Infrastructure an insulated asset class not to be ignored in a downturn

With rising interest rates and the inflation genie proving resistant to being put back in its bottle, there remains uncertainty about investment in some asset classes.

With rising interest rates and the inflation genie proving resistant to being put back in its bottle, there remains uncertainty about investment in some asset classes. These include those that can support the economy through a downturn in broader consumer and business activity levels.

Australia’s macro drivers are increasingly attractive in a world beset by so much uncertainty. Our economic and political stability, strong demographic tailwinds supported by a growing and ageing population, return to pre-Covid immigration trends, coupled with favourable long-term returns, job creation, social development and the overall public benefit potential, means infrastructure assets will play a central role in helping the Australian economy recover.

This puts the spotlight increasingly on the role of infrastructure assets, which include airports, toll roads, energy distribution, data centres, social housing and other essential elements for a growing, sustainable and prosperous modern nation.

Infrastructure assets have benefited from favourable financing conditions and reduced borrowing costs through the period of loose monetary policy, making it more feasible for governments and private investors to pursue and fund large-scale projects.

This in turn has left some infrastructure investors concerned that high levels of dry powder and a beneficial financing backdrop has placed upward pressure on valuations in recent years, and that we are now set for a period of downward readjustment.

Infrastructure has not been immune to market adjustments across other asset classes. You do not have to strain to find pockets of value where assets have been written down, sometimes substantially. That does not mean that opportunity for investors has dried up. Consider the impact we saw on sectors such as airports and student accommodation during the height of the pandemic; now we see latent opportunity across the infrastructure landscape.

Both sectors are now experiencing favourable long-term economic conditions, with domestic and international travel firmly back in favour and international students flocking back to Australia for its world-class education system.

Michael Cummings, Dexus co-head of infrastructure.

During an economic downturn, regulated infrastructure assets such as toll roads, and energy transmission and distribution networks also come into sharper focus as interest rates increase because there is a regulated cost of capital which reflects the cost of debt and equity.

As such, there is a built-in direct correlation between CPI and revenue, meaning shareholder returns move in line with inflation.

There is also an important role for public-private partnerships (PPPs) to play in delivering infrastructure projects efficiently. PPPs can ensure infrastructure projects are beneficial to both parties during periods of high interest rates and inflation by aligning public and private sector capabilities.

Infrastructure asset valuations benefit from long-term contracted cashflows supporting predictable returns as well as high barriers to entry.

In general, valuations are known to have a positive correlation with inflation, but a negative correlation with interest rates.

Because of these attributes, the situation which would potentially work most unfavourably for real asset valuations would be the unlikely outcome of inflation falling and interest rates remaining high.

However, governments and central banks around the globe are attuned to the need for interest rates to start falling at the first sign of that inflation genie being contained.

The best safeguard for infrastructure valuations from high interest rates is a laser like focus on earnings growth.

Some may argue this has not always been a priority for this asset class, compared with careful management of the regulatory risks and a sensible approach to leverage. The market is showing this shift is happening in real time. Dexus’s raise for its wholesale airport fund demonstrates there is outsized demand for assets that can expect strong annualised returns. The taking-private of Sydney Airport was done on a similar premise – revenue and earnings growth underpinned by favourable macro conditions and infrastructure characteristics.

With an increasing possibility of Australia entering a technical recession, infrastructure must play a critical role in supporting the recovery given the significant multiplier effect on the economy.

This is not a new phenomenon. We have seen this play out during periods of low or negative GDP growth: infrastructure spending stimulates activity and counteracts negative effects of a recession, both directly in construction and indirectly in related industries.

Given the quality and diversity of assets, and the stable political and policy environment, Australian infrastructure is likely to continue to exceed expectations and attract considerable attention from global investors.

Michael Cummings is co-head of infrastructure at Dexus.