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4D podcast: interest rates, inflation and infrastructure

4D’s Global Portfolio Manager and Chief Investment Officer, Sarah Shaw, speaks with Bennelong’s Jodie Saw about the impact changing interest rates and inflation can have on infrastructure; and the opportunities presented in the asset class.

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“Given the distinct features of varied infrastructure assets, with active management a listed infrastructure equity portfolio can be positioned to take advantage of the long-term structural opportunity set, as well as whatever near-term cyclical events may prevail – whether they be environmental, political, economic or social.”


  • 0:36 – How exposure to infrastructure can be adjusted according to interest rates and inflation
  • 4:54 – Why the current equity market volatility is showing a disconnect to company fundamentals (and where the opportunities are)
  • 7:24 – Why 4D continues to like emerging markets over the long term
  • 8:39 – How the portfolio could be positioned in a stagflation or recessionary environment
  • 10:13 – The ongoing, critical need for global infrastructure spend


The content contained in this audio represents the opinions of the speakers. The speakers may hold either long or short positions in securities of various companies discussed in the audio. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the speakers to express their personal views on investing and for the entertainment of the listener.


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Jodie Saw:

Hello and welcome. My name is Jodie Saw, an account director with Bennelong Funds Management, and I'm pleased to be joined today by Sarah Shaw, the portfolio manager and chief investment officer with 4D Infrastructure. Welcome Sarah and congratulations on the release of your new hedged version of the 4D Global Infrastructure Fund.

Sarah Shaw:

Thanks very much. Yeah, we're really excited to be able to offer our existing and new clients access to both the hedged and unhedged version of the infrastructure asset class now.

Jodie Saw:

That's excellent. Sarah, global hedge headline inflation is high and interest rates are moving up. So should we expect infrastructure to underperform in these conditions?

Sarah Shaw:

Inflationary pressures have been building across the international economy over the past 18 months to two years, largely due to COVID supply chain disruptions, causing product delays and shortages. Together, we have very accommodative fiscal and monetary policy, which has boosted aggregate demands. The Ukraine invasion is also adversely impacting the global economic outlook, pushing up energy costs in particular. As a result, global monetary policy is now moving to become more contractionary, with official interest rates increasing around the world.

Infrastructure though, contrary to common belief, is an asset class that can provide investment portfolios with some protection against inflation and rising interest rates, depending on the type of infrastructure assets held. So the common market belief that all infrastructure stocks underperform as interest rates in inflation rise is incorrect. This is often associated with the perception of these stocks as being a bond proxy. The logic flows that just like the government bond, as interest rates rise share prices fall as the present value of their fixed future cash flows is now worth less and the required yield from the asset must increase to match the rise in market interest rates.

However, this is a very simplistic assessment and ignores the varied characteristics of asset in the infrastructure sector. In an inflationary scenario, some parts of the infrastructure universe, namely user pay assets, such as toll roads, airports, port and rail companies, can enjoy the perfect storm over the short to medium term. Interest rates that are still supportive of future growth, economic activity flowing through to volumes, and explicit inflation hedges through their tariff mechanisms to combat any inflationary pressure they may experience. In contrast, regulated utilities can be more immediately adversely impacted by rising interest rates inflation, because of the regulated nature of their business.

The flow through of inflation to revenues is dictated by whether their utilities return profile is real or nominal. If the utility operates under a real return model, the inflation is passed through into tariffs, much like a user pay asset. This model is more prevalent in parts of Europe and Brazil, for example, and can provide the utility with protection from inflationary pressures and in fact could positively boost near term earnings and long term valuations. In contrast, if the utility is operating under a nominal return model, it must bear the inflationary uptick reflected in certain costs until it has a regulatory reset, when the changing inflationary environment should be acknowledged by the regulator and revised tariff revenue assumptions are incorporated in the utilities business model.

The nominal return model is the standard model for the US utility sector as such, those utilities in a real return model are better placed to weather inflationary spikes than their nominal peers. However, in terms of interest rate shifts, the issues for both real and nominal utility models are consistent. For a regulated utility to cover the cost of higher interest rates, it must first go through its regulatory review process. While a regulator is required to have regard for the change in cost environment utility faces, the process of submission, review and approval can take some time or can be dictated by a set regulatory period of anywhere between one to five years.

