Infrastructure development has accelerated on the back of strong government support (Credit: Transurban)

Infrastructure as a sector has defensive revenues and is a great industry in which to invest for a downturn. It does particularly well in moderate downturns though, because the companies use high levels of debt and obtains a greater than average benefit from interest rate cuts.

The main issue which investors are divided on at present is the extreme valuations within the infrastructure space. The sector is currently benefitting from an unprecedented boom in federal and state government infrastructure spending, which comes off the back of a long period of underinvestment in infrastructure that made it a political issue. Since this current period of elevated infrastructure spending will not last forever, the growth multiples widespread throughout the sector could come under pressure.

One notable development within the sector is Transurban (ASX: TCL) reporting full year results in August. Transurban saw 26.3% revenue growth, but EBITDA grew by a more modest 12.3%. With most infrastructure projects now done privately and the sector having a long-term growth rate much in line with GDP, this growth rate is unlikely to be sustainable over a long-term horizon. Investors are attracted by the company’s 4% dividend yield which, though sustainable for a few years, may come under pressure if infrastructure sells off.

Another infrastructure stock which does not get a lot of attention Is Auckland International Airport (ASX: AIA). The company trades at 25x EBITDA but will benefit from a 25-hectare expansion of Auckland Airport that will include expanded terminals, cargo processing facilities and a second runway. It remains to be seen whether this can justify the high multiples of the stock, which is a concern for a number of stocks in the sector. Sydney Airport however trades at 21x EBITDA and has more risks in the eyes of most analysts, a factor that could limit AIA’s downside.

Over the medium to long term, infrastructure stocks will be largely driven by the level of government infrastructure expenditure and interest rates. As private operators like Transurban often have long periods during which to monetise their infrastructure investments, a few years of low spending on the sector will not cause earnings to completely dry up.

Current Spending on Infrastructure

Governments often accelerate infrastructure expenditure in a recession, given it hires a lot of people and is one of the most effective ways to stimulate economic growth. The Great Depression is the reason why the Sydney Harbour Bridge was constructed, and Australia was saved from the GFC by the minerals which supplied China’s booming infrastructure development. What this means is increased political pressure for infrastructure spending to avert or moderate recessions, which plays directly into the hands of large infrastructure companies through increased profits.

The reason for the current boom in infrastructure expenditure is not recession related however, it is to counteract the increased political pressure from underinvestment in the sector. The coalition announced $100bn in infrastructure spending in their recent re-election campaign, with most of that coming within the next four years.

Infrastructure spending can however sometimes be a negative for existing infrastructure companies. Sydney Airport (ASX: SYD) is likely to suffer from the end to its monopoly on the Sydney market, which is set to occur after the completion of the Badgerys Creek airport in 2026. While Sydney Airport did have the option of keeping its monopoly by building and operating the second airport, they would still have to pay for the project. Furthermore, they would be adversely affected by increased flight capacity within Sydney either way, as eliminating overcapacity eats into the business’s pricing power.

Interest Rates

The GFC was a game changer for Aussie savers, and not in a good way. Rates hit a then intergenerational low of 3%, and, after a brief rebound, only headed downwards from there. The RBA sees more downside than upside at present, so if anything changes, interest rates are more likely to fall than rise from here on.

To make matters worse, that 1% interest rate doesn’t even offset our 1.6% inflation, meaning the real value of your wealth declines by 0.6% even if you don’t spend a cent of your savings. Negative real returns on fixed income instruments often precedes debt monetisation, which is delayed as long as possible and used as a last resort. Even if you spend every cent of the returns on your low interest savings account, it still takes over $10m in the bank just to match Sydney’s average household income off bank interest. With most analysts also believing that property will take a long time to recover and rental yields sit at record lows, equities is the only game in town.

While many retirees have been holding out for higher interest rates, the unfortunate reality is that rates simply cannot rise to the levels they once were. Household debt is far higher than it ever used to be, which constrains the ability of central banks to increase debt levels.

To illustrate this example, lenders will typically lend up to 6 times someone’s income for a home loan. If mortgage rates were to rise to even 6%, implying a cash rate around 4%, all new home buyers who maximised their borrowing capacity would be paying 36% of their income on interest alone for their home loans. Most economists would consider such a high interest bill indicative of severe mortgage stress, and it would hurt spending in the economy so much that it is highly unlikely the RBA will embark on this path.

Figure 3: Australian Household Debt Set to Keep Rates Low (Source: RBA)

Adding high debt levels to a slowing global economy, increased uncertainty from the US/ China trade war and low inflation all but rules out that sort of rate rise. The global economy is slowing rapidly, which is of increasing concern to both the RBA and its international counterparts.

What is the lowest they can go?

While interest rates are at record lows in Australia, the success of quantitative easing (QE) across the US and Europe and the possibility of a recession all combine to indicate interest rates can go a lot lower. The RBA cut interest rates by 425bps in the GFC, and they would have less than a quarter of that room today before interest rates went negative.

This makes negative rates a real possibility if there was a recession today. It would be almost unprecedented for a central bank not to cut interest rates by more than 1% in a recession where inflation was running below the central bank’s target range. This would mean that you would not only not get interest at all on bank deposits, you would be billed for keeping cash there.

Sounds crazy? Then check out these advanced economies which have already cut rates to negative territory, even before a recession:

Figure 4: Major advanced economies already have negative interest rates

With the whole of the Eurozone accepting a negative cash rate, the concept is not confined to smaller advanced economies. There are already $15tn in negative world bonds worldwide, meaning that investors accept a guaranteed loss on investment if the securities are held to maturity. Switzerland’s central bank has an interest rate of -0.75%, and individuals who keep money in Swiss banks are already suffering from negative rates.

Phillip Lowe said that is “possible” for the RBA to be forced to cut interest rates to 0%, if there is a serious downturn. He said he “hoped” to avoid negative interest rates, but coming from the RBA Governor, that is a far cry from ruling it out. If a moderate to severe recession was on the cards for Australia, negative rates are more likely than most people realise.

 

Disclaimer:

This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)

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August 23, 2019