Interest Rates and Infrastructure Investments

Michael Hainsworth:
The utilities sector has had a difficult year thanks to the rise in interest rates, while the clean energy sector has also struggled. But as Ninepoint Partners Portfolio Manager Jeff Sayer sees it, the rate tightening cycle is coming to an end and that could create opportunities for the infrastructure sector, particularly in wireless towers. There’s a balance between investing in renewable energy and traditional energy within infrastructure and Sayer emphasizes the importance of infrastructure as a core holding in investment portfolios and highlights the potential for income generation and capital appreciation. In this episode of the Alt Thinking Podcast, he also discusses the factors shaping the infrastructure investment landscape, including government spending. Overall, Sayer is optimistic about the opportunities in the space and encourages investors to consider it as part of their investment strategy. We began our conversation by looking back at the rate environment over the last year, and it’s influence.

Jeff Sayer:
As you know, the infrastructure sector is made up by several sub-sectors or sub-industries, right? You have your GDP linked or growth linked sub-sectors like energy and industrials. And you also do have your rate-sensitive sectors like the utilities and the real estate sectors. Clearly, now we're in a real rate shock environment, seeing the 10-year bond yield move for about 3.25 in April to almost 4.90 in the first week of October and today. And so this is after the fastest Fed tightening cycle and over the past 40 years on 525 base points since March 2022.

So this really has been an extreme move in interest rates. The utilities have had a really terrible year due to this rate shock. So this is recently, we recently saw the first worst day of performance in utility space going back 20 years and utilities have fell to only an 80% market multiple valuation. And so this is really unusual and so this is probably the second-worst relative performance of the utility space relative to the S&P 500 in maybe 40 years.

The clean energy sector is also struggling a little bit this year. They're a capital intensive sector. They require financing, they're in growth mode, so that does impact valuation and forward growth. But we certainly think that we're very close to the end of the fed tightening cycle. I think the four or the future curve already indicates that there's less than a 50/50 chance of another rate hike at of the next two fed meetings over the balance of the year.

And inflation is clearly slowing. We've seen signs of stress popping up in the financial sector. So we had the regional banking crisis to start the year around March, and jobs really are a coincident indicator and so although the unemployment rate is still relatively low at 3.8% in the US, is starting to tick higher. And so we're going to be watching a lot of these macroeconomic variables very carefully to really confirm that the Fed is likely done tightening and so they're going to keep talking tough on inflation. That could be part of their mandate.

Their dot plot currently has one more hike in this year and then only two cuts next year. But I think that's going to be proved to be quite hawkish and I think they're actually done for the cycle. And so pausing or stopping the rate hikes and a pullback in those rates, I think they've gone too far, too fast. I mean the US tenure, I think that's going to be really supportive of a really short quick recovery rally here, in things like the utility sector or even the real estate sector. And for infrastructure, the real estate sector really means the cellular towers that are in the benchmark.

Michael Hainsworth:
So you see opportunity for the infrastructure sector with this potential pause for another interest rate increase, and the tower sector, the real estate side of things, expand upon why that is an opportunity. And do you see it as an opportunity today or do you need to see more sort of dot plot movement and read the tea leaves before you could definitively say, "Yeah, here's the opportunity".

Jeff Sayer:
Well the tower sector is derated significantly this year and they are really rate sensitive businesses because they grow 68%, they grow their distribution slightly above that. So it's a very really steady consistent cashflow business and therefore they are quite rate sensitive, given the sell up we've seen this year, I mean it has been really dramatic. They have gone from 2% dividend yields to 4% dividend yields. We've been very big supporters of the tower sub-sector, sub-industry for a long time. This year I've actually gone underweight the towers. So I'm really looking at adding back my exposure at the first sign of seeing that relief rallying the interest rates. I think they're fabulous businesses. They tie into a bunch of themes that are working here going forward, such as the continual demand for communication, content delivery over 5G. So there really are some tailwinds behind the tower sector. That's a sector I'm really watching closely here.

Michael Hainsworth:
What about the energy transition investment theme? How is that being affected within the infrastructure space? Are there strategies to balance exposure on both energy transition and traditional energy investments within infrastructure?

Jeff Sayer:
So we're agnostic as to what we own. We're going to follow our investment process and philosophically we don't have a problem with owning either renewable energy or clean energy technologies or traditional fossil fuel investments for the infrastructure space. That really means oil and gas storage and transportation assets. And so what you want to do is you want to take a barbell approach. We have our own process that dictates when we're buying these individual specific companies. That's based on our assessment of the valuation, the growth and the yield of these companies, but we're comfortable owning both. And so we became very heavily involved in the clean energy trade, for example, as Biden was gaining the polls in 2020. And so you could see a real re-rating, you can see this excitement building expectations arise through 2020 and the actual elector results in the inauguration actually proved to be a good selling signal.

