Headwinds to Equities Are Often Tailwinds to Infrastructure

Infrastructure is the physical assets that provide an essential service to society. These are the services we use and interact with every day. For instance, we use gas, water and electricity to carry out our daily activities and we also use infrastructure, such as airports, rail and roads, to move people and goods from location to location.

Due to the essential nature of infrastructure assets, demand is relatively stable, providing lower volatility than traditional equities and resiliency of infrastructure revenue during various business cycles. Even at times of economic weakness, consumers continue to use water, electricity and gas, drive cars on toll roads and use other essential infrastructure services.

Persistent inflation and rising interest rates have weighed on equity markets in 2022, but macro-economic headwinds are often infrastructure tailwinds due to the way infrastructure treats inflation and the rising rates it engenders largely as a pass-through. Infrastructure assets act as an inflation hedge due to the largely pre-programmed way — through regulation and contracts — that infrastructure can adjust to inflationary environments. This applies to both utilities and user-pays assets such as toll roads or rail, as both generate inflation-linked revenues. Infrastructure’s pricing power gives it true inflation protection.

With strong diversification as well as income characteristics, the asset class also has a long-term track record of consistently delivering attractive yield and offers a growing income stream linked to the asset base of the companies rather than the business cycle. The ClearBridge Global Infrastructure Income Strategy, for example, has delivered dividend growth above inflation and that has closely tracked the asset growth in its underlying companies (Exhibit 1).

Exhibit 1: Infrastructure Dividends, Above Inflation, Linked to a Growing Asset Base

Evidence also suggests this income is both dependable (Exhibit 2) and supportive of portfolio diversification. Infrastructure’s low correlation to equities enables it to provide greater portfolio diversification than other traditional income equity sectors (Exhibit 3).

Exhibit 2: Infrastructure Yield Offers a Dependable Premium to Most Asset Classes

Exhibit 3: Infrastructure’s Correlation to Equities

Infrastructure’s diversification and income benefits go hand in hand, strengthening portfolio outcomes. With government bond yields low and in many cases delivering negative real yields, investors have had to look beyond traditional sources of income. While both global equities and REITs can provide attractive yields relative to bonds, both have revenues and, ultimately, dividends closely linked to economic activity. In this way, infrastructure has an edge as a long-term income solution, as revenues are generally linked to the asset base of these companies.

Using an efficient frontier created by different combinations of global equity and global fixed income over 10 years, we see that splitting the global equity allocation between equities and infrastructure would shift the efficient frontier, increasing returns while reducing portfolio risk (Exhibit 4). Conversely, splitting the global equity allocation by adding REITs or global dividend equity with the same weights negatively impacts portfolio efficiency.

Furthermore, infrastructure allows exposure to several secular themes. Its assets will play a pivotal role in the path to net-zero emissions. Trillions of dollars need to be invested over the coming decades to decarbonize the economy and expand electrification, which will underpin the allowed returns, and ultimately dividends. The proliferation of data and buildout of 5G will require both greater electrification and communication towers. Decarbonization, electrification and 5G will likely drive the asset base growth of infrastructure companies and provide a tailwind for infrastructure investors seeking income and the potential for capital appreciation.

To summarize, highlights of infrastructure as an asset class include: lower volatility than equites due to the stable demand for its essential services; steady, predictable and inflation-linked cash flows supported by regulation and long-term contracts and driving attractive relative income; strong diversification benefits given its low correlation to equites and bonds; and exposure to key mega trends in which the world will be investing heavily for some time such as decarbonization, electrification and 5G.

Exhibit 4: Adding Infrastructure Improves Portfolio Outcomes