The coming tide will test investors

Mia Kwok

Livewire Markets

A classic Buffett-ism is "Only when the tide goes out do you discover who's been swimming naked" and Lazard Asset Management's infrastructure portfolio manager Warryn Robertson believes a lot of investors are about to be caught out by the coming tide.  

"A pandemic recession is different to a normal recession - we all know about this, but we haven't thought about it in this sense," said Robertson. 

The economy had to shrink on both supply and demand sides of the equation, which is why the recovery has been so strong. But what does this mean for investors? It means we aren't out of the woods when it comes to inflation. 

Inflation shock won't impact all assets in the same way. Infrastructure is a sector that is largely inflation resilient. Often pricing power resides with the infrastructure provider or the regulator, hence the regulatory environment is crucial to the success of an infrastructure asset.  

But out of 95 viable major infrastructure assets, Robertson said only 25 names have made the cut.

"The majority of the universe is too expensive. Infrastructure is a safe asset, but not if you buy it at the wrong price," he said. 

In this video, Robertson breakdown the infrastructure headwinds and provides two safe options. 

Warryn, tell us a little bit about the risk of inflation and the current outlook and how this is impacting global infrastructure markets.

Sure. It's interesting that people talk about the risk of inflation now. When we first sat down as a team and started to think about the impact of the pandemic, one of the economic principles that we came up with was that a pandemic recession is different from a normal recession, and what I mean by this is that we anticipated that inflation would become a bigger risk. A pandemic is different and we all know about this, but we haven't thought about it in this sense, in a normal recession as I said, demand shifts to the left just as it did during the COVID-19 pandemic but also we had supply disruptions. Manufacturing processes had to stop, there were situations in the aggregate supply curve that made it also move to the left.

So, you had the economy shrink both ways and that is not necessarily deflationary across the board, it could be inflationary depending on if demand fell less than supply. 

Now, what's certainly our core belief is that in the short to medium term probably over the next three to six months, demand will increase and you will see the recovery out of the pandemic allow for that demand curve to shift back, but it will shift back far more easily than the supply curve will and that we believe will be inflationary in pockets.

Do you think that some of that is already priced in? A lot of people have been tracking the rebound as it gets delayed by vaccinations and it comes back again. How do you avoid that sense that it's priced in already and where do you find the pockets of opportunity?

To answer your question specifically, there are a number of examples we think in markets today where the demand is certainly recovering and we're seeing that with traffic volumes in some of the toll roads particularly in Europe but also in North America and we think that the market is anticipating that there is some recovery there, but where the inflation shock will come through, we're not seeing that reflected universally across the board. If interest rates rise because inflation rises and you've got an infrastructure stock like Spark Infrastructure or OzNet both of which are undertaken out a bit today or National Grid in the UK - they have full inflation protection. So, if inflation rises in Australia or the United Kingdom then it's reflected immediately in the rights and there's full inflation protection for those assets.

In the US, it's subtly but importantly different. There isn't an automatic adjustment in the vast majority of regulatory arrangements in the US. So, if inflation does pick up in the US, regulators have to acknowledge that inflation's higher I need to allow a higher return. And we think that's why we've been cautious around US utilities, but so constructive and found European utilities attractive. It's that nuance of difference that we think the investment market has essentially said, regulators are going to allow mid-cycle return on equity in the US, but we're going to capitalise it at below mid-cycle or almost trough level risk-free rates and that gap between the risk-free rate and the allowed return on equity is the widest it's ever been. The infrastructure market today it's similar to most investment markets around the world, most things are expensive.

So, finding quality infrastructure assets that fulfil our preferred infrastructure criteria that are attractively priced is becoming a far more difficult exercise than it was five, six years ago. Low interest rates have driven expectations of investors to low return levels that we think don't fully compensate you for the risk in most situations. 

Of the 95 investment opportunities that we have today, we own a very concentrated portfolio of 25 names. The reason for that is, the vast majority of our universe we think is expensive.

And so, infrastructure's considered safe assets and they genuinely are, but it doesn't mean they're a safe investment unless you buy them at the right price and our belief is that the vast majority of the infrastructure universe is expensive probably to the tune of 25, 30%. So, that's why we've concentrated in those 25 names that we think will generate around inflation plus 5% return over the next five years. But it will come with some volatility with markets at these elevated levels we're expecting some volatility in equity markets and caution is really important now.

The key thing if I must say it around infrastructure and around equity markets in general is the last place you want to be invested is in a well-diversified index fund. You need to be concentrated, you need to be selective and you need to be with managers who are prepared to make those active investment decisions now more than ever, because it is very few companies that are attractively priced and when the tide does go out, we'll find out who's been swimming naked.

Learn more

Warryn's Global Listed Infrastructure Fund offers access to an attractive asset class with low correlation to global equities and fixed income over the long term and is managed by one of the world’s most experienced listed infrastructure teams. Find out more below. 

Managed Fund
Lazard Global Listed Infrastructure Fund
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Mia Kwok
Livewire Markets

Mia Kwok is a former content editor at Livewire Markets. Mia has extensive experience in media and communications for business, financial services and policy. Mia has written for and edited several business and finance publications, such as...

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