Posted by Macquarie Asset Managemnt
March 15, 2019
In fact, historically the reverse has been true, says Macquarie Infrastructure and Real Assets Economist, Daniel McCormack. And infrastructure has historically performed better than equity in a downturn, meaning it has the ability to weather all market cycles, including a recession.
“Unlisted infrastructure tends to perform better when interest rates are going up rather than going down,” McCormack explains. “It is just that for the past 10 to 20 years we’ve experienced a low interest rate environment at the same time as infrastructure delivering strong returns, so people erroneously connect the two.”2
McCormack points out that while infrastructure has performed well overall between the start of 2004 and mid-2018, it has risen 13.2 per cent in annualised terms when interest rates went up and just 6.6 per cent when interest rates fell.2
McCormack also says infrastructure’s performance in rising interest rate environments can be based on its close relationship with two other factors.
The first is inflation. Infrastructure assets usually have their returns linked to the level of inflation - either explicitly in the case of regulated assets such as water or electricity and gas distribution networks, or implicitly in the case of transport assets such as roads.
“For both asset classes, higher inflation tends to increase revenue,” McCormack says.
He argues that, for this reason, infrastructure has been used as an effective hedge against inflation as it performed relatively well when inflation was unexpectedly high. That’s because, unlike other equity investments, inflation hasn’t cut infrastructure profits but has contributed to them.
Macquarie Infrastructure and Real Assets Economist
The second factor is GDP growth. Again, a look at the numbers between the start of 2004 and mid-2018 shows infrastructure has delivered average annualised returns of 14.3 per cent when GDP was stronger than average. When it was weaker than average, returns were only four per cent.2
That’s perhaps unsurprising given high inflation is usually associated with the late stages of the business cycle. It’s then that aggregate demand begins to outstrip aggregate supply and prices start to rise naturally. It’s also when central banks begin lifting interest rates to stop the economy from overheating.
“For this reason, infrastructure, like other equity investments, also likes GDP growth,” McCormack explains. “Although it historically hasn’t performed quite as well as listed equity in an expansionary market because it was not coming off the same low base.”
Conversely, when an economy starts to weaken or enters a downturn, central banks tend to cut interest rates and increase the money supply to stimulate the economy. When this happens, McCormack says infrastructure has historically performed better than other equity because, like bonds, it continued to produce some income.
“When GDP growth has been strong infrastructure has gone stride-for-stride with listed equity in terms of returns, but when growth has been weak infrastructure's fundamental defensive traits enabled it to perform better than equities,”2,3 McCormack says. “This is what has given infrastructure its strong through-the-cycle returns.”
So why has infrastructure delivered solid returns throughout an extended period of lower-than-average interest rates?
McCormack believes it comes down to a combination of three things: work conducted to optimise infrastructure assets that have transitioned from government to private ownership, investor flows into infrastructure as an asset class as it has become more mainstream, and better earnings performance than other equity due to infrastructure's high barriers to entry.
“The fall in interest rates was not the causal factor in infrastructure’s strong returns over the period,” he concludes. “In short, returns were twice as good when interest rates were rising.”
1 A Preqin Survey found 43.3% of infrastructure investors believed low interest rates were driving returns (Preqin Ltd. 2018).
2 Based on the performance of the Cambridge Associates Unlisted Infrastructure Index from 1Q2004 to 2Q2018. For interest rates we use a GDP weighted average of the US, German and UK 10-year government bonds. For interest rates over the same period, we used data from Bloomberg Finance LP. For GDP growth, we use CEIC data to calculate a GDP weighted average of US, German and UK GDP growth.
3 When GDP growth is above average unlisted infrastructure delivers and average annualized return of 14.3% while equities deliver 14.4%. When GDP growth is below average unlisted infrastructure delivers 4.0% annualized while equities deliver -0.5%.
This market commentary has been prepared for general informational purposes by the authors, who are part of Macquarie Infrastructure and Real Assets (MIRA), a business division of Macquarie Group (Macquarie), and is not a product of the Macquarie Research Department. This market commentary reflects the views of the authors and statements in it may differ from the views of others in MIRA or of other Macquarie divisions or groups, including Macquarie Research. This market commentary has not been prepared to comply with requirements designed to promote the independence of investment research and is accordingly not subject to any prohibition on dealing ahead of the dissemination of investment research. Nothing in this market commentary shall be construed as a solicitation to buy or sell any security or other product, or to engage in or refrain from engaging in any transaction. Macquarie conducts a global full-service, integrated investment banking, asset management, and brokerage business. Macquarie may do, and seek to do, business with any of the companies covered in this market commentary. Macquarie has investment banking and other business relationships with a significant number of companies, which may include companies that are discussed in this commentary, and may have positions in financial instruments or other financial interests in the subject matter of this market commentary. As a result, investors should be aware that Macquarie may have a conflict of interest that could affect the objectivity of this market commentary. In preparing this market commentary, we did not take into account the investment objectives, financial situation or needs of any particular client. You should not make an investment decision on the basis of this market commentary. Before making an investment decision you need to consider, with or without the assistance of an adviser, whether the investment is appropriate in light of your particular investment needs, objectives and financial circumstances. Macquarie salespeople, traders and other professionals may provide oral or written market commentary, analysis, trading strategies or research products to Macquarie’s clients that reflect opinions which are different from or contrary to the opinions expressed in this market commentary. Macquarie’s asset management business (including MIRA), principal trading desks and investing businesses may make investment decisions that are inconsistent with the views expressed in this commentary. There are risks involved in investing. The price of securities and other financial products can and does fluctuate, and an individual security or financial product may even become valueless. International investors are reminded of the additional risks inherent in international investments, such as currency fluctuations and international or local financial, market, economic, tax or regulatory conditions, which may adversely affect the value of the investment. This market commentary is based on information obtained from sources believed to be reliable, but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in this market commentary. Opinions, information, and data in this market commentary are as of the date indicated on the cover and subject to change without notice. No member of the Macquarie Group accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this market commentary and/or further communication in relation to this market commentary. Some of the data in this market commentary may be sourced from information and materials published by government or industry bodies or agencies, however this market commentary is neither endorsed or certified by any such bodies or agencies. This market commentary does not constitute legal, tax accounting or investment advice. Recipients should independently evaluate any specific investment in consultation with their legal, tax, accounting, and investment advisors. Past performance is not indicative of future results.
This market commentary may include forward-looking statements, forecasts, estimates, projections, opinions and investment theses, which may be identified by the use of terminology such as “anticipate”, “believe”, “estimate”, “expect”, “intend”, “may”, “can”, “plan”, “will”, “would”, “should”, “seek”, “project”, “continue”, “target” and similar expressions. No representation is made or will be made that any forward-looking statements will be achieved or will prove to be correct or that any assumptions on which such statements may be based are reasonable. A number of factors could cause actual future results and operations to vary materially and adversely from the forward-looking statements. Qualitative statements regarding political, regulatory, market and economic environments and opportunities are based on the [authors’ // relevant MIRA team’s] opinion, belief and judgment.
Other than Macquarie Bank Limited ABN 46 008 583 542 (MBL), none of the entities noted in this document is an authorized deposit-taking institution for the purposes of the Banking Act 1959 (Commonwealth of Australia) or banking legislation in other jurisdictions. The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities.