AMP shows why rates are over-rated for listed infrastructure

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Historical evidence suggests global listed infrastructure would bounce back strongly after a poor run in the latter half of 2016 that included the worst monthly performance relative to equities for more than 10 years, according to new research from AMP Capital.

In ‘Global listed infrastructure: not just a bond proxy’, AMP Capital says the recent divergence in the asset class from the broader international equities index reflects market over-reaction to rising interest rates rather than long-term fundamentals.

Giuseppe Corona, AMP Capital head of global listed infrastructure, said the ability of the underlying assets to generate cashflow growth was more important for investors than rising interest rates.

“Having said that, volatility that comes with short-term increases in interest rates can present a buying opportunity for savvy investors to capitalise on the dislocation between value and price,” Corona said in a statement.

Infrastructure tends to be marked down during periods of rising interest rates due to generally high leverage in the underlying assets, which ultimately impacts cashflows, the AMP paper says, with the listed version hit first.

“Indeed, volatility and/or increases in the sovereign bond markets (and yields) have an immediate effect on listed markets, although our analysis suggests equity markets usually overreact to these periods of higher volatility,” the report says.

The AMP analysis shows listed infrastructure has underperformed equities in the wake of the last three “meaningful” periods of rising rates since the 2008 global financial crisis. However, in all three cases the asset class recouped its underperformance relative to global shares within 12 months “following these periods of increase in nominal yields”.

“What this shows is a market overreaction to a rising yields environment,” Corona said. “A strong correlation between the performance of global listed infrastructure and its cashflow growth shows investors should focus on the underlying assets and their ability to generate visible and growing cashflows, and not be spooked by the dramatics of short-term market moves.”

Over June to December last year global listed infrastructure fell 4 per cent in absolute terms and underperformed global equities by 12 per cent in a period that saw US 10-year yields jump from 1.4 per cent to 2.6 per cent. The November 2016 monthly drop of 5.7 per cent in the listed infrastructure index was “the worst since 2002”, the AMP study says.

But the report says as well as tending to “overreact” to rate rises, markets typically ignore the diversification effects of the underlying infrastructure sectors. The AMP analysis shows the four infrastructure sub-sectors – communication, oil and gas storage and transportation, transportation, and utilities – demonstrate idiosyncratic behaviours in different interest rate environments.

“Given the different duration, regulatory frameworks and exposure to growth, it is not surprising that [listed infrastructure sectors’]performance have seen meaningful divergence during the aforementioned periods of rising sovereign yields,” the paper says.

For example, during the latest bout of rate hikes the oil and gas sector returned about 10 per cent as utilities was 5 per cent in the red.

“The biggest driver of infrastructure’s sensitivity to changes in interest rates, both on cash flow and valuation, is from the duration of the assets themselves, with factors such as regulation, financial leverage and growth, both economic and stock/sector specific, also having an impact,” the AMP report says.

The study also maps out how listed infrastructure would likely perform in three different real interest rate scenarios: falling inflation expectations; reflation – or possibly “unanchored” inflation followed by central bank tightening; and, normalisation – where inflation, growth and interest rates conform to long-term trends.

Under the first two regimes the AMP analysis says listed infrastructure would either outperform or be on par with global equities. However, if ‘normal’ conditions return listed infrastructure would underperform global shares, the report says.

Across all three inflation scenarios the listed infrastructure sub-sectors would have different return characteristics.

“As we transition to a different economic and financial environment (i.e. tail end of unconventional monetary policy), and given the recent volatility in global bond markets, we believe it is important to differentiate the impact of various nominal and real interest rates’ scenarios on the asset class, in order to provide a framework for portfolio construction and asset allocation,” the AMP report says.

– David Chaplin, editor of Investment News NZ

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