The covid-19 pandemic has reverberated through the global economy, corporate profits and consumer confidence, and caused investors to recast their return expectations across asset classes.
Looking back to financial year 2020, international stocks delivered positive returns on the back of huge fiscal and monetary stimulus measures, but infrastructure companies fell over the period as restrictions on everyday activity, including air and road travel, hit this pocket of the global equity universe to a greater degree.
Notwithstanding our expectations for higher volatility in the short to medium term driven by this health crisis, we are confident that the infrastructure asset class - as we've defined it - will deliver investment returns of 5% above inflation over an investment cycle.
Here, I seek to outline how we think about the investment case for infrastructure, the impact of the covid-19 crisis upon the different sectors that make up this asset class and their outlook.
The investment case for infrastructure
Central to the investment case we make for infrastructure is that such assets generally produce reliable earnings because they provide services that are essential to the efficient functioning of communities and face limited, if any, competition.
Because the services provided by infrastructure companies are essential, the prices charged can be increased with limited impact on demand.
As a result, earnings are reliable and generally enjoy inherent protection against inflation.
Over time, the predictable earnings derived from infrastructure assets are expected to deliver income and capital growth for investors.
The sector-level impact of covid-19
Our investment universe comprises regulated utilities (water, gas and electricity) and infrastructure companies (toll roads, airports, communications infrastructure, energy infrastructure and rail). Overall, the health emergency has hit infrastructure businesses harder than utilities and we can expect to see a disparity in short-term earnings pressure across the universe.
The lockout of physical commerce in response to covid-19 has hit utility volumes and utility operating costs. Data from the US Energy Information Administration shows that the volume of electricity demanded in the US fell about 5% in April 2020 and 7% in May 2020.
- The drop reflects the reduction in commercial and industrial electricity volumes as businesses closed due to quarantine requirements. This effect has been somewhat offset by an increase in household demand due to people working from home.
- The crisis is likely to lead to pressure on short-term earnings unless the regulated utilities can take actions that will offset this. However, regulators generally allow losses incurred due to issues outside of the control of the regulated utility to be recovered by the utility over the near to medium term by socialising these costs across the customer base.
- Due to this regulatory arrangement, regulated utilities might face some short-term declines in earnings but we do not expect significant changes to their long-term earnings outlooks.
In an environment where our base case is that economic growth will be difficult to come by and interest rates are likely to remain at historically low levels, we believe regulated utilities remain attractive investment propositions.
In response to the crisis, airports were quick to ensure they had sufficient available cash to pay their expenses by raising debt and suspending dividends. The large listed airports in our universe were able to raise significant amounts of debt.
- For example, Sydney Airport announced on April 20 that it had raised an additional A$850 million, Aena of Spain raised more than 1.9 billion euros in April and May while ADP of France raised 2.5 billion euros in April. The ability to quickly raise significant amounts of debt reflected the powerful earnings track record of airports and the expectation from debt providers that when the crisis is over airports will again generate reliable earnings.
- After each shock in the past (e.g. 9/11, SARS and the GFC), aeronautical activity rebounded strongly such that the number of passengers travelling quickly rose above previous levels. The desire to travel meant that the demand for long-distance mobility won out.
- Despite this track record, the impact of the covid-19 crisis on the aviation sector is unlike anything the industry has previously experienced.
We expect that travel volumes will progressively return as the desire to travel reasserts itself but that the time period over which it takes to return to previous levels will be much longer than experienced in previous shocks.
Accordingly, we remain cautious about the investment prospects for airports compared with other infrastructure sectors.
The combination of government-mandated quarantines and the lockout of physical commerce has led to significant reductions in traffic on all roads.
- While the covid-19 crisis has made movement around and between communities more problematic in the short term, we expect traffic to return to more normal levels over the medium term. Indeed, traffic is ultimately a function of population and economic development in the communities the toll roads serve.
