What’s next for infrastructure? 

Tom Levering, Global Industry Analyst
Tim Casaletto, Global Industry Analyst
2023-12-31
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

As we look back at 2022, global equity markets experienced high levels of volatility driven by multiple factors. These range from the war in Ukraine and the subsequent natural gas and power crisis to rising interest rates and surging inflation as well as continued COVID-related supply-chain issues. Despite these headwinds, global infrastructure equities have provided relative protection compared to broad global equities (the MSCI ACWI). As we enter 2023, inflation is showing signs of peaking but with central banks still committed to curtailing demand, we think the probability of a global recession is rising. Countering these pressures are the potential reopening in China and improving supply-chain dynamics. Within this uncertain environment, we believe that infrastructure business models could offer continued relative strength. However, from our perspective, diversification and targeting those assets that display enduring qualities (Figure 1) will remain essential. Typically, we see these as companies owning physical assets with reduced levels of economic sensitivity and very long economic lives that provide essential services to the economy. Below we discuss our high-level outlook for each of the key areas. 

Figure 1
Enduring assets: an attractive universe

Utilities and renewables

  • US — The growth rate targets for the US utility sector have never been higher, with the average US utility forecasting growth rates in the 6% – 8% range. This growth is driven by more intermittent renewable energy displacing fossil fuel generation and is amplified by the associated necessary investment in electric grids. The Inflation Reduction Act that was passed earlier this year provides tax incentives for clean energy infrastructure that we believe should help these attractive growth rates persist for decades to come. We are also seeing strong growth from gas utilities replacing old gas distribution pipes to increase safety and reduce methane emissions. Lastly, it’s worth noting that utilities earn a regulated return that has historically been correlated with US Treasuries. A “higher-for-longer” environment for US interest rates should, over time, result in increased allowed returns. Similarly, renewable developers have already been able to pass on both higher raw material costs and higher cost of capital through their pricing, thus maintaining their current levels of value creation. 
  • Europe — We remain positive on the outlook for the European utility sector. In response to the Ukraine war, we expect significant investment in domestic European energy infrastructure as Europe focuses on security of supply (e.g., more electric networks, more renewables, more gas infrastructure). This investment, coupled with a strong commitment to decarbonisation and policies such as the European Commission’s REPowerEU plan, will, in our view, lead to attractive structural growth tailwinds for the European utility sector. Lastly, several European countries have regulatory utility pricing that is directly linked to inflation, which we think is particularly positive in this current macro environment, even allowing for potential windfall taxes.  
  • Asia/Emerging markets — We view the outlook for Asia and emerging markets more broadly as mixed. While every country is different, we find that Asian and EM-based utilities and renewable developers generally have both less favourable regulation and valuations compared to the US and Europe, except for China. We think the Chinese government’s target of net zero by 2060 aligns well with the growth ambitions of Chinese renewable energy developers and natural gas utilities who are part of the drive towards net zero. We recognise that this viewpoint feels contrarian today, but we consider specific Chinese renewable developers and gas utilities to have very attractive valuations, with the potential for longer-term outperformance.  

Data infrastructure

We see positive tailwinds for certain tower companies and telecom operators as the world increases its reliance on connectivity. Business models tend to be resilient to an inflationary environment as tower companies typically have embedded inflation indexation or price escalators in their contract structures, while telecom companies operating in healthy competitive environments tend to have pricing power that is more pronounced in periods of high inflation. In addition, we believe that many of these businesses combine stability and solid growth prospects with attractive valuations.  

Midstream energy

In general, we try to avoid businesses that have high commodity price sensitivity, but we do find value in parts of the midstream sector that earn a higher percentage of profits from stable, contracted segments (e.g., long-haul transmission). We also believe that growth opportunities have improved for midstream energy as more liquid natural gas (LNG) terminals are built in North America, which will require new gas pipeline infrastructure.  

Transportation

We are generally cautious about transportation infrastructure in this environment. Toll roads are more attractive because many operators are contractually allowed, at least partially, to inflation-proof their rates. However, we are concerned about companies with high leverage, which we believe is problematic in a period of high interest rates. We are also concerned that airport valuations do not adequately reflect the negative effect of a potential recession on passenger traffic and airport retail spend. While the rail sector’s economic cyclicality poses some near-term risks, we believe that as the lowest-carbon-emission form of transport, railways should maintain long-term pricing power and growth.

Bottom line

While equity markets are likely to remain volatile in 2023, we believe that the long-term outlook for global infrastructure assets remains attractive. With valuations well within historic ranges and positive growth opportunities in our favoured sectors, we see the opportunity for relative stability and, longer term, attractive forward returns.

Experts

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