The inherent benefits of infrastructure as an investible asset class have transformed this sector from sitting on the periphery of investors’ universes, to become a key component of diversified portfolios. The stable nature of returns due to long term contracted cash flows, inbuilt inflation protection from operator leases with CPI linkage, and the potential for diversification across a number of subsectors, vital to the functioning of society, provides an attractive opportunity for investors.
Despite their stable nature, infrastructure funds, and particularly those focused on investing in the UK, have been met with certain macroeconomic challenges in recent months. However, whilst there is no denying the current challenges facing UK infrastructure funds there are signs pointing to a recovery across the sector.
Increased inflationary pressure has caused a rapid and aggressive interest rate hike cycle to be implemented in the UK. This has proved challenging for infrastructure funds, with higher interest rates contributing to an upward shift in yield expectations. Whilst expectations in terms of where the rate cycle might peak and how long these elevated levels may persist might be overdone, this has resulted in companies owning income-producing assets within the infrastructure sector facing downward pressure.
This downward pressure is in part due to the impact of higher interest rates on discount rates, which are primarily used for asset valuation in the sector, and also, higher rates have meant that the yields available across other asset classes, particularly short-dated yields in the gilt market for example, have meant that there has been an opportunity for a rotation in portfolios, away from infrastructure.
Amidst the prevailing economic conditions, infrastructure assets have encountered significant pressure, leading to a considerable devaluation. This decline can be primarily attributed to the external macroeconomic factors mentioned above, rather than inherent weaknesses in individual company fundamentals.
Despite these macroeconomic challenges, the market remains optimistic. This stems from several positive factors that counterbalance any negative impacts resulting from elevated discount rates. Notably, if interest rates surpass predicted or modelled expectations, it will benefit the underlying net asset value and offset any increase in the discount rate. Moreover, higher inflation rates and a positive growth outlook can also serve as offsets to the discount rate. Additionally, higher interest rates typically lead to higher deposit rates, which is positive for cash held on balance in special purpose vehicles.
Resilience of cash flows has been seen across many companies in the sector, representing a silver lining for infrastructure funds. Notably, the renewables sector is anticipated to witness the most substantial dividend growth, largely due to the advantages of operating within a high-power price environment. Despite a slight retreat in power prices in recent months, the sector continues to experience a relatively elevated power price environment, sustaining its positive outlook.
Looking ahead, the infrastructure sector shows promising signs of long-term recovery, as evidenced by the recent price rally driven by positive inflation data in the UK. This highlights the disconnect between share prices and market valuations, indicating potential growth opportunities in the future.
As the market looks past immediate interest rate increases and envisions a more positive economic outlook, an opportunity arises for a recovery in infrastructure fund performance, positioning the sector for potential growth. In addition, the market’s response to modest inflation improvements suggests potential shifts in central bank interest rate policies. As investors anticipate a less aggressive approach to interest rates hikes, infrastructure funds have the potential to recover lost ground and regain their value.
In the short-term, companies within infrastructure portfolios are projected to deliver strong cash flow generation and income accrual, providing a compelling case for investment. The potential for asset recycling adds to this appeal, as it can bolster financial flexibility and allow funds to reduce debt by reinvesting in higher-yielding opportunities. Additionally, there is the possibility of investing in share buybacks, further enhancing the attractiveness of such investments.
The essential services provided by infrastructure assets, coupled with their consistent and stable cash flows, present a strong case for sector resilience, positioning infrastructure funds favourably in the event of a potential recession. Additionally, with assets currently trading at heavily discounted levels, there is significant recovery potential. New investors, commencing at these lowered levels, are securing attractive rates of return. This is particularly relevant when considering the discount rates embedded within portfolio valuations. Consequently, the downside risks are mitigated, and investors are effectively “paid to wait” for price recovery through an attractive income yield.
The diversified nature of infrastructure funds, combined with their exposure to various security types and historically stable returns, positions them for recovery. It is crucial to recognise that recent macroeconomic factors such as aggressive interest rate hikes and yield expectations have caused a turbulent period for the sector. Despite these challenges, there is substantial opportunity for recovery due to the resilience of cash flow generation and income accrual from portfolio companies.
As economic conditions improve and market sentiment shifts, infrastructure funds are poised to regain favour among investors seeking reliable income and capital appreciation. The outlook for the infrastructure sector remains promising, and with the right investment strategy and long-term perspective in place, infrastructure funds will continue to hold a crucial position in investors’ portfolios.
Gravis. Important Notice (2023)
Past performance is not indicative of future performance, the value of your investment may go down as well as up. This video is published for general information only and is not to be relied upon in any way. Although high standards have been used in the preparation of the information, analysis, views and projections presented in this video, no responsibility or liability whatsoever can be accepted by Gravis for any loss or damage resultant from any use of, reliance on, or reference to the contents. As a general report, the views and opinions contained herein may not necessarily represent views expressed or reflected in other Gravis communications, strategies or funds.