CONTRIBUTORS
Nick Langley
Portfolio Manager
ClearBridge Investments
Key takeaways
- We view pressure on infrastructure from rising real yields in 2023 as a short-term phenomenon, while infrastructure’s inflation pass-through worked well, supporting earnings across the asset class.
- If 2023’s spike in real bond yields fades, we expect a significant uptick in the valuations for infrastructure companies; even if bond yields don’t roll over, merely reduced volatility could be supportive for valuations.
- We believe a recession is still a strong possibility and with a higher-than-normal concentration in equity markets, infrastructure provides a significant (and cheap) diversifier within a portfolio.
A challenging 2023, but inflation pass-through is working
In 2023, increasing earnings and strong fundamentals were not enough to keep infrastructure valuations from falling due to the rise in real bond yields, and the group underperformed the broader equity market. Real yields in the US rose 1% in 2023 (as of November 30, 2023), resulting in a contraction in price/earnings multiples for utilities from 19x to 17x.1 Utility and wireless towers companies in the S&P 500 Index sold off roughly 10.5%, creating a challenging environment for infrastructure portfolios built around these steady, defensive and income-producing businesses.
At the same time, we believed this would be a shorter-term phenomenon, and accordingly we saw infrastructure’s inflation pass-through working well, supporting earnings across the asset class. It can take anywhere from a few months to a few years for inflation to come through in infrastructure companies’ financials. A toll road, for example, can increase its prices along with inflation generally every quarter, but at minimum every year, while a US utility must wait until it negotiates rates with its regulator, which may not be for a year or two, and then the price increase arrives a year after that. Given these dynamics, we expect allowed returns to increase, even if for most of 2023 we saw some valuation compression for infrastructure due to this variable lag.
We have seen this yield-driven volatility before. As in 2023, in 2018 infrastructure returns relative to equities declined as real bond yields increased (Exhibit 1). Nonetheless, as rates began to decline after October 2018, infrastructure returns outperformed the broader equity market.
Exhibit 1: Infrastructure Has Outperformed as Real Yields Have Fallen
Source: ClearBridge Investments. December 2015 to December 2019. Infrastructure: FTSE Global Core Infrastructure 50/50 Index; Global Equities: MSCI All-Country World Index (ACWI). Real yields calculated as US 10-year Treasury yield adjusted for 10-year breakeven inflation. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Stable or falling bond yields would support a rebound
If 2023’s spike in real bond yields fades, we expect a significant uptick in the valuations for infrastructure companies in the next year or two. We don’t necessarily need bond yields to roll over for investors to benefit from the returns of infrastructure; merely reduced volatility could be supportive for valuations. Should yields fall if economic activity starts to slow, the long end of the curve would come down and those valuations could recover more than the whole of that current gap.
Infrastructure’s diversification benefits could be timely
Importantly for 2024, markets are now pricing a US recession at odds of around 15%, which is extremely low for this point in the cycle—that is, in the midst of the fabled “long and variable lag” time period following an unprecedented rise in cash rates. We believe a recession is still a strong possibility and with a higher-than-normal concentration in equity markets, infrastructure provides a significant (and cheap) diversifier within a portfolio. The past year has been dominated by the Magnificent Seven, but infrastructure should continue to add ballast to a portfolio, which we believe could generate strong return potential over the longer term.
Any slowdown in economic activity in 2024 puts corporate earnings broadly at risk. However, we continue to see positive earnings revisions for infrastructure companies, particularly utilities, based on that pass-through of inflation and growth in their underlying asset bases as the energy transition continues. We expect to enter 2024 with positive earnings revisions for infrastructure just as broader equities begin to see negative earnings revisions.
Strong fundamentals and favorable valuation backdrop will likely define 2024
Against this backdrop, entering 2024 infrastructure is trading at historically attractive valuations given the growth prospects of infrastructure companies. Much of this growth will be driven by the energy transition as the world addresses its need to build out the networks of poles and wires to connect all the renewable facilities generators. A public policy tailwind is particularly prevalent in the US (following the Inflation Reduction Act or IRA) and Europe (following REPowerEU and the Green Deal Industrial Plan). We expect this to strengthen in 2024, given it will be an election year in many jurisdictions.
Endnote
- Source: S&P Global.
Definitions
The FTSE Global Core Infrastructure 50/50 Index gives participants an industry-defined interpretation of infrastructure and adjust the exposure to certain infrastructure sub-sectors. The constituent weights for these indices are adjusted as part of the semi-annual review according to three broad industry sectors – 50% Utilities, 30% Transportation including capping of 7.5% for railroads/railways and a 20% mix of other sectors including pipelines, satellites and telecommunication towers.
The MSCI All-Country World Index (ACWI) captures large and mid-cap representation across 23 developed markets and 24 emerging markets countries.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the US.
The Magnificent Seven are megacap company stocks focused and capitalizing on tech growth trends including AI, cloud computing, and cutting-edge hardware and software. The companies included are Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla.
The Inflation Reduction Act was signed into law by US President Joe Biden on August 16, 2022. The Act aims to curb inflation by reducing the deficit, lowering prescription drug prices, and investing in domestic energy production while promoting clean energy.
REPowerEU is a European Commission proposal to end reliance on Russian fossil fuels before 2030 in response to the 2022 Russian invasion of Ukraine.
The Green Deal Industrial Plan provides a framework to support the transition of European industry toward climate neutrality and to develop the net-zero technologies necessary to achieve the European Union's climate targets.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Diversification does not guarantee a profit or protect against a loss.
Companies in the infrastructure industry may be subject to a variety of factors, including high interest costs, high degrees of leverage, effects of economic slowdowns, increased competition, and impact resulting from government and regulatory policies and practices.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.