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With recession likely in Q3, look to infrastructure for downside/upside capture: ClearBridge
The “most anticipated recession ever” is set to become a self-fulfilling prophecy, but it will be deeper and last longer than the market consensus expects, according to ClearBridge Investments – and for investors looking for opportunity amid the uncertainty, the fund manager says listed infrastructure offers plenty of upside in multiple economic scenarios.
Understanding the effect of macroeconomic events on the fundamental values of stocks provides investors with agility in shaping a resilient portfolio. In a new white paper, portfolio manager Nick Langley (pictured) examined the impact of six short- and long-term economic scenarios, including a severe credit event and stagflation, on Clearbridge’s Global Infrastructure Income Strategy, and found macroeconomic changes would have positive effects on returns in most cases.
Infrastructure can broadly be divided into two subsectors: regulated and contracted utilities, considered more defensive, and the more economically sensitive “user pays” infrastructure such as airports and toll roads. Both subsectors provide exposure to an uncorrelated asset class that can offset higher interest rates and inflation, with the potential to maximise upside and downside capture through active portfolio rebalancing.
The utilities subsector, according to Langley, is “the very defensive end of infrastructure, and the very, very defensive end of markets generally”. With fewer companies in the space and a regulator matching their pricing models to the current economic environment, utilities have power to pass changes in bond yields and inflation through to their customers.
In contrast, he said, “think about user-pays as being linked to business cycles because they’re usage-based assets, and think about them as longer-duration assets because they don’t have the ability to reset their prices based on changes in bond yields”.
These different profiles mean an infrastructure allocation can be tweaked in response to macroeconomic changes to achieve the greatest benefit from a given scenario. The white paper tested the infrastructure sector’s resilience in the event of three potential short-term or cyclical scenarios – a severe credit event, quantitative tightening and stagflation – as well as the long-term, structural scenarios of financial repression, deglobalisation and climate inflation.
“Testing three key variables – inflation, real GDP growth and the change in 10-year nominal bond yields – our analysis indicates infrastructure returns demonstrate resilience”, according to the white paper, with the effect of macro changes on returns “positive in most cases”.
Looking at inflation, for example, different types of infrastructure stocks will have different means of passing rising costs through to consumers, as regulated utilities have their prices indexed to inflation annually or adjusted at incremental regulatory resets, allowing for direct or indirect pass-through of inflation.
“These transmission mechanisms are key to delivering a more stable earnings profile to infrastructure companies relative to other equities,” the paper stated. For instance, comparing returns for infrastructure and global equities from 1999 through 2021, it notes that infrastructure had only one year of negative returns, in pandemic-affected 2020, while global equities saw negative returns in seven years (see chart).
Meanwhile, the white paper found regulated utilities tend to have little long-term GDP exposure, “although a high-growth economy will require additional energy infrastructure and therefore result in higher asset base growth for local utilities”. In contrast, while user-pays infrastructure companies’ pricing is generally set by regulation or concession contracts, they have exposure to GDP growth because of cyclical impacts on toll road traffic and passenger volume.
As for the longer-term, structural changes examined in the paper, financial repression – which assumes central banks and governments allow inflation to run hotter while keeping bond yields low – “represents a solidly positive outcome for infrastructure returns, as the scenario would likely result in an upward revaluation of all financial assets as the ‘risk-free’ rate would likely be reassessed downward,” according to ClearBridge.
“Deglobalisation is a substantial headwind; however, it still provides investors with an expected return of about 9 per cent per annum of a five-year investment horizon.”
With ClearBridge director and investment strategist Jeff Schulze highlighting ClearBridge’s Anatomy of a Recession program showing a recession likely in the third quarter of this year, agility will become especially important for infrastructure investors crafting a portfolio that responds to the economic backdrop.
To that end, Langley stressed that active rebalancing of utilities and user-pays exposure is paramount, adding that active management, “unconstrained by reference to a market index,” can help investors navigate the various potential macroeconomic scenarios and focus on the stocks that will provide the best returns.
“When we come to sell those stocks in five years’ time, it’s clear that we’ll be in a different environment, likely with bond yields lower and inflation and growth a little bit higher,” he said. “You want to own some infrastructure in your portfolio should that occur.”