In addition, the whole environment surrounding costs, household bills and utility profitability can be very politically charged. As a result, both the regulatory review process and the final outcome can be a little bit unpredictable.

So these key differences between infrastructure assets should see user pays and real return utilities, fundamentally outperform during a rising inflation interest rate period, due to a more immediate and direct inflation hedge flowing through to revenues and bottom lines. At 4D, we remain overweight these assets and favor those with the real returns in the utility space. However, I guess, should the market overreact to the economic outlook, we would be using in a buying opportunity across all sectors as the fundamental investment pieces for infrastructure remains intact.

Jodie Saw:

Let's talk equity market performance versus company fundamentals. Are the fundamental characteristics you just mentioned being reflected in current equity market moves?

Sarah Shaw:

Unfortunately not. So, listed infrastructure remains an equity market investment, and as such can be caught up in general market volatility, much as was the case of the 2020 COVID-19 selloff. Unfortunately, infrastructure didn't participate in a subsequent equity market rally. We just weren't sexy enough. But if you separate the equity market moves from the investment fundamentals we discussed, the earnings of the asset class over the COVID years proved to be far more resilient than the asset price volatility suggested. The asset class proved its defensive characteristics with solid earnings momentum underpinned by strong balance sheets.

We started 2022 seeing strong growth momentum supported by the reopening trade and infrastructure as an asset class responded and started closing the gap between the general equity markets. However, current equity market volatility is being driven by concerns on a geopolitical as well as a global economic front and we believe there has recently been a significant flight to safety with some disconnect to fundamentals. This has definitely benefited large US yield paying names, including the US utilities within our space. These stocks are high quality, have attractive investment growth pipelines and are providing investors a solid yield. They are also on the other side of the world to the current geopolitical conflict. They are good, well managed companies and very much a safe haven.

However, they are also subject to the fundamental earning squeeze in a rising inflation and interest rate environment. The true bond proxy of equity markets. And we're seeing current valuations at a 20% premium to historical averages, which we don't believe are justified at a fundamental earnings level. As such, we are currently underweight this subset of infrastructure, despite the current sentiment support. In contrast, the user pay assets and the real rate utilities that we discussed are fundamentally benefiting at an earnings level from the COVID reopening and, or higher inflation, but have been pressured by noise around travel disruptions, rising energy costs and potential shortages across Europe and the general risk of trade. It is these assets that are offering investors significant value over the medium term and this is where we, at 4D, remain overweight in the current equity market environment.

Jodie Saw:

Has your view on emerging market exposure changed?

Sarah Shaw:

Look, there continues to be a significant risk of trade of presence, which continues to pressure emerging market names. However, again, looking through the sentiment, the emerging market infrastructure stocks are offering a very strong value proposition at present, and we believe the market must ultimately recognize this. So for example, the Mexican airports have just reported their Q2 2022 results and we saw traffic as a whole above 2019 levels. We also saw an inflation pass through and strong regulatory support.

To put some numbers behind this, the three Mexican airport operators reported revenue growth of between 39 to 48% year on year and more importantly, 22 to 60% above 2019 pre-COVID levels. This top line growth translated to bottom line earnings growth of over 80% on 2019 levels for two out of the three operators. This has not yet been reflected in their share prices and we believe ultimately will be.

So 4D are long-term fundamental investors and we will look through the current noise for long term value. We remain committed to the EM, infrastructure value proposition.

Jodie Saw:

So what happens, Sarah, if we move into recessional stagflation? How would you change the portfolio?

Sarah Shaw:

Given the distinct features of the infrastructure assets discussed earlier, with active management a listed infrastructure equity portfolio can be positioned to take advantage of the long-term structural opportunity set as well as whatever near-term cyclical events may prevail, whether they be environmental, political, economic, or social. So revisiting some of the asset characteristics discussed earlier, in a stagflation environment we would be increasing our exposure to utilities and in particular, real rate utilities. This would remove volume growth limitations while still capturing the upside of inflation. This re-weighting would likely be at the expense of some of the growth sensitive user pay assets.

If we move into a recessionary environment, whereby both growth and inflation revert, and ultimately interest rates start moving down again, this would trigger a re-weighting to utilities in general, including the nominal rate stocks who would also fundamentally benefit from a retraction in inflation and interest rates. Of course, this all assumes the names meet our quality value thresholds at that point in time.

