DEFENSIVE GROWTH, OR JUST DEFENSE? - Franklin ...
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2022 Infrastructure outlook
DEFENSIVE GROWTH, OR JUST DEFENSE?
December 2021 KEY TAKEAWAYS
• In an uncertain macroeconomic environment, the certainty of future earnings and
growth will be key: infrastructure and utilities significantly outperform other equities on
this measure.
• Given our base case of slowing growth and higher inflation, our playbook for infrastruc-
ture portfolios broadly is to watch for a transition from a growth orientation to a more
defensive positioning as growth fades and utility underperformance unwinds.
Nick Langley
Managing Director,
• Generally, user-pays infrastructure and utility returns are positively correlated to inflation,
Portfolio Manager but results differ by sector and region; meanwhile, climate inflation looms and is under-
Clearbridge Investments appreciated at present.
INFLATION AND GROWTH SLOW IN 2022, BUT HOW AND WHEN?
The surprises over the last 12 months should give some indication of the significant uncer-
tainty facing investors in 2022, with forecasts for global gross domestic product (GDP)
growth and inflation having a high chance of coming in well above or below consensus.
Market expectations for 2022 have moved significantly in recent months, on the whole
pointing to a hotter than expected economy (Exhibit 1: red dots are expectations as of late
2020, green dots as of late 2021). Broadly, markets expect gently slowing inflation and
growth over the 2021–23 period (the green dots move progressively to the lower left corner
for 2021, 2022 and 2023). The question will be how much and when.
With supply chain issues, higher housing costs, higher commodity prices and producer
price inflation remaining square in the sights for 2022, we think higher inflation is a risk for
global markets. We expect growth to slow to trend or below by mid-2022 and US Treasury
yields to rise, which would mean a continuation of negative real bond yields. Additional
forecast volatility and therefore market uncertainty will arise as new COVID-19 variants
appear and circulate. However, with high levels of vaccination across the developed world
and less propensity for mobility restrictions and lockdowns, we expect the economic
implications to be limited.
EXHIBIT 1: MARKET Inflation (core PCE) Case Infrastructure performance
EXPECTS SLOWER GROWTH 4.0 Stg Hot Market
AND INFLATION Declining growth and inflation
expectations Positive for utilities (rate base growth,
As of November 30, 2020 3.5 good ROEs). Rotation away from
(blue), and November Median forecasts as of late 2021 economically sensitive sectors.
’21
30, 2021 (green) ’22
3.0 Recession & Low/negative growth, low inflation
low inflation Bond yields lower. Utilities shine with
strong earnings growth. Economically
2.5 sensitive sectors disappoint.
’23
Running hot High growth, high inflation
2.0 Higher bond yields weigh on utilities.
’22 Fed response critical. Economically
’21
sensitive sectors outperform.
1.5
Median forecasts as of late 2020
Stagflation Low growth, high inflation
1.0 Rec UK/EU utilities do well, economically
1.0 2.0 3.0 4.0 5.0 6.0 sensitive sectors mixed. Negative real
GDP growth (real) yields supportreal assets.
Sources: ClearBridge Investments, Bloomberg Finance LP. Forecasts may not be met. Opinions may change at any time without notice.
Rising bond yields are relatively more important for longer-duration assets. Within infra-
structure, utilities tend to be shorter duration (as their assets are repriced by regulated
returns at frequent regulatory resets, making them relatively less sensitive to movements in
bond yields over the medium term), whereas toll road and concession assets without the
ability to reprice their assets or returns tend to be longer duration and hence relatively more
sensitive to changes in interest rates. We expect nominal bond yields to remain relatively
low by historic standards for the long foreseeable future; this means real yields would
remain negative and continue to support investment in infrastructure.
• Utilities, generally the defensive play, performed poorly early in 2021 amid a sharp
cyclical rally and have traded sideways since. Electricity, gas and water companies have
continued to invest in their asset bases and regulators have continued to provide
attractive returns (8%–11% nominal return on equity (ROE)), resulting in highly predict-
able earnings growth over multiyear horizons. However, expectations of rising bond
yields (particularly real yields) continue to weigh on the sector, and traditionally utilities
have lagged the market until the first rate hike is announced and the path of rate
hikes becomes more certain. As a result, utilities could lag for the first half of 2022.
