RARE Market Update:
Current Volatility and Infrastructure


By Nick Langley, Co-Founder and Senior Portfolio Manager at RARE Infrastructure
10 March, 2020

Concerns about COVID-19 and declines in oil prices have roiled markets; what does that mean for listed infrastructure?
RARE Co-Founder and Senior Portfolio Manager Nick Langley and Head of Global Distribution, Matt Bushby discuss current markets and what it all means for investors in the following podcast.

  • Matt Bushby

    Today is the 10th of March 2020 in Sydney. We're talking after the sharp sell-off in markets that everyone saw around the world on the 9th.

    Nick, first off-- thanks for joining me. We thought it was really important to be talking directly to our clients in this podcast format due to the extreme volatility in the markets. Can you just put in your own words what's happening?

  • Nick Langley

    Great. It's an important time to catch up. We've had a very sharp sell-off, sharp as in, we've seen some [big] down days in markets. It's also sharp in terms of the time frame with which it's happened. You know, the market really has been quite blindsided by COVID-19, and most recently, the moves in the oil market.

    I think what's going on here is we're coming off elevated levels in equity markets around the globe. The market generally had been getting a lot more confident in the growth outlook for 2020 and, you know, that was on the back of --  if you go back to Q3 of last year and into early Q4, you know, there were some real concerns for the US. And if you listened to our earlier podcasts, you will have heard us say that we thought that the market was pricing in about a 40% chance of a recession in the US in 2020. That was at the end of Q3 last year. That dropped down to almost zero by the end of the year, so everybody was feeling pretty good about the world. And then obviously, that's turned on a dime again.

    So broadly, the concerns are will COVID-19, and the spread of that, impact economies; and what will the impact be on earnings? And the answer to those two questions is quite dependent on what governments do and just how long this goes on for. Will the government shut down businesses, schools and so on? And we think certainly overnight the market started to price that, you know, quite aggressively -- which is why we saw the big sell-off. So, there is potential for recession in the US this year. There's potential for a global recession this year if economic activity really comes to a standstill.

    What’s been interesting then about infrastructure in this market-- you know, year-to-date global equities are off 15%  -- Value strategy is off about 10% n-- and our Income strategy is off about 5%. Now that's what you'd would expect infrastructure to do obviously over a shorter period of time in the course of the last week or so.

    You know, the correlations tend to go to one in those very short trading days. But we would expect over the course of this month-- you know, we'll see that defensiveness of infrastructure come through.  We'll be down this quarter, no doubt, but we do expect a much better outcome than global equities generally.

  • Matt Bushby

    Where do you put the difference between, you know, Value – down10%, Income down 5%? What's sort of driving that difference?

  • Nick Langley

    Value is a balance strategy. It looks for a balance between income and capital growth over rolling five-year periods, whereas our Income strategy really is focused on delivering 5%+ annualized dividend yield and, as a result, tends to be much more conservatively or defensively positioned…so [with] higher utility exposures, around the globe.  I think of Income as the defensive strategy, Value is a bit more balanced.

    And so it will take a bit more exposure to the growth elements of infrastructure -- the toll roads, the airports, the rail and ports and so on. Right now, Value is relatively conservatively positioned, but it does carry more of that user-pays exposure than Income, [which is] very much at the defensive end.

  • Matt Bushby

    I guess that slightly more defensive positioning, you know, [of] Value via its history would, I guess, explain the performance versus the infrastructure indices as well.

  • Nick Langley

    Certainly right. We've been cognizant that we're getting later in the cycle. And so, you know, when we think about portfolio construction for both Value and Income, but certainly for Value, we recognize that we need to have more defense in the portfolio. And where we do have a bit of that user-pays or beta exposure, we're pretty careful about picking high-quality names like Transurban locally. And that's held up pretty well through this time period.

  • Matt Bushby

    Probably a good segue into looking at the sectors or even sub-sectors that we have within the portfolios. We've seen the energy sector get hit very hard overnight and we might come back to that one in a second. But broadly speaking, have there been sort of movements as expected, have there been any surprises? What are we seeing in the movements between the various sub-sectors?

  • Nick Langley

    What's worth introducing here is a little bit of context as to what's going on in markets at the moment. We did see quite a number of the hedge funds kind of lever up through February, exactly the wrong timing. And they have been, you know, quite aggressive, marginal buyers and that perhaps led to the peak in February.

