Select exposure to recovering growth
While we expect the global economic environment to remain weak overall, there will be changes in the nature and allocation of that growth. We have often talked about a focus on growth which is structural rather than cyclical. While structural growth will remain the main source of returns for the asset class, we see an opportunity to capture some cyclical recovery.
We expect this growth to significantly vary by region, with earnings risk on the upside in the US and Asia, but on the downside in Europe, where the rate of decline is expected to slow but not reverse. Select ports and rail companies, such as China Merchants Holdings and Union Pacific are well positioned to capture this recovery.
Reduced political pressure in major economies
The threat of political or regulatory intervention can be a key risk for infrastructure investors. Elections or leadership transitions have occurred in many of the major economies. The US president does not face re-election. In France the worst of socialist changes are behind us and going forward we expect the government to be more pragmatic. The Chinese leadership transition has now occurred and in Japan a more pro-business government has been installed. Lingering risks include Italy, Germany and Australia, which are scheduled for national elections in 2013, but overall we anticipate lower levels of political intervention than last year.
We expect political stability to reduce uncertainty through better public policy. This should help remove the discounts currently placed on some infrastructure businesses, such as French utility company GDF Suez, which has been hit by new taxes, gas tariff deficits and generation closures in recent years.
Avoiding exposure to regulatory decisions
Over the past few years, regulators have largely resisted substantial reductions in returns, despite an extremely low interest rate environment. This reflected the view that the low interest rate environment was temporary. We are now four to five years into this environment and believe that the consistent over-earning in regulated assets is less likely to be tolerated. Upcoming rate cases will probably expose utilities to a drop in allowed returns.
While this is anticipated to some extent, we do not think it has been fully priced in and the first significantly negative rate case decision (e.g. allowed ROE of seven to eight per cent in a ‘safe’ US state) would hit the sector broadly. In contrast, those with rates locked in should be least impacted, such as the electricity utility National Grid which recently secured an eight-year rate agreement in the UK.
Inflation back on the minds of investors
Central banks around the world have been printing money on an unprecedented scale for a number of years in an attempt to stimulate economic growth. Combine this with high commodity prices and the re-emergence of some cyclical growth, and we get an environment conducive to inflation. While our expectation is not for inflation to run away in 2013, we do expect to see it back on the minds of policy makers and investors.
The pricing of infrastructure services are generally linked to the Consumer Price Index. This may be explicit through direct contractual links, such as toll roads which pass through inflation linked toll increases each quarter or year, or implicit through strong pricing power given the essential nature of most infrastructure and limited competition. Consequently, infrastructure provides a natural hedge to rising inflation and the uncertainty it creates.
Bull Points
– The asset class provides a reasonable dividend yield and is expected to grow above the rate of inflation
– Structural growth should remain the core driver of returns, but portfolios can be positioned to benefit from recovering growth in US and Asia
– The passing of elections and leadership transitions in 2012 should remove the discounts currently seen on some infrastructure stocks
Bear Points
– Listed infrastructure stocks can be vulnerable to political interference
– Regulators may reduce the benefits of lower interest rates
– Due to their defensive characteristics, infrastructure securities tend to lag general equities in a cyclical upturn
Peter Meany is head of global infrastructure securities, First State Investments
