What’s next for infrastructure?

Key takeaways:

• Despite challenging economic and market conditions, there are compelling opportunities in the global listed infrastructure space in different countries.
• Strong demand for listed infrastructure has been coming from “dry powder” sitting unused in unlisted funds.
• Decarbonization, reshoring and 5G evolution trends should support global listed infrastructure assets going forward.
• Regulated utilities can provide a hedge during periods of high inflation and can also benefit as inflation declines.

Challenging global economic and market conditions

The global markets have been going through a challenging period, with many countries implementing aggressive interest-rate increases. In the United States the US federal funds rate has risen to the highest level in the last 40 years. Additionally, US equity market performance has seen very limited breadth; year-to-date, artificial intelligence (AI) stocks have dominated gains in the Standard & Poor’s 500 Index.¹ Inflation has also remained stickier than expected.

In our view, high interest rates will translate to slower economic growth around the world, albeit in an unsynchronized manner. China is trying to stimulate its economy but continues to experience weak growth. The European Union is very bifurcated, with nations in the south faring better than those in the north that have led the region in the past. The United Kingdom and Australia are similar in that they are feeling the effects of higher interest rates. Lastly, although the US currently appears solid, cracks are starting to appear in terms of growth.

Listed vs. unlisted global infrastructure valuations

Listed infrastructure assets are traded on public markets and more liquid than unlisted infrastructure assets, which are privately held. There has been a big disconnect between the valuations of listed and unlisted infrastructure, with listed trading at a big discount versus unlisted. As of December 31, 2022, the gap—as measured by the Global Listed Infrastructure Organisation (GLIO) Index vs. the Wilde/Preqin Infrastructure Index—has been the largest seen since the global financial crisis.² Since then, according to Preqin, there has been US$300 billion of dry powder (capital committed but yet to be drawn) sitting in unlisted funds looking for a home. This capital has already been coming to the market to acquire assets, and we think it will continue to do so.

Over the last year or two, unlisted investors have been narrowing their focus to core infrastructure assets, such as regulated utilities (roads, rail, airports, etc.). Thus, we still see strong demand from unlisted that proves the valuation point for the listed space. At the same time, listed companies can sell assets in whole or in part to finance their growth going forward, rather than having to go to equity or debt markets.

Decarbonization, reshoring and 5G evolution trends

Our strategy only invests in listed infrastructure. The two areas we concentrate on are regulated and contract utilities (such as water, electricity, gas and renewables) and user-pays assets (such as railways, roads, airports, communications and ports). Regulated and contract utilities have low sensitivity to gross domestic product (GDP) changes, are defensive and less volatile than user-pays assets, and can provide high levels of income. User-pays assets have more of a link to GDP and provide lower income than regulated and contract utilities.

Utilities has been one of the worst-performing sectors so far this year, especially in the United States.³ This is mostly due to rising real yields. Also, as mentioned earlier, AI-linked companies have driven most of the S&P 500’s performance. On a fundamental basis, we believe utility companies are generally solid and continue to hit their cash flow earnings and dividend targets. It’s also worth remembering that these are regulated assets with regulated returns.

Among major tailwinds for listed infrastructure is the move toward net zero. Decarbonization continues to gain momentum globally. In our analysis, to get anywhere near net zero by 2030, power spending needs to increase from about US$0.8 trillion to US$2.5 trillion per annum. Specifically, spending on wind and solar needs to increase 5.5x by 2030 in order to be on track for a net-zero outcome by 2050.  Similarly, to reach net zero by 2050, by 2030 60% of all cars sold annually will need to be electric—for 2023 we are at 18%, according to the International Energy Agency.

Reshoring has been another major theme and has gathered momentum post-COVID as supply chains have begun to shorten and become more domestic. In the United States, since the Inflation Reduction Act (IRA) started incentivizing local manufacturing, 83 new clean energy manufacturing facilities or expansions have been announced, adding 184 gigawatts of new capacity.⁴ This not only benefits utilities but also electric vehicle transport infrastructure needing electricity sourced from renewable energy.

Many governments around the world have launched manufacturing incentives tied to clean energy, including the European Union’s Green Deal Industrial Plan and the United Kingdom’s “Powering Up Britain.” Canada has also announced a similar plan.

Thus, despite the drop in share prices, we believe utilities remain attractive due to these incentives as well as continued solid fundamentals.

In terms of user-pays assets, capital expenditures on cell phone towers have also been increasing as 5G has been rolled out and demand remains strong. US$80 billion of new capital is expected to be spent on new capacity and data usage is expected to quadruple from 2021 to 2025.⁵ This would offer a direct benefit to communications towers, one major infrastructure subsector we focus on.

Attractive opportunities in the United Kingdom and other countries

UK utilities sold off last year due to major sewage leaks, but have re-rated toward the end of 2022 and into this year. In our analysis, UK water companies offer what we consider attractive valuations and provide good opportunities for future returns. Additionally, while there has been a lot of noise in the sector, future capital spending needs have not changed. In our view, substantial private investment—not just public funding—is needed to rectify UK water systems.

We have found opportunities in other countries as well, such as in Japan, where rail companies are benefiting from a delayed COVID-19 recovery. In Europe and in the United States, utilities are performing well following restructuring efforts. Brazil has some of the best regulations in the world and its energy and toll road companies look attractive to us. And in China, we believe gas companies will pick up with the conversion to gas from coal.

Stable dividends and inflation hedge

Most listed infrastructure companies can pass inflation directly or indirectly through to the ultimate consumer. This doesn’t necessarily mean their dividend payouts will follow inflation as it goes up and down because they keep a constant dividend policy. In times of higher inflation, they’ll retain some of that cash, and in times of lower inflation, they’ll pay some of that out. Companies globally with the best dividend coverage are generally the most solid. These companies have also been able to compensate for rising inflation, which we believe has peaked, and will likely moderate going forward. Lower inflation will also benefit regulated utilities since they will feel less pressure to increase their prices.

Conclusion

Given the current backdrop, we favor being defensively positioned in utilities with what we consider compelling valuations and that are less sensitive to GDP. Additionally, in our analysis, there are long-term drivers—such as decarbonization, reshoring and 5G growth—that should provide attractive opportunities in the listed infrastructure space.