• Transportation infrastructure generally offered a mixed bag in 2021: toll roads recovered
quickly from the initial stages of the pandemic and did well amid subsequent waves of
COVID-19 as people decided against public transport and commuted in cars. Airports
remain challenged as additional lockdowns loom. Ports and rails have lagged as snarled
supply chains have reduced utilization and volumes. Transportation infrastructure should
see a strong start to 2022 as growth returns to the economy and supply chain
constraints ease (likely over the course of the year).
• Communications infrastructure such as tower companies struggled in 2021. We expect
communications to perform well in 2022 on continued negative real rates and high
growth, driven by increased bandwidth needs as 5G buildout increases. The 5G network
buildout is likely to continue at pace in 2022 and beyond as users (mobile handsets)
increase in number and data continues to trend higher with more macro and micro sites
required. This will support 5G network speeds; however, more work is required to
reduced latency.
2 Defensive growth, or just defense?• After a strong 2020, renewables had a poor 2021 until the run up to COP26 conference
as focus returned to the enormous policy support for renewable energy. The passing
of the US infrastructure bill and ongoing revisions of global emission reductions targets
supports renewables, so we expect the sector to carry strength into 2022. Higher
fossil fuel prices should assist the transition to renewable energy as projects that were
marginal become economically justifiable.
• Energy infrastructure, while generally not directly correlated to energy prices, benefits
from future growth in production activity. The development of gathering networks and
gas and liquids transportation provides ample opportunity for investment and attractive
returns in a world of higher energy prices. Meanwhile investments in green hydrogen
and carbon sequestration activities may assuage those investors concerned about the
long-term viability of these (largely and currently) fossil-fuel-focused networks.
Against this backdrop, given our base case of slowing growth and higher inflation, our
playbook for infrastructure portfolios broadly is to watch for a transition from a growth
orientation, in which we prefer higher exposure to economically sensitive user-pays infra-
structure and lower utility weightings, to a more defensive positioning as growth fades and
utility underperformance unwinds. In the base case economic view this will be a measured
process throughout 2022, while in the alternate view this transition will be accelerated.
We’ll look for defensive growth exposure through communications and high-growth utilities,
including renewables, and we’ll look to ensure strong inflation correlation with utility
positions, including the use of midstream pipelines that would benefit from a structural
change in the view of long-term equilibrium energy prices.
A MULTIPLE/MARGIN CONUNDRUM
Overall, markets will find support given excess liquidity, but should be subject to corrections
as growth and inflation expectations are recalibrated. We expect markets to be broadly
in a mid-cycle phase, where earnings growth is required to support multiples and returns
moderate from the relatively high levels of the last three years. Consumer price inflation
is running in the mid-single digits and is likely to continue to well in 2022. Meanwhile,
producer price inflation is running in the low double digits and is also likely to continue to
well in 2022. This sets up an interesting conundrum: companies will have the option to
pass on the increased input prices (producer price inflation) to finished goods. This should
ramp up inflation and rates expectations as well as bond yields, leading the cost of capital
to increase and earnings multiples (and therefore stock prices) to decrease. Alternately,
they can absorb the increased input prices, which would lead margins and earnings (and
therefore stock prices) to decrease.
Going forward, in an uncertain macroeconomic environment, the certainty of future earnings
and growth will be key: infrastructure and utilities significantly outperform other equities
on this measure, with the impact of the pandemic and large trends such as decarbonization
in the face of climate change either largely known or highly predictable.
INFLATION AND INFRASTRUCTURE ASSETS
Uniting our base case and alternate views is higher inflation, and we have written exten-
sively about how inflation is generally a pass-through for infrastructure assets. Generally,
user-pays infrastructure and utility returns are positively correlated to inflation, but
results differ by sector and region. Some sectors have a direct link to inflation: utilities
in the U.K., parts of Europe and Australasia have returns and often asset bases indexed
to inflation annually. Utilities in the U.K. and Europe should do well in a low-growth,
3 Defensive growth, or just defense?high-inflation scenario as their earnings certainty and direct inflation pass-through will look
attractive. Toll roads have earnings rates indexed to inflation on a quarterly or annual
basis. Airports will often have inflation-indexed retail leases and regulatory regimes for
aeronautical activities.
