Investing in infrastructure – reasons to be optimistic?

Higher interest rates equal higher discount rates. The discount rate is the interest rate used to convert future cash flows into today’s money. So, the higher the discount rate, the lower the current value of a given future amount.

This has put downward pressure on infrastructure asset prices, as their future earnings have been discounted to a lower value. In particular, many investment trusts are now trading at a discount to the estimate worth of their underlying assets (net asset value, or ‘NAV’).

Additionally, higher interest rates and bond yields are competing for the attention of those investors and asset managers seeking income, and who can now meet their desired rate of return with less risk.

The outlook for interest rates

We believe that interest rates have peaked. Both in the UK, and across other major economies such as the US and Europe. This is in line with the market consensus. The big question now, is when will the rate cutting cycle start?

At the start of 2024, market expectations were pricing in interest rates cuts by as early as the summer. In our view, this was bullish. Since then, inflation has remained stickier in the UK than expected. As a result, market expectations have now moved in line with our view and currently look more realistic with just one or two rate cuts by the end of year.

In May, the Bank of England (BOE) decided to keep interest rates unchanged at 5.25% for the sixth meeting in a row. This follows 14 consecutive meetings where rates were increased from 0.1% in December 2021 to 5.25% in August 2023.

How have our infrastructure investments performed?

Across our Charles Stanley products, we take an actively managed approach to investing, with global multi-assets portfolios and a diversified asset allocation. We believe spreading your investment across different asset classes reduces overall risks and helps smooth out returns over the longer term.

The macro-economic environment mentioned above has acted as a headwind for the sector and investment trusts in general leading to price weakness and infrastructure investment trusts trading at discounts to NAV. We attribute the negative price performance primarily to:

1. The sharp increase in interest rates over the past couple of years and the expected negative impact on asset values. However, we believe that interest rates have peaked.
2. The decreasing relative attractiveness of sector yields compared to fixed income alternatives. We believe fixed income yields should come down from here onwards which will be a tailwind to inflation linked and higher yields provided by the trusts.
3. Power prices falling from their extreme highs seen in 2022. As a result, we have seen increased investor caution towards the sector. Such price levels were distorted by exogeneous factors, as such we do not believe these to be recurrent.

However, we believe the worst of these pressures are behind us and expect the prospects for infrastructure investments – and therefore prices – to improve.

We have a comprehensive research coverage in house at Charles Stanley, looking at everything from direct equities through to active and passive collective investment vehicles. Our portfolios leverage this research function with regards to security selection, particularly relevant to infrastructure investment trusts held across some of our multi asset solutions. Despite volatility, these trusts did not discontinue nor rebase their dividends and continue to buy back their shares. Active portfolio management and sustainable dividend payments give us confidence in the trusts’ managers ability to generate outperformance over the longer term.

As interest rate pricing has become more realistic, this should act as a tailwind for asset prices moving forward. With this in mind, we remain constructive on the outlook for both diversified and specialist infrastructure exposure within our in-house asset allocation framework.