And so valuation became extreme, expectations were super elevated, so we're able to pare back that exposure. And conversely, when we see an opportunity in the oil and gas space that has been under capitalized for many, many years and we don't actually think the use of fossil fuels is ever going to zero in any time reasonable timeframe. And so whenever there's a fear of recession or an economic slowdown or that we've seen peak demand for oil and gas, that's always an opportunity for us to add investments in your traditional oil and gas, and fossil fuel business. So it's a really nice barbell within the portfolio that we get to manage.

Michael Hainsworth:
For investors exploring infrastructure opportunities. What are the primary distinctions as you see them between investing in infrastructure equities and direct infrastructure products?

Jeff Sayer:
Well, I think the key differences are liquidity and time horizon. And so within the Ninepoint Global Infrastructure Fund, the only thing I do own is publicly traded equities or REITS. And so I don't have those same issues with dealing or investing in privately held infrastructure where you need a big capital pool and you're locked in for a long time and you have to worry about marking to market these individual assets. I prefer the flexibility of owning and investing in publicly traded assets. I think it matches more closely the time horizons of my clients. Occasionally you will need to withdraw money or you want to add money. So I think that's much more suitable vehicle from an investor standpoint. I've been involved in the equity business for almost 25 years now. I like that flexibility. I like being able to take advantage of opportunities in the market because of either fear, greed or valuations become dislocated over time. And that I think has allowed us to add some value for our clients and through the performance of refunds over time.

Michael Hainsworth:
Yeah. You mentioned fear. I've always been fascinated by the Fear Index as an indicator as to timing the market. I can't imagine those as a long time Base 3 guy that timing the market is something that the average individual ought to be considering. But having said that, what does fear look like in the market today and what's your sense as to where investor sentiment is right now?

Jeff Sayer:
Well, I think it is fearful, right? I think we are in a rate shock. It's scaring people. The pace of the move in interest rates has been scary. It does take time for people to adjust to the idea of higher rates, plus you also have to refinance. You're facing that threat of higher rates in the future. And so I think the market has sold off dramatically here, but I think like we talked about at the very beginning, I think the movement rates has overdone, right? And so you could have a really short sharp relief rally here at any sign that the idea that rates have moved too far or that the recession is imminent, fails to come to pass.

And so we're pretty comfortable with how the world is looking like inflation's come down from 9.1% in June, the CPIs at all items three seven, the PCE, which is one of the fed's key measures of inflation 3.5. So they've actual ly done a really good job at controlling or getting inflation back towards their target. Growth is hanging in the third region of Q2 GDP was 2.1%. So that's a pretty decent number. We haven't seen any sort of signs of an imminent recession currently in the market. And so right now it really does feel like the market's being whipped around by sentiment and fear as opposed to the fundamentals. And so for us, that always creates an opportunity when you're able to pick off your individual names that you really believe in.

Michael Hainsworth:
Do you think though that we need to see evidence of a recession before the Fed takes, I was going to say takes its foot off the accelerator, but we're accelerating higher, not lower.

Jeff Sayer:
So I think the Fed has already acknowledged that by the time you see the evidence of the recession, it's too late because of the lagged effect, but because of the lagged effect of policy. And so to be honest, in their most recent commentary, they've paused hike and they still have one in the dot plot. But I'm surprised at the hawkish tone of their commentary. I think it's almost time for them to start acknowledging that risks of the economy are more balanced. I think that would've been quite soothing to the market. And so I understand why they're continuing to talk tough on inflation. They really do want to ensure that lower inflation becomes entrenched, but I'm certainly feeling comfortable that the Fed has been doing the best job it can under the circumstances to get inflation back towards its targets.

Michael Hainsworth:
So when it comes to infrastructure investments, how can investors effectively balance the need for yield and income generation with the potential for capital appreciation, especially in light of where we are in the interest rate cycle?

Jeff Sayer:
Sure. So I'm not a distressed asset buyer. I'm really trying to buy companies that are able to grow their earning cashflow through the cycle, looking for businesses that pay a 2 to 4% dividend yield and grow it at 8 to 10%. And I find that's the real sweet spot. I don't want to be buying really high dividend payers because that occasionally is a sign of financial difficulties with the balance sheet.
And so I want to find that nice mix of companies that have been performing well through the cycle at an attractive valuation pay me that 2 to 4% dividend or distribution. Our product at Ninepoint Global Infrastructure Fund does pay a 4.5% annualized distribution. We pay it monthly. I think it's really important for our clients to receive the monthly income if they require it, if they want to reinvest it back into the funds, that's fine. So when we're trying to make up that distribution, I'm willing to give back a little bit through return of return investment capital as opposed to earning the full dividend or distributions. But I think over time that's been really beneficial to the performance of our fund, both in absolute terms and relative to many of our peers.

Michael Hainsworth:
So for whom is your fund specifically most appropriate for?

