By Jayson Forrest - Managing Editor - IMAP Perspectives
In a wide ranging discussion on real assets at the 2022 IMAP Portfolio Management Conference, John Julian (AMP Capital) and Dan Cave (Zenith Investment Partners) consider the role of infrastructure in portfolios, particularly as a defence against inflation.
As an asset class, global infrastructure is extremely diverse. Often considered an alternative asset class, infrastructure encompasses investment in the facilities, services, and installations considered essential to the functioning and economic productivity of society. Think airports, hospitals, telecom towers, bridges, and energy supply.
Whether infrastructure is accessed through either public or private markets, it essentially offers the investor access to the same types of asset. However, each approach is different, having implications for a portfolio, says John Julian - Managing Director, Global Infrastructure Equity at AMP Capital.
Speaking at the 2022 IMAP Portfolio management Conference, John says ultimately, the decision to access infrastructure through public or private markets comes down to which approach best suits an investor’s portfolio objectives.
When looking at an infrastructure business, whether it be a publicly-listed or private business, there are certain common characteristics that AMP Capital looks for. These mean the asset:
* must provide essential services, meaning that it’s an asset that people have to use on a daily basis, which helps to provide resilience through market cycles;
* should benefit from a natural monopoly position, or enjoy high barriers to entry in the market in which it operates;
* should have consistent and predictable cashflows, often derived under regulated frameworks or long-term contractual arrangements; and
* have inflation-linked cashflows.
And in today’s high inflation environment, John believes infrastructure offers the investor an added benefit as a hedge against inflation. However, he qualifies this by saying that it does depend on the type of infrastructure asset. And similarly, whether the asset provides a full or partial hedge depends on the characteristics of the asset.
He explains: “In any conversation about infrastructure, it’s important to acknowledge the heterogeneous nature of the assets. Despite the fact that assets might look very similar on the surface, they may be subject to very different drivers of risk and return. And for that reason, it’s very important to understand each individual asset’s underlying specific characteristics.”
According to John, many infrastructure assets have their revenues linked to inflation, but this varies by sector, asset, and jurisdiction in which the asset is located.
Some examples include: built-in contractual inflation escalators (a clause in a contract providing for increases or decreases in price depending on fluctuations in inflation); through the regulatory framework, in which the asset operates; or the asset having pricing power by occupying a monopolistic position within the market, and therefore, being able to limit the impact of inflation to its users.
John Julian - AMP
Dan Cave - Zenith Investment Partners
In any conversation about infrastructure, it’s important to acknowledge the heterogeneous nature of the assets. Despite the fact that assets might look very similar on the surface, they may be subject to very different drivers of risk and return.”
An inflationary environment
While the market is expecting to see inflation rise this year, John believes it’s important to not just think about inflation in isolation. Why? Because inflation is just one of many factors that influence the performance of infrastructure assets, and often those factors are interrelated, he says.
As an example, John points to the economic outlook for Australia for this year, where the headline inflation is expected to reach 5 per cent by the end of the year, with an increase to the cash rate of 0.75 per cent. AMP Capital is also expecting real GDP growth to be strong, rising to 4.5 per cent on an annual basis by year’s end, giving a nominal GDP growth rate of 9.5 per cent. All of these factors, says John, will influence the performance of infrastructure assets.
“This type of inflationary environment is likely to increase demand and usage of many types of infrastructure assets, however, their operating costs are likely to increase. The net impact of these factors on infrastructure cashflows and valuations, depends on how those positive and negative impacts balance out,” he says.
This type of inflationary environment is likely to increase demand and usage of many types of infrastructure assets, however, their operating costs are likely to increase. The net impact of these factors on infrastructure cashflows and valuations, depends on how those positive and negative impacts balance out
Impacts of infrastructure cashflows
To demonstrate the net impact of the current inflationary environment on infrastructure, John compares the positive and negative impacts of three different infrastructure categories: growth linked assets (airports, toll roads), regulated assets (electricity transmission and distribution, water supply), and public private partnerships (schools, hospitals).
Growth linked assets
The positive impacts expected on assets in the current environment include:
* Patronage increases with growth; and
* Service charges can increase due to inflation (or other factors, like demand).
The negative impacts include:
* Operating costs to increase with growth and inflation; and
* Potential increased cost of debt, but mitigated through hedging.
Regulated assets
The positive impacts include:
* Throughput increases with growth; and
* Inflation-linked service charges.
The negative impacts include:
- Operating costs increase with growth and inflation;
- Ability to raise prices is constrained; and
- Potential increased cost of debt, but mitigated through hedging arrangements.
Public Private Partnerships
The positive impacts include:
* Passthroughs on consumables; and
* Revenues are often partially or fully hedged to inflation.
The negative impacts include:
* Residual risk to inflation where revenues are only partially hedged; and
* Potential increased cost of debt, though very limited due to long-term hedging arrangements (often for the full term of the concession).
“The net effect of these varying impacts on infrastructure cashflows, means we are generally positive for growth linked assets, neutral to moderately positive on regulated assets, and neutral to slightly negative on Public Private Partnerships,” says John.
The net effect of these varying impacts on infrastructure cashflows, means we are generally positive for growth linked assets, neutral to moderately positive on regulated assets, and neutral to slightly negative on Public Private Partnerships
Opportunities in the market
Given the current macro environment, with high inflation and interest rates, and persistent geopolitical issues, are there sectors investors should be looking at?
“In a high growth, high inflation environment, we’d expect growth linked assets to do well, like North American rail and airports, which have been through a torrid time with COVID, but they are coming off a low base. Having invested in infrastructure over the years, we’ve seen a number of aviation shock events, but airports do bounce back and that’s what we expect to see coming out the other side of this pandemic,” says John.
And what about the effects of the Russia/Ukraine conflict? How is that impacting infrastructure, like airports?
“The conflict has had a significant impact on the price of oil, which is one of the factors driving inflation and higher costs,” says John. “And a secondary impact has been the change to air traffic routes over Ukraine and Russia, which is significantly adding costs to aviation companies. Typically, airlines take the first hit on these types of costs, although eventually - and quickly - they get passed onto customers through increased passenger and freight fares.”
AMP Capital is invested in five airports, including three in Europe, and what it’s already seeing is an increase in energy costs.
About
John Julian is Managing Director, Global Infrastructure Equity at AMP Capital.
This session ‘Do real assets offer protection from inflation’ - was part of a discussion on real assets at the 2022 IMAP Portfolio Management Conference.
This session was moderated by Dan Cave, Senior Investment Analyst at Zenith Investment Partners.