In the weeks following the UK’s EU referendum, financial markets have staged a remarkable recovery. There was significant volatility immediately following the vote but, since then, many markets have recovered to levels higher than before the crisis. Despite this recovery, the UK departure from the EU is a multi-year process and the full economic and financial market impacts will only manifest themselves over the coming quarters.
Although the nature and severity of geopolitical shocks cannot be predicted, it is possible to draw out the ways in which they would be likely to impact specific asset classes. This linkage between the economy and drivers of financial market performance can be used to explore the impact of specific shocks to the infrastructure asset class.
Asset class implications of any shock depend on their relationship with GDP and inflation, the specific characteristics of individual asset classes and the severity of the macroeconomic impacts. Public equities and fixed income tend to be inversely related to GDP and inflation shocks respectively. Private asset classes provide some resilience to GDP and inflation shocks, but the way in which they do this depends on the nature of their cashflows and linkage to the broader economy.
For infrastructure, there are marked differences in investment characteristics across the asset class. In essence, infrastructure investments can be more equity or bond-type in their nature and these differences will influence the way in which they respond to economic shocks.
The diagram of infrastructure investment returns captures the typical variations in performance for different styles of infrastructure investment. Assets at the lower levels of risk tend to be associated with a high proportion of income return, often highly regulated and contracted with long-term stability. At the other extreme, higher return assets with a high proportion of return coming through capital growth tend to be less regulated and have less contractual cashflows. Such growth assets are more exposed to economic drivers of growth and competition.
Beyond these fundamental drivers of infrastructure performance, there are two additional important considerations for investors in the asset class, its diversification potential and regulatory and political influences:
Beyond attractive cashflow, duration and return characteristics, infrastructure tends to provide additional diversification benefits compared with other asset classes. The intrinsic characteristics combine with the appraised nature of the asset class to generate low correlations, particularly with public equity and fixed income. These diversification characteristics can be particularly relevant during elevated periods of financial market uncertainty.
While diversification benefits can be attractive to investors, the asset class can suffer from the strong potential regulatory and political influences on its performance coupled with its relative immaturity. The combination of these factors means that the asset class is likely to be susceptible to geopolitical shocks, in terms of both the process for privatisation of infrastructure assets and investor appetite for the asset class.
ECONOMIC OUTLOOK REMAINS UNCERTAIN
It remains too early to assess the full economic implications of Brexit, although the implications are likely to vary significantly by geography:
For the UK, an economic slowdown or mild recession is expected over the coming quarters, despite the boost to exports from lower value of sterling. In line with this, inflationary pressures are likely to be lower over the short term, but the devaluation of sterling is likely to increase these pressures during 2017-18.
For the rest of Europe, weaker growth is expected and inflationary pressures are set to remain lower for longer given the weaker growth and uncertainty facing specific markets, such as the Italian banking sector and the Greek economy.
For the rest of the OECD, Brexit is likely to have minimal impact given the relatively small scale of the UK, but a weaker Europe will dampen overall growth and a stronger dollar might slow US growth. Inflation and interest rates are set to remain lower for longer but only on a temporary basis, with rates set to rise in US over the coming quarters.
Given the macroeconomic consequences of Brexit and the relationship between economic drivers and different asset classes, it becomes possible to draw out the implications of the specific Brexit shock on the infrastructure asset class in the UK, Europe and globally, summarised in the table below.
Given that more growth-oriented infrastructure (such as airports and ports) is strongly influenced by broader economic activity, the weaker outlook for UK GDP will be likely to adversely impact the cashflows from these more growth-oriented assets. This weakness is likely to be reinforced by the regulatory uncertainty that would also impact those assets that have more contractual cashflows, as well as the infrastructure lending market.
Since the Brexit decision, listed infrastructure stocks have performed relatively well compared with broader utilities, given their defensive characteristics and their ability to generate a relatively attractive yield. This certainly was the case following Brexit and before the Hinkley Point delay, which has heightened regulatory uncertainty for the asset class.
There are a similar set of contradictory pressures for the UK private infrastructure lending market. It is possible that infrastructure assets will be seen as relatively safe havens, leading to increased bank lending to the asset class or, conversely, as currently seems more likely, the uncertainty will lead to less European Investment Bank and other bank lending to infrastructure, increasing the spreads and improving the terms available to private lenders.
Outside of the UK, the shock could have a relatively favourable impact for infrastructure investments. Within the rest of Europe, the ‘lower for longer’ scenario is likely to fuel the demand for stable and relatively high-yielding cashflows and lending, as provided by private infrastructure. Beyond Europe, in markets less impacted by the economic consequences of the decision, infrastructure investment is likely to benefit from the relatively high yield and greater maturity of the asset class. This is particularly the case in North America, where growth assets are likely to be supported by stronger economic growth.
The analysis is high-level and illustrative of the relationship between economic shocks and asset class performance and preferences. The relevance will vary according to the situation of individual asset owners, based on their investment objectives, current portfolio and view on the macroeconomic and financial market outlook.
Despite these caveats, it is clear that the attractive yield, return and diversification characteristics of infrastructure places the asset class in a relatively attractive position compared with many other asset classes. This is certainly the case given the increased uncertainty, reduced scope for growth and a ‘lower for longer’ monetary policy, which enhances the search for yield.
However, the economic and political uncertainty of the UK might reduce the relative attractiveness of this market for investors although, even here, assets with more exposure to contracted or regulated income streams would tend to be better insulated against any economic downturn. Outside the UK, infrastructure assets and lending are likely to be relative beneficiaries in the current environment, given its relatively high yield, diversification potential and the further maturation of the asset class.