- By the middle of June, average daily traffic for Atlantia’s roads in Italy and France, where the lockdown conditions had been loosened, was down by 26% to 28%; that is to say, the level of average daily traffic had recovered from being more than 80% down to about 30% down. For Atlantia’s roads in Spain, average daily traffic had fallen by approximately 50%, which reflected the stricter lockdown conditions still applying in Spain.
While toll roads will face a hit to earnings in the short term, we are confident that traffic and consequent earnings will return to more normal levels over the medium term.
Indeed, given the natural reluctance of people to travel on public transport in the absence of a vaccine it might be that traffic levels return to pre-covid-19 levels relatively quickly.
The quarantining of communities and the shutting down of physical commerce have proved to be significant blows for rail companies.
- For example, the volumes transported by CSX declined by 21.5% in the second quarter of 2020 (the 12 weeks ended 13 June 2020) compared with the same period a year earlier, according to the Association of American Railroads.
- However, the US rail businesses are diversified across industries and we expect volume losses due to interruptions to supply and economic decline to be recouped as the US economy recovers.
While railroads will face a hit to earnings in the short term, we are confident that as the US economy recovers, rail will enjoy rising freight volumes. This will lead to a recovery in the earnings of rail companies.
Communications infrastructure companies have been largely unaffected by the covid-19 crisis. Many customers have experienced increased network demand due to an increase in the number of people working from home.
- Further, in the US and most other countries, communications were deemed an essential service and investments in infrastructure exempt from quarantine orders.
- While increased near-term demand is unlikely to provide an immediate boost to revenues for communications infrastructure companies due to the nature of the contracts, investments by customers in response to more permanent shifts in behaviour are likely to support demand for their assets over time.
- For consumers, social isolation and working from home have demonstrated the importance of high-quality broadband networks.
As Jessica Rosenworcel, Commissioner of the US Federal Communications Commission, recently noted: “This pandemic has demonstrated conclusively that broadband is no longer nice-to-have. It’s a need to have.”
We expect the earnings of communications infrastructure companies to be highly defensive in response to this crisis and the outlook to remain positive as demand for data grows and network investment required to meet this demand is made.
The customers of energy-infrastructure companies are typically energy producers and these companies face reduced revenues and earnings due to a decline in energy prices.
- If these customers have solvency issues then this could lead to an increase in bad debts, but access to energy-infrastructure services is essential to the ability of energy companies to earn revenues; that is to say, the use of energy-infrastructure services is non-discretionary if energy companies want to get their product to their customers.
- Typically, the overwhelming bulk of customers are investment-grade credit quality. For example, Enbridge has noted that more than 95% of customers are investment-grade credit quality while APA Group, an Australian gas pipeline company, has noted that 93% of revenues are derived from investment-grade customers.
The shutdown of many businesses and any consequent slowdown in the economy could lead to a reduction in the volumes transported across energy networks. While the revenues energy-infrastructure companies earn from transporting oil and gas can change with movements in volumes, underwritten ‘take or pay volumes’ usually account for the majority of revenues so we assess their exposure to volume decreases as low.
In terms of our outlook, we believe that infrastructure assets, with their reliable earnings that are protected to a degree from inflation, are an attractive long-term investment proposition.
An investment in listed infrastructure can be expected to reward patient investors.
- At 31 December 2019, the Magellean Infrastructure Fund had an allocation of about 55% to infrastructure, including an allocation of about 18% to airports and about 40% to utilities with less than 5% in cash.
- At the end of June 2020, the investment portfolio comprised about 45% regulated utilities, 45% infrastructure and 10% in cash.
Following the onset of the covid-19 crisis we adopted a more defensive positioning. We reduced exposure to infrastructure, and particularly to airports, and increased our allocation to regulated utilities and cash.
Looking out to the through the cycle, we believe the predictable nature of their earnings compared with those offered by other asset classes means that infrastructure assets offer diversification benefits. In uncertain times, the reliable financial performance of infrastructure stocks makes them particularly attractive.
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