Sarah Shaw

Fund manager 4D Infrastructure, a Bennelong boutique, has launched a new currency hedged fund, the 4D Global Infrastructure Fund (AUD Hedged).

4D’s flagship fund has been renamed the 4D Global Infrastructure Fund (Unhedged) for clarity. Its investment team, objectives and processes remain unchanged.

Sarah Shaw, 4D’s global portfolio manager and CEO/CIO, said that increasing client demand led to the introduction of a hedged product, which aims to mitigate the impact of currency by hedging foreign currency exposure.

“We’re committed to making our strategy available to anyone who wants access to the attractive and growing investment themes of global infrastructure, which offers defensive characteristics plus growth and generally displays lower volatility of earnings and higher yields than the broader equity markets,” she said.

“The revenues of most of the portfolio’s stocks also have some form of inflation hedge, whether explicit or implicit.”

Ms Shaw emphasised that the Hedged Fund would be managed according to the same investment strategy as the Unhedged Fund, which has returned 8.81% p.a.* since its inception in 2016 (outperforming the fund’s benchmark of the OECD G7 Inflation Index + 5.5%).

“We’ll continue to manage both funds in line with our proven strategy, aiming to deliver attractive total returns over the long term,” she said.

4D was established in 2015 by Ms Shaw and Greg Goodsell in partnership with Bennelong Funds Management. It is majority-owned by its team, who also invest in the strategy – ensuring their goals are aligned with those of their investors. In addition to the Hedged and Unhedged Funds, 4D also manages a dedicated emerging markets strategy, the 4D Emerging Markets Infrastructure Fund.

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* As at 30 June 2022, after fees and expenses. Past fund performance is not indicative of future performance.

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What does the Ukraine/Russian conflict mean for the global infrastructure sector in the near and medium term?

The recent invasion of Ukraine by Russia was clearly a shocking event which, in 2022, was hoped would never happen again. At 4D, we are supporters of sanctions imposed on Russia and have reviewed our portfolio for Russian exposure (regardless of materiality), while conducting a deep dive into what this conflict means for the global infrastructure sector in the near and medium term. In this article, Sarah Shaw (4D’s Global PM & CIO) and Greg Goodsell (4D’s Global Equity Strategist) examine the politics, economics and investment impact of the current conflict.

The politics

Putin’s reasoning behind the Russian invasion of Ukraine seems principally related to Ukraine’s potential desire to join the North Atlantic Treaty Organisation (NATO), and Putin seeing this as a threat to Russia.

The Western world quickly united (including the traditionally neutral Switzerland) in opposing Russia’s actions and introducing a broad array of sanctions.

NATO is unlikely to directly assist Ukraine militarily as Ukraine is not a member, and such an intervention would lead to the first ever direct conflict between two nuclear armed super-powers. Hence the importance and extent of the non-military, economic and political sanctions. If the sanctions can effectively target and hurt wealthy Russians, then they may also ultimately influence Putin, or a social movement to oust him.

Further afield, China’s Xi Jinping will be watching the evolving situation – and importantly, the West’s response – closely. Our view is that Xi’s biggest concern is domestic social unrest, which could derail his leadership. As such, we don’t believe he can achieve this by supporting Russia (discussed further below). However, nor do we believe China will condemn Russia.

Global economic implications of the Russian invasion

IMF^[1] analysis suggests that, in addition to the suffering and humanitarian crisis from Russia’s invasion of Ukraine, the entire global economy will feel the effects of slower growth and faster inflation. The IMF identified three main channels through which impacts will flow.

1. Higher prices for commodities like food and energy will push up inflation further, in turn eroding the value of incomes and weighing on demand.
2. Neighbouring economies in particular will grapple with disrupted trade, supply chains and remittances, as well as an historic surge in refugee flows.
3. Reduced business confidence and higher investor uncertainty will weigh on asset prices, tightening financial conditions and potentially spurring capital outflows.

The IMF added that, while some effects may not fully come into focus for many years, there are already clear signs that the war and resulting jump in costs for essential commodities such as oil will make it harder for policymakers in some countries to strike the delicate balance between containing inflation and supporting the economic recovery from the ongoing COVID pandemic.

