Infrastructure: shelter from the storm

15 March 2019

It’s a misconception among investors that infrastructure performs best when interest rates are falling.1 In fact, historically the reverse has been true, says Macquarie Infrastructure and Real Assets Economist, Daniel McCormack. And infrastructure has historically performed better than equity in a downturn, meaning it has the ability to weather all market cycles, including a recession.

“Unlisted infrastructure tends to perform better when interest rates are going up rather than going down,” McCormack explains. “It is just that for the past 10 to 20 years we’ve experienced a low interest rate environment at the same time as infrastructure delivering strong returns, so people erroneously connect the two."2

McCormack points out that while infrastructure has performed well overall between the start of 2004 and mid-2018, it has risen 13.2 per cent in annualised terms when interest rates went up and just 6.6 per cent when interest rates fell.2

McCormack also says infrastructure’s performance in rising interest rate environments can be based on its close relationship with two other factors.

The close bond between infrastructure and inflation

The first is inflation. Infrastructure assets usually have their returns linked to the level of inflation - either explicitly in the case of regulated assets such as water or electricity and gas distribution networks, or implicitly in the case of transport assets such as roads.

“For both asset classes, higher inflation tends to increase revenue,” McCormack says.

He argues that, for this reason, infrastructure has been used as an effective hedge against inflation as it performed relatively well when inflation was unexpectedly high. That’s because, unlike other equity investments, inflation hasn’t cut infrastructure profits but has contributed to them.

"For the past 10 to 20 years we’ve experienced a low interest rate environment at the same time as infrastructure delivering strong returns, so people erroneously connect the two."

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.”

  1. A Preqin Survey found 43.3% of infrastructure investors believed low interest rates were driving returns (Preqin Ltd. 2018).

  2. Based on the performance of the Cambridge Associates Unlisted Infrastructure Index from 1Q2004 to 2Q2018. For interest rates we use a GDP weighted average of the US, German and UK 10-year government bonds. For interest rates over the same period, we used data from Bloomberg Finance LP. For GDP growth, we use CEIC data to calculate a GDP weighted average of US, German and UK GDP growth.

  3. When GDP growth is above average unlisted infrastructure delivers and average annualized return of 14.3% while equities deliver 14.4%. When GDP growth is below average unlisted infrastructure delivers 4.0% annualized while equities deliver -0.5%.