The age of interest rate uncertainty

The decision by the Reserve Bank of Australia to cut interest rates by 25 basis points in November might result in good news for both investors and the markets, according to Paul Williams.

On the first Tuesday in November each year, Flemington Racecourse hosts what has become famously known as ‘the race that stops a nation’.

During the Melbourne Cup festivities this year, the Reserve Bank of Australia (RBA) did its bit to get the nation going again.

As punters eagerly awaited the result of the photo finish in the big race, Australian households and corporate borrowers were already rejoicing at the RBA’s 25 basis point cut in policy interest rates.

The first rate cut in Australia in more than two and a half years is sure to provide some relief to home owners. Businesses, too, are likely to benefit from an expected boost to consumer sentiment and an increase in consumer discretionary spending power.

But what does this mean for investors?

RBA Governor Glenn Stevens’ statement accompanying the announcement highlighted the recent moderation in the pace of global growth, flagged Europe as a key concern and noted the recent financial market turmoil may result in “a period of precautionary behaviour by firms and households”.

Such precautionary behaviour has been evident for some time, with households around the world saving more and starting to pay down debt.

This heightened aversion to risk and consequent household deleveraging is the natural aftermath of a multi-year credit boom and subsequent downturn, which could have important implications for investment markets.

Research conducted by Bank of America Merrill Lynch found that previous periods of household deleveraging around the world lasted six years on average. In share markets over this time:

• Dividends accounted for a much larger share of returns than during normalised periods, with over half of total returns derived from dividends during deleveraging compared to the historic average of less than one-third;
• Defensive securities outperformed, whilst banks and industrials tended to underperform; and
• Returns were lower and volatility higher than the historical norm.

We believe an investment in the publicly traded equity securities of stable, income producing global infrastructure companies may be one solution to navigating through this period of continued uncertainty, risk aversion and household deleveraging.

Now to look at each of these points in more detail.

Dividends accounted for a much larger share of returns 

Infrastructure companies own and operate long-lived assets that provide essential services, such as toll roads, airports, sea ports, oil and gas pipelines, electricity transmission lines, water pipelines and treatment plants and communication towers.

Most offer dividend yields ranging from 2.5 per cent to 7 per cent, with a number delivering over 10 per cent. Importantly, these dividends are backed by stable, long-term cashflows that are less impacted by the broader macroeconomic environment than typical broad market equities.

Such stability is depicted in Chart 1, with infrastructure securities realising positive cashflow (earnings before interest, taxes, depreciation, and amortisation) growth each year over the past decade, even during the 2008 global financial crisis.

This has translated into weighted average dividend growth of 5.8 per cent per annum over the past five years.

Defensive securities outperformed

Infrastructure securities can be thought of as ‘no boom – no bust’ securities due to the inherently defensive nature of the infrastructure asset class.

Infrastructure assets serve as the foundation for basic, irreplaceable public services, which are necessary to support economic and social activity. As a result, they are less impacted by economic cyclicality. 

Electricity transmission companies such as ITC in the US or Red Electrica in Spain, for example, own and operate high voltage lines carrying electricity from power stations to cities. Their revenues are guaranteed by regulation, and have no sensitivity to the amount of electricity used by households or commercial properties.

Infrastructure assets are often owned in perpetuity and subject to regulatory contracts, or underpinned by long-term concessionary agreements lasting 25 to 99 years.

This framework supports visibility on future real earnings, with price increase provisions often embedded to ensure a predictable and growing return over time.

Transurban’s concession agreement for the M1 motorway in Sydney, for example, regulates toll increases at the greater of either the consumer price index or 1 per cent per quarter for the remaining life of the concession, which currently stands at 37 years.

Further, the typical features of high barriers to entry, monopoly-like pricing power and modest ongoing operational and maintenance expense often translate into high operating margins once an asset becomes operational. This creates significant free cashflows which can be used to support dividend distributions.

Whilst defensive as a whole, the infrastructure asset class is comprised of sectors with varied degrees of defensiveness.

The demand for water pipelines and electricity transmission lines, for example, remains relatively stable throughout economic cycles, whereas passenger and freight volumes (which drive the demand for airports and seaports) are much more closely tied to regional or global economic activity.

Through active management, a portfolio of global infrastructure securities can be adapted according to the growth prospects and prevailing market conditions in each sector and geography.

In addition to offering an attractive yield, an active strategy can also provide diversification and enhance the opportunity to deliver sound capital growth.

Returns were lower than normal and volatility higher

Whilst still relatively nascent, the global infrastructure securities asset class has consistently delivered strong total returns relative to both equities and bonds.

Indeed, the Dow Jones Brookfield Global Infrastructure index has outperformed global equities over every rolling three-year period since inception of the index in 2002 (see Chart 2). 

In this ‘new normal’ environment of lower returns and higher volatility, investors may rightly focus on risk-adjusted returns.

On this metric, too, the global infrastructure securities asset class has delivered relative to the broader equity markets, as shown in  Chart 3 below.

Of course, past performance is not necessarily a good predictor of future returns.

We strongly believe, however, that the fundamental attributes of the global infrastructure securities asset class makes it an appealing investment proposition, well-suited to today’s uncertain and volatile environment.

As households continue to delever and governments globally work through their significant fiscal imbalances, an asset class which offers strong, growing dividend yields and the opportunity for capital growth is certainly one that warrants attention.

Paul Williams is an investment specialist for global property and infrastructure securities at AMP Capital.