    Of course, all of that has unwound quite quickly. And as that unwound, they were getting margin calls and so they were selling the defense in their portfolios. And a lot of that was centered around gold, so actually it was first week of March when all this blew up, gold was off on the week. And that was pretty extraordinary. That shouldn't have happened.

    And it was the hedges in particular, you know, selling down their gold exposures to cover some of their margins. And also, utilities which initially [that] sold off -- that actually recovered quite nicely. Yes, though, we're down a little last night but not nearly anything like the market.

    So we've seen kind of an unwind of a number of positions. So, a lot of technicals in the trading. Broadly, we've seen utilities-- you know, when I look over the time period, dip, [then] come back. So that held up well. The two companies have also held up well. You know, they're in a lot of indices and so on now.

    And a number of the smaller utilities have kind of underperformed their better quality peers. And then you've got, you know, rail companies, airports and so on which have sold off kind of to mid-level, you know, double-digit drops. And then, you know, most recently the pipelines have been caught up with the oil and the energy stocks.

  • Matt Bushby

    Can we just touch on that pipeline comment a little bit further? You know, one of the hallmarks of RARE is the definition of our own investable universe. We screen out companies that are explicitly exposed to commodity prices. Why have we seen the pipeline companies, especially, sell off so hard?

  • Nick Langley

    Broadly what had happened is the concerns around growth globally have resulted in a view that as economic growth is going to slow, then the demand for oil is going to slow and therefore the oil price was dropping. OPEC got together to talk about their production levels and they've been constraining their production to try and keep oil prices a little higher.

    And the relationship between OPEC and Russia, who actually sits outside of OPEC but has been constraining their production as well, that all broke down. And so basically from an OPEC perspective and a production perspective, all bets are off. They're going to flood the market with oil at a time when demand is coming back and so we've seen the oil price drop -- it dropped 30 percent yesterday. And it'll probably continue to go a little further. Now, the pipeline companies don't have direct exposure to commodity prices, but a lot of their customers do.

    And so in this kind of panic in the market, the market's a little worried about some of the customers of the pipeline companies and the potential for them to need refinancing or even bankruptcy protection or something like that in the US, which would interrupt  potential revenue streams and will certainly interrupt forward growth projections -- which obviously goes to, you know, the multiples that these stocks will trade on.

  • Matt Bushby

    How much do we do on the underlying customer base of the pipelines that we own?

  • Nick Langley

    The short answer, and excuse my language, is a hell of a lot. We’ve been through this before in 2015. We bear the scars, we learned some lessons. And so we do a lot of work now on the credit profile of the customers for each of our pipeline companies and understand how much of their EBITDA is at risk.

    And when you look at [firms] like Kinder Morgan, and Williams -- Williams is in the portfolio today, and Kinder Morgan's been in the portfolio recently-- we're talking 3%-4% of their EBITDA. So it's not a significant amount. But in these sorts of environments everything gets sold down. Now, the other point, -- and it's more of a technical trading point-- to recognize is in the US a lot of the institutional owners of these pipeline companies are leveraged funds.

    And so once you get a sell-off happening it becomes self- perpetuating because they get margin calls, they've got to sell more stock to cover those margin calls and de-lever their funds. And so you tend to get quite a significant turnover in the market within a short space of time. And, you know, we've obviously seen that yesterday. We may see that over the next couple of days as well.

  • Matt Bushby

    You touched on a couple of sort of comments-- in that section on, you know, credit quality and so forth. One of the things that people look at infrastructure and utilities is that they sometimes are more highly geared than your typical industrial type company. Are we seeing any evidence of credit stress amongst the broader portfolio?

  • Nick Langley

    The short answer is “no” across the broader portfolio. Obviously pipelines, we've made some comments there. There are some concerns around their customers. But regulators are quite prescriptive as to how much debt these companies should have and they recognize that in the allowed returns. So, the UK water sector, for example, currently the regulator expects the companies to have 60 %debt against their asset base.

    In the US it's anywhere from 45% up to 55%. And the regulators say, if you move too far away from that then I'm actually going to change your allowed returns. So I want you, company, to have an optimized balance sheet to help keep your cost of capital down, to help keep the consumer bills down.

