Defensive growth, or just defence?

Broadly, markets expect gently slowing inflation and growth over the 2021–2023 period. The question will be how much and when 

by NICK LANGLEY / pic by BLOOMBERG

THE surprises over the last 12 months should give some indication of the significant uncertainty facing investors in 2022, with forecasts for global GDP growth and inflation having a high chance of coming in well above or below consensus. 

Market expectations for 2022 have moved significantly in recent months, on the whole pointing to a hotter than expected economy. 

Broadly, markets expect gently slowing inflation and growth over the 2021–2023 period. The question will be how much and when. 

With supply chain issues, higher housing costs, higher commodity prices and producer price inflation remaining square in the sights for 2022, we think higher inflation is a risk for global markets. 

We expect growth to slow to trend or below by mid-2022 and US Treasury yields to rise, which would mean a continuation of negative real bond yields. 

Additional forecast volatility and therefore market uncertainty will arise as new Covid-19 variants appear and circulate. 

Rising bond yields are relatively more important for longer-duration assets. Within infrastructure, utilities tend to be shorter duration (as their assets are repriced by regulated returns at frequent regulatory resets, making them relatively less sensitive to movements in bond yields over the medium term), whereas toll road and concession assets without the ability to reprice their assets or returns tend to be longer duration and hence relatively more sensitive to changes in interest rates. 

We expect nominal bond yields to remain relatively low by historic standards for the long foreseeable future; this means real yields would remain negative and continue to support investment in infrastructure. 

Utilities, generally the defensive play, performed poorly early in 2021 amid a sharp cyclical rally and have traded sideways since. 

Electricity, gas and water companies have continued to invest in their asset bases and regulators have continued to provide attractive returns (8%–11% nominal return on equity [RoE]), resulting in highly predictable earnings growth over multi-year horizons.

However, expectations of rising bond yields (particularly real yields) continue to weigh on the sector, and traditionally utilities have lagged the market until the first-rate hike is announced and the path of rate hikes becomes more certain.

As a result, utilities could lag for the first half of 2022. Transportation infrastructure generally offered a mixed bag in 2021: Toll roads recovered quickly from the initial stages of the pandemic and did well amid subsequent waves of Covid-19 as people decided against public transport and commuted in cars. 

Airports remain challenged as additional lockdowns loom. Ports and rails have lagged as snarled supply chains have reduced utilisation and volumes. 

Communications infrastructure such as tower companies struggled in 2021. We expect communications to perform well in 2022 on continued negative real rates and high growth, driven by increased band-width needs as 5G buildout increases. 

After a strong 2020, renewables had a poor 2021 until the run-up to COP26 conference as focus returned to the enormous policy support for renewable energy. 

Higher fossil fuel prices should assist the transition to renewable energy as projects that were marginal become economically justifiable. 

The development of gathering networks and gas and liquids transportation provides ample opportunity for investment and attractive returns in a world of higher energy prices. 

Meanwhile, investments in green hydrogen and carbon sequestration activities may assuage those investors concerned about the long-term viability of these (largely and currently) fossil-fuel-focused networks. 

Against this backdrop, given our base case of slowing growth and higher inflation, our playbook for infrastructure portfolios broadly is to watch for a transition from a growth orientation, in which we prefer higher exposure to economically sensitive user-pays infrastructure and lower utility weightings, to a more defensive positioning as growth fades and utility underperformance unwinds. 

In the base case economic view this will be a measured process throughout 2022, while in the alternate view this transition will be accelerated. 

A Multiple/Margin Conundrum

Overall, markets will find support given excess liquidity, but should be subject to corrections as growth and inflation expectations are recalibrated. 

We expect markets to be broadly in a mid-cycle phase, where earnings growth is required to support multiples and returns moderate from the relatively high levels of the last three years. 

Consumer price inflation is running in the mid-single digits and is likely to continue to well in 2022. 

Meanwhile, producer price inflation is running in the low double digits and is also likely to continue to well in 2022. 

This sets up an interesting conundrum: Companies will have the option to pass on the increased input prices (producer price inflation) to finished goods. 

Going forward, in an uncertain macroeconomic environment, the certainty of future earnings and growth will be key: Infrastructure and utilities significantly outperform other equities on this measure, with the impact of the pandemic and large trends such as decarbonisation in the face of climate change either largely known or highly predictable. 

Inflation and Infrastructure Assets

Uniting our base case and alternate views is higher inflation, and we have written extensively about how inflation is generally a pass-through for infrastructure assets. 

Generally, user-pays infrastructure and utility returns are positively correlated to inflation, but results differ by sector and region. 

Some sectors have a direct link to inflation: Utilities in the UK, parts of Europe and Australasia have returns and often asset bases indexed to inflation annually. 

Toll roads have earnings rates indexed to inflation on a quarterly or annual basis. Airports will often have inflation-indexed retail leases and regulatory regimes for aero-nautical activities. 

Sectors with indirect links to inflation include utilities regulated on a nominal basis, as in North America and parts of Europe, where the utility commissions generally provide an allowed return based on a nominal RoE invested in their asset bases. 

There the inflation pass-through may lag as the RoE, capital structure and costs are adjusted when the utility files for its rate case. 

Pipelines include regulated and commercial activities; while there is inflation pass-through for the regulated component of the business, the level and speed of inflation pass-through for the commercial activities depends on the nature of the contracts underpinning those activities. 

Should inflation persist as we believe it will, infrastructure portfolios will hinge mainly on what type of growth we see: Amid lower growth, we would look to add utilities, with bond yields lower and utilities not sensitive to a downswing in GDP. 

If growth surprises to the upside, transport infrastructure, in particular toll roads, will look attractive as higher GDP would result in higher economic activity and higher throughput. 

The Other Inflation: Climate Inflation

Once pandemic-related supply inflation begins to fade, looming not too far off is climate inflation, which remains a relatively under-discussed issue. 

We expect climate inflation to begin to appear in the middle of this decade and likely run for a decade or two. 

There are several drivers for this: Carbon pricing will be critical to delivering market-based decarbonisation, even while this likely leads to higher prices for everything in the medium and long term. 

For example, the European Union Fit for 55 programmes will implement a carbon border adjustment mechanism, which will result in carbon being priced into goods (across a range of industries) sold in Europe and may result in a decade of rising prices. 

Among renewables, project build costs are now starting to rise because of rising commodity costs (copper particularly). 

Additionally, the nature of renewable energy generation will require significant additional electric transmission lines and additional generation to offset the interruptible nature of renewables. 

A Quick Word on Valuations 

Infrastructure looks attractive from a valuation perspective. Common earnings multiple metrics for global utilities and user-pays infrastructure has traded in the 10 times to 12 times range since 2012, adjusting the earnings of infrastructure companies, particularly airports and passenger rail networks, for the impact of the pandemic. 

Yet over the last decade we have seen a steady decline in the cost of capital for utility and infrastructure companies, combined with an increase in forward earnings growth, particularly in the utility sector that is investing in its asset base to decarbonise economies and mitigate the effects of climate change. 

We believe the market has not taken into account the cheaper cost of capital and better growth profile for these sectors. 

Based on this disconnect, we believe there is room to run for infrastructure in 2022. 


Nick Langley is the MD and portfolio manager of ClearBridge Investments LLC 

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