CONTRIBUTORS
Charles Hamieh
Portfolio Manager
ClearBridge Investments
Shane Hurst, CFA
Portfolio Manager
ClearBridge Investments
Nick Langley
Portfolio Manager
ClearBridge Investments
Key takeaways
- Infrastructure’s differentiated returns could offer some diversification away from the risks of concentrated trades, and with President-elect Donald Trump’s policies potentially leading to a second round of inflation, infrastructure’s inflation pass-through mechanism could be even more attractive in 2025.
- Peaking interest rates are a good sign for infrastructure, as we have seen it outperform global equities following the last Federal Reserve (Fed) interest-rate hike prior to cutting cycles. At the same time, we believe we’re still seeing a catch-up of a gap between infrastructure earnings and total returns since 2022, and valuations are attractive for this reason.
- Opportunities remain widespread across the infrastructure landscape, with utility fundamentals some of the best we have ever seen and the market still massively underestimating the growth in electricity demand driven by artificial intelligence (AI) and data growth.
Defensive and diversifying returns valuable in 2025
The concentrated market of 2024 and the return of inflationary pressures are a good reminder of what sets infrastructure apart from other asset classes and why we believe this will be attractive in 2025. First, infrastructure offers a differentiated source of returns; unlike general equities and real estate, the key driver of long-term returns for infrastructure investors is growth in the underlying asset bases. Regulators generally provide an allowed return with reference to the underlying asset base of these essential companies, though how this occurs varies by region. If the regulator is providing steady allowed returns on a growing asset base, we would expect earnings to increase at broadly the same pace as the underlying asset growth.
Second, infrastructure offers inflation protection. Infrastructure assets are designed to provide long-term benefit for their communities and stakeholders and, as a result, allowed returns are generally linked to inflation. This inflation “pass-through” mechanism allows prices paid by the users of the asset to adjust periodically and ensures that the returns to equity investors funding these assets are not eroded over time due to the effects of inflation. Importantly, this inflation pass-through can take anywhere from three months to three years to have an impact on reported earnings, depending on the type and location of the assets.
With early 2024 returns for most investors dominated by momentum related to the Magnificent Seven stocks,1 or more recently cyclical stocks surrounding the US presidential election, infrastructure’s differentiated returns offer some potential diversification away from the risks of concentrated trades. And with Trump’s policies potentially leading to a second round of inflation, infrastructure’s inflation pass-through mechanism will likely be all the more valuable in 2025.
Total returns still catching up to strong earnings
Peaking interest rates are a good sign for infrastructure, as we have seen it outperform global equities following the last Fed rate hike prior to cutting cycles (Exhibit 1). After central banks kicked off easing in late 2023, market breadth has continued to improve. As this has occurred the market has begun to recognize the strong fundamentals and secular themes of the infrastructure asset class. These include decarbonization, growing power demand from AI and data growth, and significant network investments to replace aging assets, improve resiliency and meet the needs of realigning supply chains and onshoring trends.
Exhibit 1: Infrastructure Performance Following Last Fed Rate Hikes
As of September 30, 2024. Sources: ClearBridge Investments, FactSet. FTSE Global Core Infrastructure 50/50: average total return in local currency of the constituents for the past 5 years ending Sept. 30, 2024. Hypothetical outcome, noting not all stocks in the FTSE Global Core Infrastructure 50/50 were available during each historical cutting cycle. Global Equities: MSCI AC World Index, gross returns in local currency. Performance reflective of the 6-month, 1-year, 3-year and 5-year period following the last Fed rate hike prior to cutting cycles in 1989, 1995, 2001, 2007, 2019 and 2023 (2023 cycle – 6-month & 1-year performance only). For illustrative purposes only. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
For utilities, we think their earnings stability will be sought after in what looks to be a more unpredictable and volatile market going forward. Add to this the structural tailwinds we are seeing in AI, decarbonization and network investment, and utility asset bases and earnings are set to grow at some of the fastest levels we have seen in many years.
User-pays infrastructure assets are more tied to gross domestic product (GDP) growth, which is projected to stay at 3.1% globally in 2024 and rise to 3.2% in 2025,2 per the International Monetary Fund (IMF) report. This bodes well for economically sensitive assets such as toll roads, airports and ports. Freight rail in the United States should also see increasing momentum, as the US economy continues to be a standout grower among its peers. The risk remains, meanwhile, that reflation could hinder some of the consumer-driven services such as travel at the margin.
Zooming out, we believe we’re still seeing a catch-up of a gap between infrastructure earnings and total returns which has been in place since 2022, and valuations are attractive for this reason. Even though there has been a strong positive correlation between infrastructure earnings growth and infrastructure total returns, increasing earnings and strong fundamentals have yet to fully offset the dislocation in valuations due to the rise in real bond yields in 2023 (Exhibit 2). We expect this gap to close over time as the market recognizes the strong long-term themes of infrastructure.
Exhibit 2: Infrastructure Total Returns Typically Track Earnings
Data as of September 30, 2024. Source: Global Listed Infrastructure Organization (GLIO). FTW GLIO Global Index is the FT Wilshire GLIO Global Listed Infrastructure Index. *EBITDA, short for earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. It's used to assess a company's profitability and financial performance. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Opportunities remain widespread across the infrastructure landscape, with utility fundamentals some of the best we have ever seen. We believe the market is still massively underestimating the growth in electricity demand driven by AI and data growth, as well as any pro-growth fiscal policy that would boost manufacturing. Utilities with exposures to these strong themes, and a high likelihood of earnings upside surprises, look well positioned.
Overall, we believe the opportunity set for global infrastructure remains highly attractive in 2025 as an expanding and more demanding population, as well as multidecade mega trends such as decarbonization, reindustrialization and digitalization, drive growth.
Definitions
The FTSE Global Core Infrastructure 50/50 Index gives participants an industry-defined interpretation of infrastructure and adjust the exposure to certain infrastructure sub-sectors. The constituent weights for these indices are adjusted as part of the semi-annual review according to three broad industry sectors – 50% Utilities, 30% Transportation including capping of 7.5% for railroads/railways and a 20% mix of other sectors including pipelines, satellites and telecommunication towers.
The MSCI All-Country World Index (ACWI) captures large and mid-cap representation across 23 developed markets and 24 emerging markets countries.
Footnotes
- The “Magnificent Seven” are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
- Source: IMF World Economic Outlook Update, January 2024. There is no assurance that any estimate, forecast or projection will be realized.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
Equity securities are subject to price fluctuation and possible loss of principal.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Diversification does not guarantee a profit or protect against a loss. Dividends may fluctuate and are not guaranteed, and a company may reduce or eliminate its dividend at any time.
Investment strategies which incorporate the identification of thematic investment opportunities, and their performance, may be negatively impacted if the investment manager does not correctly identify such opportunities or if the theme develops in an unexpected manner. Focusing investments in information technology (IT) and technology-related industries carries much greater risks of adverse developments and price movements in such industries than a strategy that invests in a wider variety of industries.