China’s response

There are concerns that China may provide assistance to Russia in its invasion of Ukraine. This could lead to the imposition of sanctions on China, similar to those imposed on Russia. At a virtual meeting on Friday 18 March 2022, US President Biden warned Chinese President Xi of possible ‘consequences’ for supporting Russia; and Chinese President Xi indicated that ‘The Ukraine crisis is not something we want to see’. He added that the events again show that countries should not come to the point of meeting on the battlefield. Conflict and confrontation are not in anyone’s interest, and peace and security are what the international community should treasure the most.

Why would China assist Russia in Ukraine?

Reasons could include global politics and ensuring Russia’s future political and potential military support of China. It would also underpin a powerful military alliance balanced against the might of US/NATO in Europe. China may also see business opportunities in Russia given the economic void created by the sanctions.

Why wouldn’t China support Russia in Ukraine?

Put simply, economics, domestic politics and China’s self interest.

Differing global GDP positions

In considering whether China would support Russia in the Ukraine war it is important to acknowledge that China’s position in the global economy is vastly different to that of Russia. China is the world’s second-largest economy behind the US, with a GDP of US$14.9 trillion in 2020 (~17.8% of global GDP). Russia is only the 11th largest economy in the world, with a GDP of US$1.48 trillion (~1.74% of global GDP). By way of comparison, Australia has a GDP of US$1.35 trillion (~1.7% of global GDP)^[2].

With this economic context, there is far less incentive for China to risk its globally dominant economic position to engage in a major conflict at this point in time.

China and global trade^[3]

International trade is the lifeblood of the world economy, but is subject to constant change from economic, political and environmental forces. Emerging economies have seen their share of total global trade rocket in recent years.

China’s economic interests are different from its security concerns. China is deeply integrated into the global economy. Its share of global trade has increased significantly during the global pandemic, as has its share of global direct investment inflows. China’s share in global trade at the end of 2021 was about 17%, and its share in global direct investment inflows at the end of 3Q21 was ~19%. Its total trade flows, which exceeded $US6 trillion last year, dwarf those of Russia.

China’s firms and leadership are aware that major efforts to support Russia and violate existing sanctions could bring down secondary sanctions on them, especially if such support were to include military assistance. Russia is vulnerable to such sanctions; China would be even more exposed.

Below is a table highlighting China’s 15 top trading partners in terms of export sales. That is, these countries imported the most Chinese shipments by US$ value during 2020. Also shown is each import country’s percentage receipt of total Chinese exports.

Notably:

• the US alone accounts for 17.5% of Chinese exports – Russia just 2%
• 7% of Chinese exports in 2020 were delivered to the above 15 trade partners. Many of these countries have imposed sanctions on Russia for its actions in Ukraine
• the UK increased its import purchases from China at the fastest rate, up 16.6% from 2019 to 2020. In second place were importers in Vietnam, thanks to a 16.1% increase, trailed by Australia (up 11.2%), Thailand (up 10.8%) and Taiwan (up 9.2%), and
• there were three decliners year-over-year – namely India (down -10.9%), Hong Kong (down -2.5%) and Japan (down -0.4%).

Clearly, any trade sanctions imposed on China by the US or the rest of the world would have a material negative impact on its economy.

Chinese domestic politics

It is in China’s interest for the global economy to remain strong, especially as China is suffering a further wave of COVID and President Xi is seeking a record third term in office.

Given the Chinese government has recently set its GDP growth target for 2022 at around 5.5% (higher than most economists anticipated) and has set the goal of ‘common prosperity’, having a significant portion of the Chinese economy subjected to Western sanctions would be a major negative. China has indicated that it supports an end to the war – it is in the country’s interests to do so.

In summary

The domestic political and economic case for China to avoid supporting Russia in the Ukraine war, and risk severe sanctions from the rest of the world, is clear. Unfortunately, rational, humane decision-making has not been a feature of the Ukraine war so far, and we continue to monitor the situation closely.

We also do not rule out indirect support in some way, as long as it doesn’t invoke sanctions (e.g. China buying more Russian gas, which would lower energy costs in China (domestic win) while indirectly financing Putin’s activities).

Impact on infrastructure

In broader sector terms, we have assessed the immediate and longer-term impact on infrastructure assets in terms of direct and indirect consequences of the current conflict.

Energy

The conflict has seen an immediate and sharp increase in power prices across Europe as the flow of Russian gas is disrupted and countries scramble to source alternative fuel sources. In the short term this could see coal re-enter the generation mix. Over the medium to longer term we see alternative gas sources being secured, the development/extension of nuclear generation, and further fast-tracking of renewable generation as countries look to balance the social needs of their populous with decarbonisation goals.

