Nick Langley, Portfolio Manager, ClearBridge Investments wraps up the infrastructure industry in 2023 and reveals how the industry will navigate on the concerns for inflation, high-yields and what infrastructure funds would offer in 2024 in the form of diversification.
In 2023, increasing earnings and strong fundamentals were not enough to keep infrastructure valuations from falling due to the rise in real bond yields, and the group underperformed the broader equity market. Real yields in the US rose 1% in 2023 (as of November 30, 2023), resulting in a contraction in price/earnings multiples for utilities from 19x to 17x. 1 Utility and wireless towers companies in the S&P 500 Index sold off roughly 10.5%, creating a challenging environment for infrastructure portfolios built around these steady, defensive and income-producing businesses.
At the same time, we believed this would be a shorter-term phenomenon, and accordingly we saw infrastructure’s inflation pass-through working well, supporting earnings across the asset class. It can take anywhere from a few months to a few years for inflation to come through in infrastructure companies’ financials. A toll road, for example, can increase its prices along with inflation generally every quarter, but at minimum every year, while a US utility must wait until it negotiates rates with its regulator, which may not be for a year or two, and then the price increase arrives a year after that. Given these dynamics, we expect allowed returns to increase, even if for most of 2023 we saw some valuation compression for infrastructure due to this variable lag.
We have seen this yield-driven volatility before. As in 2023, in 2018 infrastructure returns relative to equities declined as real bond yields increased. Nonetheless, as rates began to decline after October 2018, infrastructure returns outperformed the broader equity market.
Stable or falling bond yields would support a rebound
If 2023’s spike in real bond yields fades, we expect a significant uptick in the valuations for infrastructure companies in the next year or two. We don’t necessarily need bond yields to roll over for investors to benefit from the returns of infrastructure; merely reduced volatility could be supportive for valuations. Should yields fall if economic activity starts to slow, the long end of the curve would come down and those valuations could recover more than the whole of that current
gap.
Infrastructure’s diversification benefits could be timely
Importantly for 2024, markets are now pricing a US recession at odds of around 15%, which is extremely low for this point in the cycle—that is, in the midst of the fabled “long and variable lag” time period following an unprecedented rise in cash rates. We believe a recession is still a strong possibility and with a higher-than-normal concentration in equity markets, infrastructure provides a significant (and cheap) diversifier within a portfolio. The past year has been dominated by the
Magnificent Seven, but infrastructure should continue to add ballast to a portfolio, which we believe could generate strong return potential over the longer term.
Any slowdown in economic activity in 2024 puts corporate earnings broadly at risk. However, we continue to see positive earnings revisions for infrastructure companies, particularly utilities, based on that pass-through of inflation and growth in their underlying asset bases as the energy transition continues. We expect to enter 2024 with positive earnings revisions for infrastructure just as broader equities begin to see negative earnings revisions.
Strong fundamentals and favorable valuation backdrop will likely define 2024
Against this backdrop, entering 2024 infrastructure is trading at historically attractive valuations given the growth prospects of infrastructure companies. Much of this growth will be driven by the energy transition as the world addresses its need to build out the networks of poles and wires to connect all the renewable facilities generators. A public policy tailwind is particularly prevalent in the US (following the Inflation Reduction Act or IRA) and Europe (following REPowerEU and the Green Deal Industrial Plan). We expect this to strengthen in 2024, given it will be an election year in many jurisdictions.
