Infrastructure: An evolving asset class

July 29, 2024

Welcome to the fourth issue of Compound Interests, Mercer Canada’s perspective on the capital markets, asset management, and how you can get the most out of your investment portfolios. Today, we are looking at an asset class that many Canadian institutional investors may be familiar with, but is also making waves around the world: infrastructure.

Canadian investors will likely be familiar with infrastructure, especially in private markets. It emerged as an asset class in the mid-1990s, and Canadian institutional investors were among the first to allocate to it. Since that time, infrastructure investing has moved into the mainstream and continues to gain momentum and interest among institutional investors. Despite a slow start to private markets fundraising in 2024, a recent survey by Infrastructure Investor indicated that 40% of investors plan to invest more (~90% plan to invest the same or more) capital over the next 12 months compared to the previous 12¹.

For an investor like a pension fund, with a very long time horizon and a need to pay out pension benefits to members decades in the future, infrastructure has a strong value proposition: 

• Intrinsic value: Infrastructure assets like airports, toll roads and utilities are inherently valuable, as they are necessary to keep society functioning and are often highly capital intensive, thereby acting as a store of value. 
• Low correlation to other asset classes: Infrastructure assets have unique return drivers and are an effective diversifier with historically low correlation to public equity and debt markets.
• Low volatility: Because many infrastructure investments provide essential services, have monopolistic characteristics, and their revenues are underpinned by regulation, contractual agreements or strong pricing power, performance is often much less volatile than other asset classes.
• Inflation protection: Many infrastructure assets have direct or indirect inflation-linkage via contractual provisions, regulatory frameworks, or market positioning that allows them to pass cost increases onto customers, making them an excellent hedge against inflation.

This value proposition is highlighted when you examine the total return of the EDHEC Infra300 index, which tracks private market infrastructure returns against the S&P 500 and MSCI World indices. $100 invested in private infrastructure in 2004 would be worth over $600 today, compared to $574 and $433 if invested in the S&P 500 and MSCI World, respectively, with less annual return volatility and lower drawdowns².

This value proposition, which has held up through economic downturns, COVID-19, high inflation, and a rising interest rate environment continues to attract investors from all over the world. But the asset class itself is changing. Traditional infrastructure assets like utilities are seeing their value proposition shifted by a changing energy mix, ESG considerations and new forms of infrastructure investments, including those supporting alternative energy, electrified transport and data , which provide strong investment opportunities. This evolution of the asset class is not an entirely new theme – renewable energy was once considered a more nascent sector and is now a core part of infrastructure portfolios. Rapidly evolving technologies and global mega-trends such as decarbonization and digitalization are today presenting the next frontier of investments.

Many of these newer infrastructure plays retain much of the original value proposition of older plays: they often have intrinsic value and lower correlation to the public markets. But they may not exhibit all the hallmark characteristics of traditional infrastructure. The lines in some cases may blur with other asset classes such as private equity, real estate or even venture capital for some emerging technologies and business models. Investors in these new segments of infrastructure may see greater returns, but they also take greater risks. For example, investors in data centres and cloud processing saw huge returns in recent years, as artificial intelligence (AI) sends demand for computing power through the roof, while certain other assets that emerged as more mainstream infrastructure investments in recent years have seen greater challenges. An example includes broadband networks and internet service provider (ISP), some of which operate in more competitive environments and have been challenged by overbuilding, higher interest rates and inflation.

At Mercer, we have long advocated for taking appropriate risk to create value where the ability and need to do so exists. This is true when it comes to Endowments and Foundations, as one of the greatest risks such institutions face is not having enough asset growth to hit spending targets. But the same can also be true for long time horizon investors such as defined benefit (DB) plans.

Canadian institutional investors were early adopters of private markets infrastructure and are well positioned to access the next frontier of opportunities in the sector. Private markets infrastructure can offer both the stable, absolute returns that many Canadian investors have benefited from over the last two-plus decades, and the potential to capitalize on the latest innovations with a new cohort of emerging, next-generation investments. Accessing and underwriting this evolving opportunity set requires a different perspective and deep understanding of its underlying characteristics. Mercer’s investment consultants can help your organization build a diverse infrastructure portfolio. We can help you navigate your infrastructure investing decisions, a dynamic landscape continuously evolving due to policy and consumer preferences, technological advancements, the rise of ESG priorities, and emerging opportunities for deployable capital. Contact us today to get started. 

As we reach the halfway point of 2024, the global economy is showing signs of moderation. Following the US Federal Reserve's "pivot" in late 2023, we are now focusing on the growth and inflation outlook, potential central bank actions, and market reactions to these factors for the remainder of the year.

From a growth perspective, our expectations of a year of normalization in 2024 have been largely met. While we anticipate the US economy to continue weakening as sectors sensitive to higher interest rates adjust, we do not foresee a recession. This is due to continued income growth supporting consumers and easing financial conditions benefiting the corporate sector.

In Canada, GDP growth in Q1 was 1.7% (quarter-on-quarter, annualized), which fell short of expectations and the Bank of Canada's April projections. Job growth has remained strong, but it has not kept pace with population growth, which averaged around 3% over the past year. Despite softness in the labor market, wage growth in Canada has not yet normalized and actually accelerated to 5.4% in June. We maintain our belief that wage growth is a fundamental driver of inflation, and we ultimately see the labor market as the final piece of the inflation puzzle. While CPI inflation decreased to 2.7% in June, rising shelter costs indicate that the ongoing housing shortage may continue to exert pressure on inflation and influence public policy discussions for some time.

The easing cycle of central banks in developed economies however seems to be well underway, with the Bank of Canada and the European Central Bank (ECB) having already implemented rate cuts. However, uncertainty remains in the US, as Federal Reserve Chair Jerome Powell continues to emphasize the importance of “data dependency” in determining the path to future rate cuts. We maintain our view that inflation in the US is on a downward trajectory, which may prompt the Fed to begin cutting interest rates later in 2024.

While moderation characterizes the overall economic outlook, financial markets saw continued rallies in equities during Q2. Developed markets underperformed emerging markets within the equities space. The US market, driven by AI optimism, breakthrough innovation in healthcare, and the so-called "magnificent seven," played a significant role in the performance of developed markets. This led to growth stocks to generally outperform valuation-based approaches.

We enter the second half of 2024 with a sense of optimism in the markets. However, we remain cautious about high valuations, increasing public debt levels in the face of high interest rates, and potential shifts in public policy. In the coming months, attention will be focused on Washington, looking at both the Federal Reserve and at the White House for any developments.

^{1 Infrastructure Investor’s LP Perspectives 2024 Study (Feb 2024)}

^{2 Bloomberg and EDHEC data (1/1/2004 to 31/12/2023); Mercer analysis}