• Those utilities exposed to merchant pricing will be directly and immediately impacted by rising prices, which is a core reason why we don’t regard merchant energy as ‘infrastructure’.
• Regulated names, by contrast, should theoretically be insulated (with a fuel pass through). However, in reality, from a social standpoint we are seeing regulated operators (e.g. Iberdrola, Enel) cap/delay the pass-through of the very high energy prices in immediate support of customers, which will have a near-term working capital impact. Governments are also introducing short-term measures to cap power prices. Longer term, however, we hope to see this recouped through the regulatory model.
• Volumes could be disrupted across the board – again, this should have a muted impact on regulated names which earn a return on investment.
• The investment outlook is very positive as new investment programs to reduce the energy reliance on Russia are prioritised and fast-tracked. Pure play renewables such as EDPR and Orsted will benefit, as will the integrated regulated names that are prioritising energy transition, such as Iberdrola and Enel.
• Energy providers across North America and other parts of the world will look to capitalise on the jump in commodity prices, with increased hard commodity exports supporting energy pipeline transportation companies as well as port and export capacity. Names such as Williams and Cheniere^[4] will benefit.
• However, we need to be cognisant of the fact that the contracted/regulated structure of the energy infrastructure names means they will not realise the full upside of the commodity price spike (much as they were largely insulated on the downside when oil was at zero – see Global Matters 25^[5] Impact of oil shock on midstream assets [March 2020]). This is a core characteristic we look for in energy infrastructure’s visibility of earnings profiles. Should these names run ahead of fundamentals, we could look to capitalise on the gain.

Transport

Immediate impacts of the conflict can be felt in the transport space, due to closure of air space and ports as well as the disruption in commodity sources and supply chains.

• Closure of air space around the region of conflict will have a limited passenger impact on certain airports as flights into and out of Russia and Ukraine are grounded. On a deep dive, passenger exposure to Russia/Ukraine is minimal for core European airports (e.g. Frankfurt <2%, AENA network <1% in 2021).
• There has also been a localised impact on certain ports in close proximity to the conflict. Should the situation escalate, this of course could extend further – some direct impact on Hamburger Hafen (not in portfolio).
• The world is looking to source soft commodities from alternative sources, increasing port activity as well as rail volumes in places like Brazil, Thailand, Chile and North America (large net exporters of soft commodities such as corn and wheat). This could support both Rumo and Santos Brasil out of Brazil, as well as the North American rail operators.
• We could see passengers more reticent to travel to certain regions surrounding the conflict area, impacting airports in the region. To date this has not materialised, but should the conflict escalate we expect this to play out.
• The conflict could exacerbate global supply chain disruptions through increased staff shortages. According to the Seafarer Workforce Report^[6] of the total workforce, ~198.1k (10.5%) of seafarers are Russian and another 76.4k (4%) of seafarers are Ukrainian. Combined, they represent 14.5% of the global seafarer workforce.

As discussed above, inflation will remain high given the contribution of energy in the CPI bucket, which continues to favour transport names (as well as real rate utilities) that have an explicit inflation hedge. However, a significant jump in fuel prices around the globe has a number of flow-on effects to infrastructure names.

• Freight rates could jump as demand profiles shift and high fuel prices are passed on to end users.
• Improved competitiveness in transportation supports those that are more fuel efficient given the spike in fuel prices (e.g. benefits rail over trucks).
• Road traffic could see some sensitivity to soaring fuel prices. While volumes will be impacted, historically toll roads have reported a net upside from rising fuel prices as the CPI uptick to tariffs (driven up by fuel hikes) has more than compensated for the sensitivity of traffic. This is, however, dependent on passenger mix (commercial vs passenger) and sensitivity to prices. The following charts shows the relative insensitivity of toll traffic to fuel prices on Italian motorways since 1970, with the sensitivity to GDP growth much more relevant as depicted in the second chart.

• Air tickets will go up as airlines look to push the jump in fuel prices through to end users. Again, the overall impact on airports will be dependent on sensitivity to ticket pricing, which itself is driven by share of low cost carriers, domestic versus international etc. Again, this can be partly offset at the airport level by any inflation pass-through to regulated tariffs and/or commercial contracts.
• The inflation hedge has historically more than compensated any demand squeeze from elevated fuel prices.

