Can infrastructure protect against persistent inflation?

Speaking at the 2024 IMAP Portfolio Management Conference in Melbourne, John says as an asset class, infrastructure is often thought of as having defensive characteristics. And while John agrees with this assumption, he also believes what is often overlooked is the fact that this asset class is actually exposed to some of the biggest structural growth themes investors are likely to see.

“There is the global energy transition, which is in its infancy. This is an extremely intensive area of infrastructure,” says John. “And in the developed world, we have an ageing population, demanding high quality healthcare, which drives demand for new and expanded healthcare infrastructure.

“In developing markets, infrastructure is benefitting from urbanisation, while in developed markets, we have rapidly ageing infrastructure, which means more money needs to be spent on upgrading and replacing that infrastructure every year.”

Pointing to Australia, John says our population is growing at one of the fastest rates in the developed world, creating significant demand for infrastructure.

“We’re also witnessing the ongoing digitalisation of our economy,” says John. “Twenty years ago, we were not using the type of connectivity devices we have today. Their broad application across society has been the catalyst for significant infrastructure asset creation over the last decade, which will continue into the future.”

John adamantly believes that infrastructure’s exposure to these structural growth themes will provide opportunities for investors for decades to come.

An obvious attraction of infrastructure assets are their built-in protections against inflation. This protection could be through ‘inflation escalators’, which are embedded in concessional contractual arrangements that apply to an asset. These growth-linked assets typically include airports, toll roads, and ports.

Inflation protection can also come through regulated assets, which operate under a regulatory framework, like electricity transmission and distribution, as well as water. Public Private Partnerships (PPP) — a collaboration between a government agency and a private-sector company — can also offer inflation protection. These assets, like hospitals and government buildings, have pricing power as a result of having a monopolistic position in the market, which allows them to pass through the impact of inflation to end users.

According to John, infrastructure is a broad investment class that has four key characteristics, which makes this asset class attractive to investors:

1. Exposure — to a series of structural growth themes that will play out over decades to come;

2. Consistent returns — due to the essential services nature of assets, which will underpin demand;

3. Generally predictable revenues, linked to inflation and in many cases, adjusting to changes in interest rates — which are attractive in the current environment; and

4. Diversification — due to its low correlation to other asset classes.

“As an asset class, infrastructure is heterogeneous rather than homogenous, meaning every asset is a little different,” says John. “Generally speaking, a significant component of the assets in the infrastructure universe have built-in protections against inflation and therefore, are well placed to protect against persistent inflation.”

David Blunt — Portfolio Manager at Perpetual Private — supports the view that infrastructure provides an inflation hedge within a portfolio. He adds that in the main, infrastructure assets tend to have roughly similar levels of return across the spectrum.

As part of its portfolio construction process, Perpetual Private has developed a framework for thinking about infrastructure, including how it allocates between different assets and sub-segments of the market.

This framework tracks a range of considerations — such as return and income expectations, volatility, market capitalisation, key risk, liquidity, and fees — to various types of infrastructure assets, like regulated, volume-linked, and PPSs.

“By using this framework, we can see that whilst the returns look broadly similar across different types of infrastructure assets, the risks attached to each of these infrastructure categories tends to be quite different,” says David.

When it comes to infrastructure investing, Perpetual Private tends to favour more conservative investments, like PPPs. “By investing in PPPs, you have to accept you’re taking on a lot more political and regulatory risk, compared to, say, an investment in listed infrastructure, where you have a different kind of risk in mark to market volatility that’s associated with listed portfolios.”

According to David, income also varies by infrastructure asset. For example, at the more conservative end, like infrastructure debt and PPPs, more of the return comes from cashflow or yield back to the investor. Whereas at the other end, like listed infrastructure, there are other influences that can impact the yield expectation for clients, such as companies undertaking share buy-backs, which effectively takes away from the dividend yield.

“And in the volume-linked, brownfield generation and regulated spaces, many of these assets are currently going through large capex programs. As such, they are not delivering income back to shareholders that you would expect through a normal operating environment,” he says.

“So, when you’re constructing a portfolio for yield hungry investors, you actually have to get down into the asset level to understand how your portfolio might operate and whether it’s suitable for those particular clients.”

And what about liquidity?

David believes infrastructure liquidity is another important consideration when constructing portfolios for retail investors. He says one way advisers can think about their approach to portfolio construction is to barbell their portfolio by having listed infrastructure at one end to provide liquidity to investors, and then using different types of infrastructure (depending on the clients’ needs) at the other end.

“For example, if you’re trying to manage more of the income component for a retiree client, then using listed infrastructure that provides liquidity with some infrastructure debt, could be a suitable combination for this type of client.”

ESG continues to be a growing area of interest for many infrastructure investors. However, David acknowledges there are some issues with ESG in the infrastructure sector that investors need to be aware of.

One such issue is with Scope 3 emissions. These are all the emissions associated, not with the company itself, but with what the organisation is indirectly responsible for, up and down its value chain. So, while Scope 1 and 2 emissions are relatively easy to capture, Scope 3 emissions will be harder for companies to work through.

“We have a couple of transmission assets in our portfolio, which on a Scope 1 and 2 basis have very modest CO2 emissions. But once you factor in Scope 3, which is the generation of energy going through the power lines, those emissions really skyrocket. This is a shock for many clients,” says David.

He also adds that the market is seeing increased consistency in ESG reporting in this space. Groups like GRESB — an independent organisation providing validated ESG performance data and peer benchmarks — are providing reports, which advisers can access through their fund managers to get a better understanding of portfolios.  

For clients wanting to invest in infrastructure assets, John concedes that in Australia, the number of listed infrastructure stocks on the ASX has fallen dramatically over the past few years. This means for an investor wanting a diversified exposure by investing in listed infrastructure, they would realistically have to look offshore to invest.

However, as for unlisted infrastructure, Australia continues to be seen globally as an attractive destination for infrastructure capital, says John. That’s because Australia has well developed regulatory and political systems that supports the rule of law.

“But the reality is, when considering global infrastructure in it entirety, Australia is only a small part of the market. Although we continue to be a leader in the infrastructure asset class, there are a lot more opportunities in infrastructure when you look globally,” he says.

When investing offshore, David says Perpetual Private has a strong preference for developed markets. These markets enjoy political stability and also support the rule of law.

“There’s no doubt that when you go offshore, you can earn a high return by investing in emerging market infrastructure. However, when you factor in political and regulatory risk, as well as the overall instability of some of these countries, the chances of losing your social licence to operate (as well as potentially losing your investment) are increased,” says David. “Whereas that sort of risk tends to be significantly less in developed markets.”