflation pass-through, visible and resilient contracted or regulated earnings profiles, and exposure to long-dated growth thematics. However, given the inflationary outlook we may face in 2023, we currently favour user pay assets and real return utilities as we close out 2022.

Invest across the globe

4D Infrastructure, a Bennelong Funds Management boutique, invests in listed infrastructure companies across all four corners of the globe. For more insights on global infrastructure, visit 4D’s website.

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4D Global Infrastructure Fund (Unhedged)

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