Conclusion

The situation in Ukraine is, above all else, a major concern from a humanitarian and global stability standpoint. The positive aspect so far is just how fast the Western world has united in opposing Russia’s actions, introducing a large and diverse suite of sanctions designed to punish Russia economically and isolate it internationally. Potentially there are more sanctions to come.

While it will be a matter of waiting to see how effective sanctions are in influencing Russia’s behaviour, from an investment perspective there are some clear near-term negative impacts (fuel prices, energy costs and inflation uptick), but also some short-term and long-term relative winners in the infrastructure space, including user pay assets (inflation link), rail (increased competitiveness and soft commodity exposure), energy infrastructure (volume support) and utilities building for the future (integrated and pure play regulated utilities).

4D has never had any direct exposure to Russian securities. Russia is uninvestible under our country review process, and has been so since our initial review in 2015, when 4D began. As a consequence of the more recent sanctions, we reviewed our portfolio for any exposure to Russian assets, no matter how negligible. We placed trading restrictions on any exposed positions until companies had confirmed an exit from Russia or a writedown of assets to zero (where exit was not immediately possible), as we expect all our portfolio positions to support the current democratic stance against the invasion. As a result, negligible exposure has now been written off or the stock is restricted.

As always, 4D looks to maintain a diversified (regional and sector) portfolio of the best combination of value and quality within the infrastructure sector. At the same time, we look capitalise on long-term infrastructure thematics while remaining cognisant of near-term head and tail winds, including the current conflict and resultant political and economic responses.

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[1] ‘War in Ukraine Reverberates Around World’, IMF Weekend Read, 19 March 2022
[2] Source – Stastistics.com
[3] SMH 16 March 2022: ‘As China quietly joins sanctions against Russia, Xi night be too rational to risk arming Putin’. Tianlei Huang and Nicholas R. Lardy are China experts with the Peterson Institute for International Economics, a Washington-based think tank.
[4] Cheniere announced on 9 March 2022 that it had agreed to amend the LNG sale and purchase agreement it has with Engie to increase the contracted volumes and extend the term of the agreement.
[5] https://www.4dinfra.com/insights/articles/global-matters-impact-oil-shock-north-american-midstream-assets
[6] Published in 2021 by BIMCO and International Chamber of Shipping (ICS)

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There is no global recovery without roads, railways, pipelines, power transmission networks, communication infrastructure, ports and airports.

To state the obvious, 2020 was a year like no other. The COVID-19 pandemic presented challenges the likes of which individuals, businesses and governments have never experienced before. The impact of this was to push an otherwise pretty robust global economy into recession, force lockdowns and create social dislocation on a previously unimaginable scale.

Despite these 2020 challenges, we remain optimistic about both the global economic outlook and the infrastructure asset class for 2021 and beyond. In this article Sarah Shaw (Chief Investment Officer and Global Portfolio Manager) and Greg Goodsell (Global Equity Strategist) from 4D Infrastructure (4D) examine the key macro issues and forces currently in play that will, we believe, lead to a positive 2021 for listed infrastructure. Infrastructure, in all its forms, will be integral to the economic recovery and returning society to ‘situation normal’. We have said it many times throughout 2020 – there is no global growth recovery without roads, railways, pipelines, power transmission networks, communication infrastructure, ports and airports.

Optimistic about the global economy and infrastructure asset class for 2021 and beyond

There is no doubt the COVID-19 pandemic remains the key issue impacting the economic and equity market outlook for 2021 and beyond. The virus’s continuing presence is clearly illustrated in the charts below.

Despite the ongoing presence of the pandemic, we remain optimistic about the outlook for the global economy and the infrastructure asset class for 2021 and beyond.

Infrastructure provides basic services essential for communities to function and for economies to prosper and grow. For us at 4D this equates to the publicly listed owners and operators of essential services (regulated utilities in gas, power and water); and user pay assets (toll roads, airports, ports, rail where a user pays for the service).

These assets are characterised by:

• monopolistic market positions, or ones with high barriers to entry;
• returns underpinned by regulation or contract;
• a largely fixed operating cost base;
• high up-front capital costs and then very low ongoing maintenance spend; and
• inflation hedges within the business.

These characteristics together provide long-term, resilient and visible cash flows which underpin a yield or potential yield. It is because of these characteristics that infrastructure is known as a ‘defensive asset class’, with generally lower volatility of earnings and higher yields than broader equities. It is these attributes that attract investors, including ourselves, to the asset class.

