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By Daniel Chu, CFA, Charles Hamieh, Shane Hurst, & Nick Langley
Rate Pressures Ease for Renewables, Communications
Market Overview
Infrastructure and equity markets rallied into the end of the year, driven by a precipitous decline in interest rates as sustained disinflationary trends created an expectation that not only is the Fed finished raising rates, but rate cuts would also begin sooner and be more numerous than previously expected.
The proverbial punch bowl was spiked as October inflation data came in lower than expected in November, then again following the December Fed meeting where Chairman Powell’s dovish press conference added to the soft landing narrative given strong current GDP growth, full employment and a Fed pivot in sight. As a result, the 10-year Treasury yield, which peaked at nearly 5% in October, ended the year below 4%, while federal-funds futures priced in six interest rate cuts in 2024. Given the current economic backdrop and market valuation, the soft landing narrative has seemingly become consensus for investors.
Risk assets rose as the interest rate regime began to shift, with both infrastructure and global equities making strong gains in the quarter. In the S&P Global Infrastructure Index, economically sensitive sectors such as airports, rails and toll roads performed well, while renewables also advanced as interest rate pressures abated. Oil prices fell in the quarter, from $90 to $72 per barrel of WTI crude, as the prospect of slower demand growth from China and increased production globally outweighed supply pressures from announced OPEC cuts and hostilities in the Middle East. Energy infrastructure, while making positive gains, underperformed the market as a result.
All sectors contributed positively to quarterly performance, with the largest contributors U.S. electric utilities and communications as well as Western Europe electric and U.K. water utilities. The strong performance of these yield-sensitive sectors can primarily be attributed to the decline in bond yields over the quarter.
While U.S. electric utilities were a key detractor to performance for the first three quarters of 2023, the sector was the top contributor in the fourth quarter as bond yields fell, also reflecting its large weight in the portfolio following recent increased exposure. Within the sector, Public Services Enterprise Group (PEG), which operates the largest utility business (~90% of earnings) in New Jersey, along with a generation business (~10% of earnings) of nuclear assets, received a good outcome on the extension of its gas replacement capex program, which came in above the current run rate of investments.
U.S. communications companies American Tower (AMT) and Crown Castle (CCI) also performed well. Both companies are leading independent owners and operators of wireless communications infrastructure in the U.S., with more than 40,000 towers in the U.S. American Tower has a further 139,000 sites across 19 countries, predominantly in emerging markets (75,000 in India, 40,000 in Latin America and 18,000 in Africa). Shares outperformed as bond yields fell and investors rotated into yield-sensitive sectors such as towers. Crown Castle was further boosted by news of an activist investor seeking to make changes to the company’s management and board and to review assets for potential divestiture.
In Western Europe, Italian electric utility Enel (OTCPK:ENLAY) outperformed with Italian bond yields lower and the company’s strong results setting up positive shareholder expectations leading into the company’s capital markets day.
The U.K. water sector, meanwhile, recovered on positive news on both growth expectations and allowed returns for the upcoming regulatory period (2025-2030). Additionally, political scrutiny on the sector receded somewhat, with the next period’s business plans meeting little negative press. Pennon (OTCPK:PEGRF), a U.K. water and waste services company, was the lead performer in the sector.
Japanese rail operator West Japan Railway (WJRYY, JR West), one of Japan’s largest passenger railway operators, was the main detractor for the quarter. JR West operates the Shinkansen high-speed rail lines near Kansai, as well as commuter trains within the Osaka metropolitan network. A jump in Japanese 10-year bond yields early in the quarter weighed on JR West, which finished the quarter largely flat.
The other detractor for the quarter, E.ON (OTCPK:EONGY), is a European electric utility company based in Essen, Germany. It runs one of the world’s largest investor-owned electric utility service providers and is the largest distribution system operator in Germany. We initiated a new position in E.ON late in the quarter, and shares traded sideways to close out the period.
Positioning and Outlook
We are maintaining our defensive positioning with greater exposure to regulated and contracted utilities (electric, gas, water and renewables) relative to GDP-sensitive user-pays sectors (transport and communications) as we believe the economy in 2024 will be facing the delayed effects of monetary tightening, which famously acts with long and variable lags. Regulated assets generally have their allowed returns (whether real or nominal) adjusted at each regulatory reset. This does lead to some lag to changes in bond yields, but generally has an immaterial impact on fundamental valuations.
Any slowdown in economic activity in 2024 puts corporate earnings broadly at risk. However, we continue to see positive earnings revisions for infrastructure companies, particularly regulated and contracted utilities, based on that pass-through of inflation and growth in their underlying asset bases. Much of this growth will be driven by the energy transition as the world addresses its need to build out the networks of poles and wires to connect all the renewable facilities’ generators. There is also significant spending to improve the resilience of networks to storms and natural disasters. That is all flowing into growing asset bases, which leads directly to growing earnings profiles for infrastructure companies. Therefore, we expect to enter 2024 with positive earnings revisions for these companies just as broader equities begin to see negative earnings revisions.
Further, if 2023’s spike in real bond yields fades, we expect a significant uptick in the valuations for regulated and contracted utilities in the next year or two. We don’t necessarily need bond yields to roll over for investors to benefit from the returns of infrastructure, merely reduced volatility could be supportive for valuations. The infrastructure companies we target typically underperform during periods of rising bond yields but subsequently recover as bond yields stabilize or decline. We continue to see excellent opportunities across the infrastructure spectrum, and contracted valuations in 2023 have increased our return expectations.
Portfolio Highlights
We believe an absolute return, inflation-linked benchmark is the most appropriate primary measure against which to evaluate the long-term performance of our infrastructure strategies. The approach ensures the focus of portfolio construction remains on delivering consistent absolute real returns over the long term.
On an absolute basis, the Strategy saw positive contributions from all eight sectors in which it was invested in the fourth quarter, with the electric sector the standout positive contributor and communications and renewables making strong contributions as well.
Relative to the S&P Global Infrastructure Index and on a U.S. dollar basis, the ClearBridge Global Infrastructure Income Strategy outperformed, driven by stock selection in the electric and water sectors and overweights to the communications and renewables sectors. Stock selection in the rail sector and an underweight to the airports sector, meanwhile, detracted.
On an individual stock basis, the top contributors to absolute returns in the quarter were American Tower, renewables utility EDP-Energias de Portugal (OTCPK:EDPFY), Crown Castle, U.S. rail operator Union Pacific (UNP) and Enel. The sole detractors were JR West and E.ON, while Italian gas utility Italgas (OTC:ITGGF), Spanish electric utility Redeia (OTCPK:RDEIY) and U.K. electric utility SSE were the main laggards.
In addition to portfolio activity describe above, during the quarter we initiated a position U.S. electric utility Dominion Energy (D) and exited our positions in SSE and Italgas.
Daniel Chu, CFA, Director, Portfolio Manager
Charles Hamieh, Managing Director, Portfolio Manager
Shane Hurst, Managing Director, Portfolio Manager
Nick Langley, Managing Director, Portfolio Manager
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Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. All returns are in local currency unless otherwise indicated. Performance source: Internal. Benchmark source: Standard & Poor’s. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