Sectors with indirect links to inflation include utilities regulated on a nominal basis, as in
North America and parts of Europe, where the utility commissions generally provide
an allowed return based on a nominal ROE invested in their asset bases. There the inflation
pass-through may lag as the ROE, capital structure and costs are adjusted when the
utility files for its rate case. Pipelines include regulated and commercial activities; while
there is inflation pass-through for the regulated component of the business, the level
and speed of inflation pass-through for the commercial activities depends on the nature of
the contracts underpinning those activities.
Should inflation persist as we believe it will, infrastructure portfolios will hinge mainly on
what type of growth we see: amid lower growth, we would look to add utilities, with
bond yields lower and utilities not sensitive to a downswing in GDP. If growth surprises to
the upside, transport infrastructure, in particular toll roads, will look attractive as higher
GDP would result in higher economic activity and higher throughput.
THE OTHER INFLATION: CLIMATE INFLATION
Once pandemic-related supply inflation begins to fade, looming not too far off is climate
inflation, which remains a relatively underdiscussed issue. We expect climate inflation
to begin to appear in the middle of this decade and likely run for a decade or two. There are
several drivers for this: carbon pricing will be critical to delivering market-based decarbon-
ization, even while this likely leads to higher prices for everything in the medium and
long term. For example, the European Union (EU) Fit for 55 program will implement a
carbon border adjustment mechanism, which will result in carbon being priced into goods
(across a range of industries) sold in Europe and may result in a decade of rising prices.
Among renewables, project build costs are now starting to rise because of rising commodity
costs (copper particularly). Additionally, the nature of renewable energy generation will
require significant additional electric transmission lines and additional generation to offset
the interruptible nature of renewables. Fossil fuel energy sources should have higher
breakeven prices in the future as fossil fuel projects will likely have higher costs of capital
associated with them (due to fewer sources of capital as banks move away from fossil
fuel lending) and capital will likely need to be recovered over shorter time periods. Utilities
are not without their climate-related expenses either: the New York City sewer system,
for example was built to handle 1.75 inches of rain per hour. During Hurricane Ida the city
got over 3 inches in an hour. It will cost US$100 billion to recalibrate the system and take
several decades. That cost will be recovered in utility bills.
THE US INFRASTRUCTURE ACT
Finally, the most significant element for private capital from the recent US$1.2 trillion
Infrastructure Investment and Jobs Act will likely be the provisions streamlining permitting
processes, particularly for electric transmission lines. These lines, for which we have
seen permitting processes as long as five years, are often the missing link as we build out a
grid for an electric future. Electric transmission is critical for the US’s emissions goals—
a Princeton University study last year concluded that the US needs to increase the electric
transmission network by 60% (in terms of gigawatt miles of wires) by 2030 in order to
hit its net-zero by 2050 target.
4 Defensive growth, or just defense?A QUICK WORD ON VALUATIONS
Infrastructure looks attractive from a valuation perspective. A common earnings multiple
metric for global utilities and user-pays infrastructure (enterprise value to EBITDA,
earnings before interest tax depreciation and amortization) has traded in the 10x–12x range
since 2012, adjusting the earnings of infrastructure companies, particularly airports and
passenger rail networks, for the impact of the pandemic (Exhibit 2).
EXHIBIT 2: UTILITY AND EV / EBITDA
USER-PAYS INFRASTRUCTURE 18x
CONSENSUS EV/EBITDA
As of June 30, 2021 16x
14x
12x
10x
8x
6x
4x
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
MSCI World Utilities Infrastructure Infrastructure (normalized pre-COVID EBITDA)
Source: ClearBridge Investments and FactSet Research Systems. Arithmetic average, current EV divided forward consensus EBITDA
(or, if not available, internal forecasts). EV = market cap + net debt + minority interest and preferred stock. EBITDA = earnings before
interest, tax, depreciation and amortization.
Yet over the last decade we have seen a steady decline in the cost of capital for utility and
infrastructure companies, combined with an increase in forward earnings growth, particu-
larly in the utility sector that is investing in its asset base to decarbonize economies
and mitigate the effects of climate change. We believe the market has not taken into
account the cheaper cost of capital and better growth profile for these sectors. Based on
this disconnect, we believe there is room to run for infrastructure in 2022.
WHAT ARE THE RISKS?
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declines in the market value of these securities.
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