However, listed infrastructure remains an equity and can be caught up in market volatility (as we saw in March 2020). This market volatility can present significant opportunity for investors to capitalise on the long-term infrastructure thematic (defensive characteristics with structural growth) and we believe 2021 will be such a year.

Our optimism stems from the following themes.

COVID-19 vaccines have been developed and are being deployed: a great demonstration of human ingenuity in a crisis

In an endorsement of how creative humankind can be in a crisis, COVID-19 vaccines have been developed in record time and are now being deployed. This is truly remarkable and should hopefully see the currently rampant virus gradually tamed. As CSL CEO Paul Perreault said recently: ‘often a crisis breeds trailblazers and ingenuity, and the acceleration of solutions to treat and prevent COVID-19 has been truly inspirational’^[1].

Huge fiscal and monetary stimulus will continue to propel global economic growth

While the currently worsening pandemic will last longer than we initially hoped, we believe the global economy will ultimately emerge stronger for the experience. The huge amount of fiscal and monetary stimulus (see chart below) is still to be fully felt in economic terms with, of course, much of that spending focused on essential infrastructure investment around the globe, including the green energy transition.

The level of public sector spending and fiscal stimulus received a further, much-needed boost in December 2020 when, after months of wrangling, US lawmakers finally agreed to a further ~US$900bn package of pandemic aid, including money for businesses and unemployment programs. In January 2021 Mr Biden announced even further stimulus – see the Annexure to this paper for a brief outline.

Similarly, in Japan the Suga administration announced a stimulus package of over US$700bn in December, with parts of it set to be funded by next year’s budget. The stimulus aims at suppressing the virus while simultaneously helping the economy transition into a post-COVID world.

Also in December, the ECB boosted the size of its stimulus package and increased its bond-buying program by €500bn (now at €1.8trn), taking total monetary stimulus in 2020 to over €3trn. On the fiscal side, the stimulus package totals ~€1.8trillion euros, consisting of both the €1.1B EU budget and €750bn Next Generation EU recovery fund.

All this investment will be a strong positive for the global economy over coming years, improving efficiency, productivity and output. In addition, we believe many of the operational changes that have been forced on businesses by the pandemic will lead to a stronger, more efficient economic environment post the virus.

A substantial percentage of this fiscal spending is focused on infrastructure reinvestment and replacement. Industry participants suggest that for every $1 of infrastructure investment, an economy gets a boost of anywhere between $3-$5. That’s a significant economic boost as a result of the infrastructure investment dynamic.

A November 2020 IMF research paper argues that a synchronised infrastructure investment push could invigorate growth, limit scarring, and address climate goals (see chart below). The IMF believes that, when many countries act at the same time, public infrastructure investment can help lift growth domestically and abroad through trade linkages. This positive ‘spillover’ effect could provide an additional boost to global output.

The IMF also argues that ‘spillovers’ created by higher demand have a greater impact when economic conditions are weak and interest rates low. When economic conditions are strong, higher government spending may push inflation above the central bank’s target and trigger a monetary policy tightening, offsetting some of the initial boost to demand. But when conditions are weak and inflation is well below target, as in the current global economic environment, monetary policy is less likely to tighten in response to higher government spending, resulting in a greater output response. The context of ample spare capacity thus amplifies the impact of both domestic public infrastructure spending and the demand that spills over from higher public investment abroad.

This is not to say we don’t expect inflation to gradually return – we want it to. Given the quantum of stimulus yet to flow through into the real economy, coupled with huge pent up consumption demand reflected in deposit rates having spiked through the pandemic, we do expect inflation will come back. While we will be monitoring this closely, we are currently in the camp of a gradual return of inflation with it continuing to track below target levels through 2021. As such, we don’t see central banks being forced into any drastic action such as near-term interest rate hikes. We are also of the belief that central banks will let inflation run a bit ahead of target over the short to medium term to assist in the reduction of headline government debt levels. However, it is worth reiterating that inflation can be positive for infrastructure assets and in particular the recovery names in the user pay space (see further discussion below). In an inflationary environment these assets will enjoy the perfect storm over the short/medium term – namely  low interest rates to support future growth, economic activity flowing through to volumes, and explicit inflation hedges through their tariff mechanisms to combat any inflationary pop we may experience.