Jeff Sayer:
Well, so I think infrastructure as an asset class in general should be thought of more of a core holding as opposed to a niche sector, given the environment and given the fact that many of the mix of segments or sub-sectors or sub industries within the infrastructure class actually do kind of act like a balanced fund. You have your growth linked or GDP linked side, the energy and industrials, and you have your rate sensitive side or your bond-like equities in the real estate and utilities. So at a rising rate environment, we've been underweight the rate sensitive ones, the ones we do own are more "growthy," so less rate sensitive. And so for an individual investor, obviously it depends on your own situation, but we like it as more of a core position as opposed to a niche segment. You can look at some of the institutional money managers or pension funds, and so if you look at CPPIB or OMERS, the real asset strategy is like infrastructure and real estate make up 20 to 40% of their books. And so I think it really is an asset class that belongs in a lot of investment books as long as it's within a diversified portfolio and given where rates are and the performance of bonds and given where the equities are and the performance of equities, infrastructure is an asset class. It's a really nice mix in between the two. And so if you need the monthly income, it's fine. You take the monthly income. If you don't, you can have it reinvested and benefit from the capital appreciation, because it is over time, you haven't given up a lot of relative performance by owning these low beta stable infrastructure assets because they've really performed extremely well over the past 20 years even when compared to something like yes, E500.

Michael Hainsworth:
You mentioned a drip. Do you find that people as individual investors are reinvesting those dividends from infrastructure funds or are they pocketing that cash in this environment?

Jeff Sayer:
No, I find that still people are putting it back into the funds. I mean, it really depends on your situation, whether the individual investor requires it for the monthly income or not. And so whether really nice features of the infrastructure distributions in an inflationary environment is that, what we've traditionally seen is that the growth in the cashflow distributions from infrastructure assets outpace the CPI. And so that's one of the key reasons why infrastructure as an asset class works in an inflationary environment and from the end buyer or the unit holder, it's great because what it does is it protects purchasing power. You're receiving dividends that are growing above CPI, it protects your purchasing power, it protects your standard of living. So that's one of those really nice features of infrastructure. As an asset class.

Michael Hainsworth:
Are you expecting that as CPI comes down, courtesy of these high interest rates, that we're going to see a pullback in the distributions as well?

Jeff Sayer:
No. Infrastructure traditionally works in an environment of moderate inflation and slowing growth. And so this is the actual environment where infrastructure really should be working. And so we track it on a monthly basis, we produce monthly commentaries. Seven out of the past eight years, infrastructure dividend growth has outpaced inflation. It really is tied to certain segments, right? You're seeing either traffic recovering from the covid lockdown, and so the revenue is growing. You see GDP link types of contracts, which are still performing really well. We're see new projects coming on in both like the oil and gas space and utility space, energy space that grow the rate base and lot of them growing distributions. And so I'm still optimistic that we're going to continue to see distributions from our underlying companies growing at that high single digit low, very low double-digit rate that we've seen over the past many, many years.

Michael Hainsworth:
So as we move forward, what do you see as the most critical factors shaping the infrastructure investment landscape?

Jeff Sayer:
Well, so other than the rate trade and the clean energy trade, which I think is a real investment theme that I think is going to last probably for decades, the clean energy trade is real. Despite the under performance this year, various reports have suggested that we've seen, suggested that we spend almost 750 billion in the clean energy trade in 2021. It's going to have to triple through 2025 to about $2 trillion and the double, again, 4 trillion by 2030 in order for us to meet the net-zero carbon goals by 2050 on the global basis. So that's a tremendous amount of tailwind pushing behind the sector. We also really think that there are two key pieces of legislation or bills that have been supportive for the sector. And so the passage of the bipartisan infrastructure spending bill, which is going to put out 550 billion worth of spending, it is barely hitting the space now.

We're seeing it first showing up in roadwork, for example, and the initial stages of project development and engineering, it's really geared towards transportation, utilities, and the environment. Really, I view that as your traditionally infrastructure, your roads, your buildings, your airports, renewable energy, the electrical grid, for example, clean water for example, and 5G and broadband. And so there's a real tremendous tailwind that's going to really allow revenue growth and revenue growth opportunities in the sector. The second piece of legislation was the Inflation reduction Act, and that really is almost a 400 billion, basically a tax credit for the renewable energy space, right? It's going to be focused on wind, solar batteries and EV production and EV roll-outs. And so that's a tax credit. And so these tailwinds are going to be lasting, going to take a long time to play out. So I'm really optimistic for the opportunities in the infrastructure segment for many years here and many decades going forward.

Michael Hainsworth:
If there was one takeaway from this conversation for the listener, what would you want it to be?

Jeff Sayer:
I really think that despite the moving rates, being actively managed in this sector with several different sub-sectors that are either growth focused or rate focused is a really nice sweet spot to be. The infrastructure asset class really I think has taken over from your traditional balanced fund or should take over from your traditional balanced fund. I certainly think it has a position or where merits a weighting in your average diversified investment account. I'm really excited about the opportunities going forward. Once we get through this seasonally week period of the September, October year-end here. I think that the Ninepoint Global Infrastructure Fund is really well positioned for the current environment. So I'm really looking forward to getting back to putting up our modest investment returns that are really good absolute and on a relative basis and just continuing to grow the business. I think it's a great time for infrastructure investing as an asset class and for individual investors to get involved here.