Infrastructure came into its own in the last quarter of 2018 as investors rotated out of growth stocks, which have soared in value, in search of more defensive assets.
In early 2018, we suggested that we were in the late stages of what has become the longest ever bull market. While we didn’t (and aren’t) calling an economic recession, we said then that we believed that it was prudent to resist the urge to ride the bull right to the inevitable end and, instead, begin moving portfolios to a more defensive posture.
Since then, we’ve seen volatility pick up again and, unlike in January, the FAANGs have not reasserted leadership and led a bounce back. We think that this provides affirmation of our view that we are seeing a market regime change that is likely to continue to play out in 2019.
The trade war between the US and China is playing a key role in all this, creating a lot of uncertainty and fuelling expectations of a slowdown, and in the final quarter we have seen a rotation out of cyclical growth stocks and a move into defensive assets such as infrastructure.
However, we do not think that the growth cycle is over yet. Our view is that the trade war will dissipate somewhat, providing the impetus for one final leg upwards next year as investors rotate back into growth names.
But, we are very near the last hurrah for growth now, and the key to investing in infrastructure next year will be in timing the switch from cyclical to defensive names.
A year of two halves
Early in 2019, we are expecting the last leg of the bull market to come into its own, buoyed by central banks acting cautiously when it comes to monetary policy in order to avoid stifling growth.
The trigger will be a de-escalation of trade tensions. When it comes to infrastructure as an asset class, investors should now be holding some cyclical assets, such as US rail companies, to gain exposure to above-trend growth in the States.
The other asset that stands out among the infrastructure universe is the US pipeline sector.
Hurt thanks to the weaker oil price, pipeline builders, operators and owners such as Enbridge and Williams Companies are attractively valued now, thanks to a combination of headwinds, which also includes a harsher regulatory landscape.
We expect these to be re-rated in the early part of the year, as the first quarter is likely to be the second year in a row of earnings growth for them, something which is simply not reflected in prices.
Amid political uncertainty across the UK and Europe, and growth concerns, utilities and other infrastructure names across the Continent have been oversold and look attractively valued.
We expect European growth to be firmer next year, coming in at trend rates or above, which will provide a boost to infrastructure valuations.
Regarding the UK, many of the concerns surrounding the utilities sector, which had been sold off so significantly on fears of a Labour government and a nationalisation programme, have also dissipated.
Some of this has already been reflected in the resurgent share prices of UK names such as United Utilities and SSE, but there is more to come and we remain overweight for now.
Peak growth and bond yields
Outside of trades around specific events such as Brexit, we expect the broader story for infrastructure to take place in the second half of 2019.
Having been through the headwind of rising bond yields (particularly in the US) for much of this year, we think that they are now near range bound and will remain so for much of next year, potentially peaking in 2020.
Bond yields will be more stable as growth rates slow and we expect to see that in the US – and globally – next year, with the numbers heading back down towards longer-term trend rates. It will push investors back towards defensive assets in a similar vein to the final quarter of this year.
There are lots of reasons for this slowdown, but among them are the end of the sugar rush from the Trump tax cuts and fiscal stimulus and, all in all, it would seem to us that this is a recipe for continued volatility in the year to come.
When the world acknowledges that growth is slowing, increased defensive equity exposure via infrastructure stocks will become one of the key ways that investors can protect themselves while remaining invested.
Nick Langley is co-CEO and co-CIO of Legg Mason RARE Infrastructure.
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