2023: Setting Sail for Choppy Waters


13 / 01 / 23 - 1 minute read

After an eventful 2022, 2023 looms as a seminal year for investors. A year ago, there were ample reasons to be sanguine – effective COVID-19 vaccine rollouts had eased the human toll of the pandemic, while the global economy continued to recover from the lockdowns of 2020 and 2021 – undoubtedly buoyed by unprecedented fiscal and monetary support.

Instead, 2022 saw inflation surge to multi-decade highs amid a perfect storm of supply chain disruptions, overly accommodative policy settings, and the tragic outbreak of war in Ukraine. Central banks, caught wrong-footed by the persistence of inflation, have scrambled to hike rates. They now face the most delicate of balancing acts, needing to temper the risk of an inflationary spiral without plunging economies into recession. 
Rising geopolitical tensions remain a key concern, with both the war in Ukraine and ongoing tensions in the Taiwan Strait likely to further desynchronise global supply chains, encourage “friendshoring” and place greater emphasis on energy and resource security. 
Finally, a raft of extreme weather events in Europe, Asia-Pacific, and North America over 2022 have offered a further tailwind in the drive for sustainable environmental outcomes.
These themes shape the investment outlook for 2023, with our view being that the global economy will likely experience stagnant growth with easing inflation, but with a material risk of an inflationary recession. Indeed, while the overarching economic sentiment at the start of 2022 may have been one of “cautious optimism”, one may well consider the outlook for 2023 more akin to “cautious pessimism”! 
How should investors navigate these challenging conditions?  In our opinion, infrastructure offers an important stabiliser and source of both growth and yield in these uncertain times.
 

Author

Graham Matthews

Source: Preqin, December 2022.

Infrastructure in a world of high inflation and interest rates

While the key challenges faced by infrastructure investors in recent years – such as valuations, competition for assets and geopolitics – remain a concern, the impact of rising interest rates is now paramount. As with other asset classes, higher rates can impact asset valuations, refinancing costs and broadly curb economic activity. 

However, compared with other classes, infrastructure can offer a stronger bulwark against the effects of high interest rates.

Firstly, a number of infrastructure sectors exhibit relatively steady demand and performance through economic and policy cycles. For example, social infrastructure sectors such as healthcare and education provide essential services often underpinned by strong regulatory support for operators. Additionally, adverse economic conditions tend to encourage allocations to true infrastructure assets, which exhibit higher pricing power owing to natural monopolies, or long-term contracted cashflows, resulting in high-profit margins even in slower growth environments.

Additionally, while inflation is expected to ease from the multi-decade highs of 2022, this is likely to be gradual, and inflation will likely remain above central bank targets into 2024 at least. As a result, the inflation insulation offered by infrastructure assets – many of which have revenues contractually linked to inflation – is also attractive to investors. 

 

Reflecting these benefits, investors retain a favourable 2023 outlook for infrastructure. Among the alternative asset classes, the highest proportion of investors expects to increase capital commitments to infrastructure in the coming year. Part of the reason for this is that infrastructure has continued to meet or exceed investors’ expectations – more so than any other alternative asset class.

We also see the near term as particularly supportive for the mid-market infrastructure segment. While infrastructure fundraising activity slowed over the second half of 2022, mid-market strategies remain popular, underpinned by the relatively smaller deal sizes for sectors such as social infrastructure, some renewables segments (such as solar and onshore wind), and “smart cities” digital infrastructure. 

Source: Preqin, December 2022.

Additionally, we consider that the increase in geopolitical risks is likely to serve as a continuing catalyst for the decentralisation of infrastructure, leading to a larger number of smaller infrastructure assets/projects. Of course, infrastructure is not without potential challenges in the year ahead.

Source: Preqin, December 2022.

 

Rising interest rates will curb economic growth and can impact infrastructure sectors with greater GDP linkage, such as transport and oil and gas, and present challenges for higher risk-return strategies, such as those with an opportunistic focus. They will also increase debt servicing costs for assets funded with loans that are floating rate or require refinancing in the near term.  As a result, investors need to be particularly selective in relation to which infrastructure sector they invest in.

Another consideration is the dry powder that has been accumulated by infrastructure managers following record levels of fundraising over 2021 and 2022 – especially those with a large-cap and North American focus. This presents a double-edged sword, enabling swift capital deployment as opportunities arise, but also increasing pressure to execute amid heightened competition in the areas of focus of these funds.

Playing the long game

Separate to the near-term benefits of infrastructure as an asset class, its investment horizon remains long term in nature, and secular trends will continue to shape opportunities in 2023.

The significant challenges to addressing climate change remain front of mind – in a recent industry survey every single infrastructure manager flagged decarbonisation as a primary driver for capital investment over the next decade. In addition to more established renewable energy sources such as wind and solar energy, green hydrogen energy delivery is emerging as an opportunity in this space, where there is likely to be an enormous need for investment over the coming years and decades.

Although the main channel for decarbonisation will be the transition to renewable energy, there are other ways in which this will be achieved. We see opportunities in areas such as green transport in Europe, where longer-term EU goals around emissions reductions will require a step change in transportation infrastructure. One example is the establishment of integrated green “corridors” for freight transportation with more environmentally friendly multimodal supply chains and the use of special hubs. Other examples include improvements to high-speed rail networks and the rollout of electric vehicle charging stations. Another segment with scope for growth is carbon capture and storage, with nascent infrastructure such as waste-to-energy facilities starting to garner government support. Finally, battery storage facilities have rapidly gained traction in a short period of time.

 

Similarly, telecommunications offers increasing opportunity. A recent surge in deal activity reflects greater appetite for digitalisation, which can help drive sustainable outcomes through “smart city” technology to improve transport network efficiency and energy and water conservation. Other emerging areas of growth within the sector are energy-efficient “green” data centres, as well as the integration of smart buildings with connected smart city infrastructure.

The need to modernise ageing infrastructure despite greater government fiscal constraints is also expected to be positive for the asset class. Rising interest rates are adding to the borrowing costs of increasingly indebted governments, while ageing demographics in the developed world are placing greater strain on shrinking tax bases. As a result, scope for investment is likely to increase, with recent infrastructure fiscal packages likely to require material accompanying private sector involvement.

Source: Preqin, December 2022.

The investment outlook for 2023 is no doubt challenging. As the global economy goes through a bout of significant uncertainty, investors will have to navigate deftly a range of headwinds. Such conditions offer support for infrastructure given the class’s relatively higher inflation protection and lower GDP linkage.

And whilst 2023 will no doubt turn out to be an interesting year, ultimately, it is the long-term megatrends that will drive investment returns.  Infrastructure’s pivotal role in generating positive environmental and societal outcomes over periods measured in decades rather than years, undoubtedly offers cause for optimism.