Analysing infrastructure performance in a low-growth environment

In this paper, we review the current economic outlook, consider the investment outlook for “mainstream” asset classes in developed markets, and also look at the roles that alternative investments can play in a portfolio.

In the second part of this series, we will examine how different categories of infrastructure are likely to perform in a low growth, low interest rate environment, and the part infrastructure can play in mitigating downside risks in a portfolio.

In brief: the economic outlook

About 18 months ago, on the back of upbeat economic growth forecasts, we examined the effect of rising interest rates in developed economies on infrastructure valuations¹. Now, those economic forecasts are proving to be overly optimistic.

As can be seen from the above graph, the latest IMF world growth outlook is distinctly pessimistic (October 2019)². In particular, the IMF forecasts a very significant, and sustained, decline in growth among the major economies.

The forecast recovery in 2020 of overall world growth is due to improving prospects for emerging economies in Latin America and the Middle East.

International trade volumes are at their weakest levels since 2012,³ largely as a consequence of trade disputes. The IMF estimates that the US/China trade war has led to a decline in world growth of 0.8%, intensified the existing Chinese slowdown, and cost the US 0.5% of GDP growth⁴.

Uncertainty about the sustainability of UK and European growth post Brexit is also a significant concern.

The weak growth outlook affects Australia’s major trading partners and will impact the Australian economy. The IMF outlook for the Asia Pacific region, including China, has growth falling from 5.5% in 2018 to 5.0% in 2019 and 2020. Australia’s growth forecast is down from 1.8% to 1.3% in both 2019 and 2020⁵.

With the worsening economic outlook, there is genuine concern that the US economy may run out of steam all together and be facing a recession in the medium term.

AMP Capital’s Chief Economist, Shane Oliver, has examined risks of a future US recession in a series of reports^6,7, and notes that:

• Recessions are an inevitable part of the business cycle;
• The current period of continual US growth is one of the longest on record, but has been subdued in comparison with past growth cycles and many of the warning signs of a future correction, such as excessive wage growth, are currently absent.
  
• Consequently, he concludes that the current subdued US growth cycle still has a way to go.
  

In the face of the poor economic outlook, governments in developed economies will have little option but to push for resolution of the trade disputes and continue stimulatory measures.

Looking forward, the current low growth, low interest rate and low inflation environment looks set to persist for the next few years at least⁸.

Exploring the investment outlook in developed economies

The broad impact of this environment on equities and bonds, two commonly used asset classes, is discussed below.

Equity markets

Equity markets move in their own cycles which may not be in phase with economic cycles. Consequently, the current high prices in equity markets in a period of subdued economic growth is not unusual. As Shane Oliver points out, the record low yield of government bonds relative to share market dividends⁹, makes shares relatively more attractive than bonds and provides support for high share prices.

Additionally, the poor economic outlook in developed economies is likely to trigger further government stimulatory measures, including lowering of government bond rates where there is still headroom. This should continue to provide some level of support for high share prices.

However, there is a growing consensus among institutional investors that the current long bull run in equity prices may be nearing its end and prices may have peaked. The following graph shows the views of major institutional investors regarding where equity market prices sat as at June 2019¹⁰. Most of those surveyed (74%) felt that equities had peaked, an increase of 18% in just 12 months.

Recessions usually trigger bear markets¹¹. There are many potential triggers which could initiate a major US economic slowdown with potential flow on effects to equity markets. Principal among these would be escalation of the US and China trade war.

The US share market has a major influence on markets around the world. The below graph¹² is an illustration of this relationship. It shows the historical US S&P 500 and the Australian ASX 200 total return indices. This shows that the Australian index largely moves in concert with the US S&P 500, especially since the GFC.

Bonds

The traditional role of bonds in many investment portfolios has been to exploit the low correlation between bond yields and listed equities to provide a partial hedge to listed equity market volatility, while delivering acceptable yields with low risk.

Government bonds have traditionally been the preferred option because of their low risk in comparison to corporate bonds. However, government bond yields are already at historical lows, as can be seen from the below graph¹³.

This leaves limited headroom for governments to use monetary policy for further economic stimulation.

Moreover, low government bond yields reduce both their attractiveness to an investor seeking yield and their effectiveness in hedging equity market volatility.

This outlook for government bond yields suggests that investors will continue to seek other investments to fill the traditional role of government bonds in portfolios.

Options may include:

• Corporate bonds, which can provide reasonable yields albeit at higher risk than government bonds. A highly diversified corporate bond portfolio can reduce these risks to a degree; and
• Alternative investments – see below.

Alternative investments

‘Alternative investments’ is a reference to a wide range on investments which are not traded through exchanges (hence ‘alternative’ to equities and bonds). They may include direct investments in real assets (such as infrastructure and real estate) or investment in a portfolio of assets through specialist wholesale funds. Such investments tend to be illiquid which may limit their maximum prudent level of allocation in a portfolio.

Alternative investments have enjoyed growing support from institutional investors, with allocations among the investors surveyed by Preqin reaching $US9.1 trillion in 2018, a threefold increase since 2008.

Allocations are set to further increase, with the main beneficiaries being Private Equity, Private Debt and Infrastructure, as shown in the following graph from Preqin¹⁴.

The following radar plot provides an indication of the roles that institutional investor expect these three investment classes, which are receiving increased allocations, to play in their portfolios over the next 12 months¹⁵.

As can be seen in the above chart, institutional investors are looking to infrastructure for its low correlation to other asset classes, for diversification, and to provide a reliable income stream.

As we have explored in previous articles, a diversified portfolio of unlisted infrastructure has a very low correlation to equity markets¹⁶ and low to moderate leverage to the economic cycle. Unlisted Infrastructure provides high levels of diversification and low correlations with other asset classes, together with reliable yield.

Taken collectively, these insights may assist investors as to the role infrastructure could play in their own portfolios.

In the concluding second part of this series, we will take a closer look at how different categories of infrastructure are likely to perform in a low growth, low interest rate environment, and consider the part that the infrastructure asset class can play in mitigating downside risks in a portfolio.

¹ The Impact of Rising Interest Rates on Infrastructure, February 2018 
² World Economic Outlook, October 2019, International Monetary Fund
³ World Economic Outlook, October 2019, International Monetary Fund
⁴ World Economic Outlook, October 2019, International Monetary Fund
⁵ Regional Outlook, Asia and Pacific, October 2019, International Monetary Fund
⁶ The US economy – does the flattening yield curve indicate recession is imminent?, July 2018, Oliver’s Insights
⁷ The longest US economic expansion ever – does this mean recession is around the corner?, July 2019, Oliver’s Insights
⁸ Negative rates, QE & other measures the RBA may deploy, August 2019, Shane Oliver
⁹ Plunging bond yields & weak share markets amidst talk of recession, August 2019, Shane Oliver
¹⁰ Preqin Investor Interviews, June 2018-June 2019. Note: Preqin is a respected consulting group that conduct regular interviews of nearly 500 major global institutional investors to determine their perspectives
¹¹ Falls of >20%, sustained for at least 12 months; Investopedia
¹² AMP Capital; Standard & Poor’s; Australian Stock Exchange. Total return indices are calculated assuming that dividends are reinvested
¹³ Global Financial Data, AMP Capital. See: Negative interest rates, QE and other measures the RBA may deploy
¹⁴ Preqin Investor Interviews, June 2019
¹⁵ AMP Capital, Preqin, Overview of Alternative Assets: Preqin-CAIA Workshop, July 2019
¹⁶ The pros of infrastructure investment in a lower-for-longer environment; 10 October 2019; John Julian, Global Infrastructure Equity