4D will always manage a diversified portfolio stocks across utility and transport sectors. We have prioritized both countries and companies with strong management teams, defined strategic environmental goals that integrate with an ESG policy, strong balance sheets to support much needed investment and those that are best in class within their sector in building a sustainable infrastructure footprint.

Jodie Saw:

Infrastructure is the bedrock of economic growth and productivity. And Sarah, over the years, you've spoken to us a lot about the chronic underspend on critical infrastructure, the changing dynamics of the global population, and the huge and growing need for investment in this space. So what are your thoughts on some of the opportunities that this can create for investors?

Sarah Shaw:

Core infrastructure provides basic services that are essential for communities to function and for economies to prosper and grow. And while the Russian invasion of Ukraine will slow global growth, especially in Europe, and the COVID outbreak in China will be a further headwind, ultimately we believe the global economy will emerge stronger for the recent experience. Much of the fiscal and monetary spending by governments in response to COVID is focused on a central infrastructure investment around the globe, including the energy transition. Much of this investment is yet to be fully deployed. This is good news for world economies, and we firmly believe there is no continual global growth recovery without investment in roads, railways, pipelines, power transmission, communications, ports and airports.

To truly understand this let's briefly revisit the long-term infrastructure thematics that I have mentioned today. These are intact despite the near term geopolitical economic noise shadowing markets at the moment. Infrastructure offers defensive earnings characteristics, but with significant potential asset class growth, as a result of the huge and growing need for infrastructure investment globally. This is a result of decades of underspend and the changing dynamics of the global population and is an opportunity that has only been enhanced by the recent health and political events.

There has been a chronic underspend on critical infrastructure in virtually every nation over the past 30 years, if not longer. This is because governments had other spending priorities during this period. During the GFC, the focus was on bailing out the global banking system, not replacing water mains. During COVID-19, the priority was social security and maintaining public health, not replacing collapsing bridges. However, the infrastructure need is now critical. Over 50% of London's water mains are over 100 years old. Over 80% of the water pipes in the US are over 30 years old and some are over 100 years old. This is an opportunity that can be capitalized on through developed market utility investment and greenfield, brownfield, transport concessions.

Another driver of the need for global infrastructure investment is population growth. In 1900, the world had a population of 1.65 billion people, and this is expected to grow to 9.7 billion in 2050 and 10.4 billion by 2100, underpinning the need for further spend. We first need to play catch up and then invest for our future generations. This population growth has also contributed to a number of environmental challenges, which underpin the need for even more spend on infrastructure to ensure the sustainability of the planet. Much has been written about the energy transition and this will play an important role in future infrastructure build, so while our speed of ultimate decarbonization remains unclear, it is a real opportunity for multi-decade investment in infrastructure as the world moves towards a cleaner environment.

The goal of net-zero is just not achievable without the right forms of infrastructure investment across both the energy and transport sectors and this is an opportunity that 4D is capitalizing on across the globe. And look, just the final driver of infrastructure investment growth is the emergence of the middle class in developing economies, which is supporting both the emerging market domestic demand story, but also the demand for infrastructure globally. It's also the reason we continue to like emerging market infrastructure investments.

The emerging economies are expected to grow rapidly over the next 30 years, changing the world economic order that has been in place for much of the First World War II era. This growth will be driven by the expanding middle class and considering the size of this middle class, their changing spend patterns will have huge ramifications for world economies and future investment opportunities. And importantly, one of the clear and early winners of this growth in the middle class is infrastructure, which is needed to support the evolution. Now, investors can capitalize on this through direct investment in emerging markets, which we do, or through developed market assets, supporting the evolution such as airports.

So when you put all these factors together, develop market replacement spend, population growth largely driven by the emerging markets, energy transition and the emergence of the middle class, the need for infrastructure investment overcoming decades is clear. What is also clear is that governments who have been traditionally providing the infrastructure investment simply cannot fully fund current and future needs. This represents a significant opportunity for private sector capital. This opportunity has only been enhanced by COVID-19 and this is a thematic that is not derailed by the return of inflation and interest rates moving up or the current conflict in Europe.

Jodie Saw:

Thanks, Sarah. It certainly seems that the global listed infrastructure investment opportunity definitely remains intact. For further information on the 4D Global Infrastructure and the Emerging Market Infrastructure Funds, please don't hesitate to reach out to your account manager or our client experience team.

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