  • Matt Bushby

    So in the listed space at least we haven't seen, you know, a leveraging output of these companies over time.

  • Nick Langley

    No, we haven't. You know, in the unlisted world they're famous for kind of double levels of leverage and all the rest of it.  We don't see that in the listed space. We track that right across the portfolio. And you know, as we sit today, the level of leverage or gearing in the portfolio companies weighted average is about 38 percent net debt to total capitalization.

    So, pretty conservative at the end of the day. And the regulators, as I said, they're prescriptive about how much debt these companies should have and they set aside a certain amount of revenue to cover the debt component of the capital structure.

  • Matt Bushby

    Big question, I guess, with the portfolios, in this kind of volatile market what have we been doing in terms of, you know, positioning changes within the portfolios?

  • Nick Langley

    Yes. Well, the first step is not to panic and to kind of step back and wrap a cool towel around the head. The approach that we've taken is, let's be clear, we assume from the majority of our clients they want us to be fully invested. And so we are. We generally run less than 5% cash.

    So what we have done is taken the opportunity to, particularly with the sharp sell-off in the utilities at the beginning of this process, to actually sell some of the names that had held up well, some of the Canadian utilities in particular, and trade into some of the US names that the hedge funds and the others were selling pretty sharply. So we've done some great trades there. And that's about increasing the quality of the defensive exposures in the portfolio.

    And that was really a last week deal. We got all that trading out of the way. Overnight we've seen some further falls and we may well see further drops in some of the more economically exposed rail companies and so on. We're not ready to buy them yet. But if we saw  another big sell-off, then we'll be in a position where tactically  for the Value strategy this might be five percent of the portfolio, technically we could see some selling of the more defensive utilities to pick up some very cheap cyclical stocks but ones that have been beaten up really badly in the market.

     So, you know, our view is that's the kind of next stage to come. So to recap, to date we've been trading out of some of the names that have that have held up well to buy quality that is sold off. And next stage would be tactically to get a little bit more exposure to some of those cyclical names.

  • Matt Bushby

    And that's common across the value and the income strategies?

  • Nick Langley

    Yes. Income to a greatest degree in terms of trading in, amongst the utilities. And that's because it has a much higher exposure. So, you know, we've done a little bit more work there.

  • Matt Bushby

    What are we saying about liquidity in the market?

  • Nick Langley

    So, because infrastructure is at the more defensive end of markets, when we get these periods of volatility we see an outsized increase in the liquidity amongst the infrastructure stocks. So when you look at the trading, say, of last week versus earlier in February, the general market-- liquidity in the general market is up about-- two-thirds, 66 percent-- and on the infrastructure side is up about 75 percent across the names in our portfolio. So we have seen, you know, our size increase in the liquidity and really that's centered around obviously the largest capitalization companies. But certainly from an infrastructure perspective, we get an increase of liquidity during these periods of volatility.

  • Matt Bushby

    What's the outlook for the future? It's been, as you mentioned upfront, a very short, sharp move based on sort of a couple of external variables. What's our gut feeling of what's going to happen from now on? What are we looking for in terms of that next move in portfolios as you mentioned?

  • Nick Langley

    From a market perspective, we've obviously had a recalibration of expectations over-- what's occurred within a very short period of time. And that's given given rise to the precipitous drop in- markets. As to what happens from here, there's a broad range of scenarios that could roll forward.

    And a lot of that centers around what decision governments make in terms of closing down schools, closing down businesses and the implications that that might have for industrial production for services, businesses like restaurants and so on. And broadly, the governments are trying to spread the peak of the infections in this pandemic to reduce the strain on the medical facilities.

    But by doing that, you're balancing damage to the economy. For us, as capitalists in markets, we'd like to get it over as quickly as possible: “let's get everybody sick, we'll recover and then move on” --  but [of course] really to the health and well-being of citizens, we need to spread that peak as much as we can. It does depend kind of how long everything gets shut down for. Our view is market's pretty close to pricing in a recession, certainly in the US this year. Arguably that's a bit of an overreaction, given what we know at this point in time.

  • Matt Bushby

    Nick Langley, thanks very much for joining us today. We will be recording these podcasts regularly during this volatile period. If you'd like to have any more information, please contact your local sales representative.

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