Rising demand helps deliver better returns
The second factor is GDP growth. Again, a look at the numbers between the start of 2004 and mid-2018 shows infrastructure has delivered average annualised returns of 14.3 per cent when GDP was stronger than average. When it was weaker than average, returns were only four per cent.2
That’s perhaps unsurprising given high inflation is usually associated with the late stages of the business cycle. It’s then that aggregate demand begins to outstrip aggregate supply and prices start to rise naturally. It’s also when central banks begin lifting interest rates to stop the economy from overheating.
“For this reason, infrastructure, like other equity investments, also likes GDP growth,” McCormack explains. “Although it historically hasn’t performed quite as well as listed equity in an expansionary market because it was not coming off the same low base.”
Conversely, when an economy starts to weaken or enters a downturn, central banks tend to cut interest rates and increase the money supply to stimulate the economy. When this happens, McCormack says infrastructure has historically performed better than other equity because, like bonds, it continued to produce some income.
“When GDP growth has been strong infrastructure has gone stride-for-stride with listed equity in terms of returns, but when growth has been weak infrastructure's fundamental defensive traits enabled it to perform better than equities,”2,3 McCormack says. “This is what has given infrastructure its strong through-the-cycle returns.”
Strength through the past decade: how to explain the paradox?
So why has infrastructure delivered solid returns throughout an extended period of lower-than-average interest rates?
McCormack believes it comes down to a combination of three things: work conducted to optimise infrastructure assets that have transitioned from government to private ownership, investor flows into infrastructure as an asset class as it has become more mainstream, and better earnings performance than other equity due to infrastructure's high barriers to entry.
“The fall in interest rates was not the causal factor in infrastructure’s strong returns over the period,” he concludes. “In short, returns were twice as good when interest rates were rising.”