The fortunes of individual global infrastructure companies will be driven by three key themes in the year ahead. Nick Langley and Richard Elmslie, Co-CEOs and Co-CIOs of RARE Infrastructure, explain the risk and opportunities to companies for each of these themes and give their general outlook for 2018.
1. Asset-based growth
Across the board in global listed infrastructure, many companies are continuing to invest in their underlying assets to generate future returns. Given that companies are trading at elevated multiples, asset-based growth has become a topical issue. Companies need to demonstrate that they have avenues of growth to support valuations in order to alleviate investor concerns.
As it relates to regulated utilities, regulators are providing most of the companies RARE invest in with an 8% to 10% return on their equity, which in turn, is being invested in the companies’ underlying assets. This investment supports cash flow, earnings and dividend growth.
2. Price elasticity of demand
Put simply, price elasticity of demand considers the impact of price increases on the usage and affordability of a company’s assets. In other words, as prices steadily increase, companies need to be careful that they continue to retain consumer usage of their assets. This is important for infrastructure companies that own user-pay assets; they need to ensure, for example, that motorists are continuing their usage levels of toll roads and passengers continue flowing through their airports.
Most of the user-pay companies RARE invests in have concession agreements in place that dictate how much they can increase their prices. Given this regulatory framework, it is a question of whether these companies will retain the same level of demand and usage as prices increase. As usage of these assets are linked to economic growth, RARE believes that as long as it continues to see strong underlying economic growth, these companies will continue to see an increase in revenue and cash flow growth, which is supportive of earnings and dividend growth.
3. Technological disruption
Moving into 2018 and beyond, markets may start to see some differentiation around technology disruption. Investors are starting to consider, and be wary of, the impacts of changes in technology on the way we utilise our infrastructure, and there may be some winners and losers out of that. Some examples of disruptors within the infrastructure sector include: the falling cost of battery energy storage, greater penetration of renewable power generation, increased inter-connection of electricity networks, and the greater prevalence of electric vehicles.
Market and macro outlook
RARE believes the macroeconomic environment to be relatively benign. While there may be volatility, RARE does not expect any major corrections as there is still significant cash on the sidelines waiting to “buy the dips”.
Moving into 2018, inflation is a key area of focus. At present, we expect the world to diverge in terms of inflationary pressures. It’s important to note that some inflation is healthy for an economy. For instance, wage inflation is necessary to reduce underemployment, encourage movement up the job quality scale and promote re-entry to the workforce. Additionally, some inflation is also important for asset prices.
We believe that this is where the central banks’ involvement will be quite significant, and as we move into 2018, it will be a topical issue to follow closely. In the US, we see the US Federal Reserve continuing to raise rates to further reduce the currently accomodative monetary policy. In Europe, the European Central Bank (ECB) is set to reduce quantitative easing (QE) – a transition that is difficult to implement steadily.
Additionally, we believe that politics will continue to play a key role in driving swings in investors sentiment. This is something that markets tend to forget. Concerning Europe, we are at quite a pivotal point given the Brexit overhang, as such, the implementation of Brexit at a macro and company-specific level is something that we are closely following.
RARE is not chasing growth at this stage of the economic cycle. It believes in risk-adjusted returns to equity and that is a consistent approach across each of its actively managed strategies. In 2017, RARE increased the defensive positioning of strategies and will continue to do that as markets move further through the cycle. Specifically, RARE is looking for a balance between the more defensive, regulated utility companies with higher-growth user-pay companies.