It’s time to stress test your portfolio

JPMorgan Asset Management’s Stephen Leh, Infrastructure Research, posits three scenarios – recession, inflation and weak energy prices – that could put pressure on core portfolios.

Favourable markets have made many investors complacent about the risks of a downturn, even as listed equity and fixed-income portfolios show signs of pressure.

Traditional investments are expensive relative to historical averages across an array of financial metrics (for example, cyclically adjusted P/E ratios are higher than at any time during the last 100 years, with the exceptions of the dotcom bubble and 1929). Greater risk is often apparent only during market downturns – correlations were much higher during the global financial crisis than more recent averages would suggest.

Investors should thus assess their portfolios’ ability to weather downturns by testing their resilience in the event of recession, higher infla­tion and interest rates, as well as technological disruption.

CORE RESILIENCE

Core infrastructure’s resilience to financial stress has strong theoretical underpinnings. The asset class is characterised by stable and forecastable cashflows, with yield making up the majority of total return. These stable cashflows typically derive from some combination of monopolistic market positions, transparent and consistent regulatory environments, long-term contracts with credible counterparties, mature demand profiles and prudent leverage strategies.

Unlisted core infrastructure is a relatively young asset class and data are, by definition, private. Consequently, there are no reliable, comprehensive third-party return indices that cover multiple economic cycles. However, the MSCI Global Quarterly Infrastructure Asset Index, the first third-party private infrastructure return index, is a relatively good performance indicator (EXHIBIT 1). Over the life of the index, private core infrastructure has demonstrated relatively low correlations with other asset classes, including both equities (0.3) and fixed income (-0.2).

However, no two downturns are the same, and underlying investments can evolve over time – especially when allocations are susceptible to style drift. Investors should not rely exclusively on historical correlations and mean-variance frameworks to assess whether a given portfolio will be resilient in the next downturn. Bottom-up scenario analyses offer a way to test portfolios against a range of outcomes, including those that have never occurred before.

To that end, we applied a scenario analysis tool to an illustrative private core infrastructure portfolio comprising 40 percent regulated utilities, 30 percent contracted power generation and 30 percent transportation. We tested how that portfolio’s cashflows – as measured by its yield on cost – would perform in the event of: a) a global recession; b) higher inflation and interest rates; and c) lower power prices.

Observing cashflows directly eliminates the impact of fluctuating discount rates during a market downturn, which can distort returns and is of reduced importance for long-term investors. Cash yield is also valuable in its own right and allows for a more direct comparison with fixed-income instruments for liability-focused investors. Yield on cost is a more useful metric than yield on net asset value: it would be little consolation if an investment registered a strong yield on NAV because the investment’s underlying value had atrophied. EXHIBIT 2 summarises the impact of these downside scenarios.

STRESS TEST SCENARIO 1: RECESSION

The greatest near-term threat to an investor’s portfolio is a global recession, as recessions are typically preceded by market downturns. That is of special concern with the global labour market uncharacteristically tight, public debt levels increasing, and populism and protectionism ascendant.

Our analysis finds a synchronised global recession has a muted impact on a private core infrastructure portfolio, as per EXHIBIT 3. This downside case models a fairly conservative 10 percent decrease in demand for electricity, heat and transportation; a 5 percent decrease in oil prices; and a 20 basis points parallel shift downward of inflation expectations and real interest rates – with concomitant decreases in power prices and utilities’ allowed returns. Power contracts anchor the long-term yield, and regulated utilities are relatively less susceptible to declining consumer spending. Transportation feels a disproportionately negative impact. Over 10 years, we would expect the average yield on cost to fall by 1 percentage point, from 9 percent to 8 percent.

STRESS TEST SCENARIO 2: HIGHER INFLATION

Higher inflation can raise companies’ expenses and increase their cost of debt. While the probability of runaway inflation is very low in the near term, there remains a possibility that low and negative interest rates, combined with massive injections of liquidity by central banks worldwide, could ultimately trigger a period of higher inflation.

We considered a scenario in which inflation and inflation expec­tations are perpetually 1 percentage point higher than the base-case forecasts. Other inflation-driven variables—such as the cost of debt, com­modity prices including energy, costs of maintenance and opera­tions, and capital expenditures—would rise in line. As EXHIBIT 4 shows, the impact on yield is slight despite the higher expenses. The 10-year average is unchanged, and back-end yields are higher, as fixed-price contracts roll off and utilities receive approval to raise rates. Quasi-monopolistic transportation investments and certain inflation-linked power contracts and regulatory regimes provide inflation protection from the outset.

STRESS TEST SCENARIO 3: POWER PRICE WEAKNESS

Because core infrastructure assets are physical assets, we believe they are less vulnerable to technological disruption than other sectors. No app can replace water mains or container ports. Nevertheless, we sought to understand how resilient infrastructure may be in the face of transformational developments.

We considered a scenario in which renewable energy sources and cheap battery storage advance more quickly than expected, lowering power prices and reducing demand for traditional baseload energy sources. This would also accelerate the transition to electric cars and reduce demand for oil. In our model, spot power prices fall 30 percent and oil prices 15 percent. However, illustrative short-term yields are relatively stable because of long-term power contracts, while longer-term yields are only slightly lower, as can be seen in EXHIBIT 5.

IMPLICATIONS

Investors should continuously assess their portfolios’ ability to weather downturns, and today’s relatively expensive asset valuations reinforce the importance of portfolio construction and downside protection.

As a fairly young asset class, infrastructure has limited performance data, but what data exist point to robust performance through the global financial crisis. Our study supplements that finding and illustrates how a diversified core infrastructure portfolio can be expected to withstand recessions, higher inflation and interest rates, and power price disruption. Consequently, core infrastructure – in addition to providing institutional portfolios with high and stable yields – may help investors to mitigate negative economic and market surprises.