Written by Benjamin Morton, head of global infrastructure at Cohen & Steers
The prospect of enduring inflation, anemic global growth and heightened market volatility in 2023 and beyond amplify the importance of a dedicated listed infrastructure allocation.
Inflation is easing but expected to remain above trend
After the challenging inflation and interest rate shocks in 2022, the global economy is in transition. Inflation, which peaked last fall, is expected to decline further. But a rapid return to pre-pandemic conditions of sub-2% annual price increases appears doubtful. Inflation will likely remain sticky and, in the U.S., may not return to the Federal Reserve’s implied 2% target before the end of 2024 due to wage pressures, higher costs from deglobalization and other factors. In the meantime, the inflation protection mechanisms in infrastructure pricing structures should remain supportive of the asset class.
Historically, listed infrastructure has produced above-average returns when inflation is elevated but falling, similar to today. Since 1973, the asset class has produced a 9.9% average 1-year real return when inflation has been above trend but moderating. That’s an annual real return 2.3 percentage points above its long-term average of 7.6% across the entire 50-year study period.
Keep in mind that economists have consistently underestimated inflation during the last two years. Previous periods of unexpected inflation similar to what the world has recently endured (such as post-WWII and the 1970s) saw a considerable volatility in inflation following its initial containment. We believe those historical periods correlate with the environment we are moving towards, suggesting the potential for future challenges in predicting inflation. And it accentuates the value of an infrastructure allocation as a portfolio inflation hedge.
Today’s macro environment suggests the appetite for infrastructure’s attributes will remain high
A spirited debate is being waged these days about the economy’s direction. A recession is possible in 2023 as the effects of credit tightening and the recent banking crisis work through the system. And the risk to growth appears to be to the downside.
Central banks are in the difficult position of balancing still-high inflation alongside financial sector instability. Backing off from further tightening to allow financial markets to stabilize may further exacerbate inflationary pressures. On the other hand, continuing to hike rates to curb inflation may further inflame financial market stress, particularly since the root cause of the recent banking crisis stems from a deeply inverted yield curve. Complicating the situation, banks are tightening lending standards, which typically leads to a slowdown in growth (particularly in the most rate-sensitive areas of the economy, such as equipment and construction) and a reduction in hiring.
Challenges may prevent a rapid rebound in traditional risk assets
Infrastructure has historically outperformed the broad global equity market in three of four phases of the business cycle. Our study is conditioned on recessions as reported by the National Bureau of Economic Research (NBER) and expansion subdivisions based on the Conference Board’s Composite Index of Coincident Indicators. Infrastructure has outperformed the broader equity market in periods characterized by overheating economic conditions (late cycle), business cycle downturns (recession) and the recoveries that follow (early cycle).
While the NBER did not declare a recession in 2022, the year saw several hallmarks of one, including two consecutive quarters of negative growth, a steep yield curve inversion and a pronounced drawdown in equity prices. The banking crisis may intensify the severity of the current recessionary period.
We believe challenges in the new economic paradigm—including persistent higher inflation and higher nominal interest rates—may prevent the rapid acceleration in economic activity usually seen in the early cycle recovery stage. For instance, with little slack currently in the system, a sharp rebound in corporate profits appears unlikely.
Consequently, a typical V-shaped rebound in traditional risk assets may not occur either. Equity valuations in most markets appear only fair, not cheap, and higher structural inflation alongside greater volatility suggests that risk premia will remain elevated, which may limit equities’ price gains. Such conditions set the stage for infrastructure to potentially outperform the broad equity market, as investors favor these businesses for their stable cash flows and attractive income generation capacity.