Increased public sector infrastructure spending is a clear positive for the listed infrastructure sector as it:

• boosts economic growth and labour efficiency, which is good for all businesses but especially those infrastructure businesses which form the ‘arteries’ of an economy;
• creates potential new opportunities for the private sector to co-invest alongside government or invest in place of governments; and
• on a longer-term basis, potentially provides a bigger pool of privatisation candidates.

We are not alone in our positive economic outlook for 2021, with the IMF also predicting an economic recovery in 2021 as shown in the table below.

A Joe Biden presidency should see a more stable, traditional form of governance

The November 2020 election of Democrat Joe Biden as US President should herald a more ‘traditional’ form of presidency, with properly developed and articulated policy returning as the mainstay of political discussion and debate.

One of the few policy areas Democrats and Republicans do agree on is the need for large-scale US infrastructure spend to both stimulate growth and replace an aged asset base.

However, as the Democrats will now control US Congress, the market will be closely watching the roll-out of Mr Biden’s policy platform, a summary of which is included as an Annexure to this paper. On balance, we believe the Biden policies are very supportive of the infrastructure asset class and managing climate change. However, we will be monitoring closely the market’s evaluation of those Democrat policies the market was concerned about prior to the election (such as the big increases in taxes).

Interest rates lower for longer: very positive for the infrastructure asset class

Of all the equity market sectors, infrastructure is one of the most closely correlated to movements in market interest rates. We have published several articles on the correlation between interest rates and infrastructure asset values, particularly in a rising interest rate environment. However, at present we look to be in a lower-for-longer scenario as illustrated in the following chart of the yield on 30-year US Treasury Bonds over time. Clearly the trend in yields over the past 40 years has been down, and there is no present indication of a significant near-term reversal.

While a low interest rate environment will benefit all equity asset sectors, it will be particularly beneficial to infrastructure because:

• Infrastructure companies commonly employ larger amounts of debt in their capital structures. This is principally driven by the sector’s key characteristics (discussed above) which makes it a ‘natural’ match with a more highly geared capital structure. In the current environment, with record low interest rates, we expect infrastructure companies to continue to take advantage of this historic scenario of low interest rate long-dated debt.

Some recent examples of this are set out in the table below.

• Discounted Cash Flow (DCF) valuation methodology is the core methodology employed to value infrastructure assets. This is typically the case as the long duration of infrastructure investment and the maturity profile of their cashflows makes them ideally suited to being valued using long-dated DCF analysis. This methodology utilises a Weighted Average Cost of Capital (WACC) concept as the key variable linking all those years of cashflow together. A core component of any WACC calculation is the Risk Free Rate used, with this rate a function of current market interest rates. If lower market interest rates prevail for longer, infrastructure investors gradually recognise this and reduce the assumed Risk Free Rate in their DCF’s WACC. All else held equal, this will lead to an increase in asset values as the lower WACCs flow through, providing a higher NPV of the cashflows.

The long-term, structural opportunity for infrastructure investment remains intact

Despite the chaos caused by COVID-19, we believe the longer-term infrastructure investment opportunity remains intact. Infrastructure offers defensiveness with economic diversity. These attributes, coupled with a significant growth pipeline, create a very attractive long-term thematic for the sector despite the near-term concerns of COVID-19. There is a huge and growing need for infrastructure investment globally, as a result of decades of underspend and the changing dynamics of the global population.

Replacement infrastructure spend

There has been a chronic underspend on critical infrastructure in virtually every nation over the past 30 years, if not longer. This has largely been due to governments having other spending priorities. For example, during the GFC the priority was saving the global banking system – not replacing water mains. During COVID-19 governments have prioritised social support – not road repairs.

The photos below are all examples of developed market infrastructure in dire need of replacement.

Population growth & environmental considerations

The second driver of the need for infrastructure investment is population growth. In 1900 the global population was approximately 1.65 billion people, and by 2000 that number had grown to almost 6.1 billion – keeping in mind that some of the infrastructure we are still using today was built to service that 1.65 billion. By the turn of the next century, the global population is expected to be over 11 billion, underpinning the need for yet more spend. As a society we need to first play catch-up, and then invest for the future generations.

This population growth has also raised a number of environmental and climatic challenges that underpin the need for even more spend on infrastructure to ensure the sustainability of the planet. Infrastructure investment is core to the climate solution; and without significantly increased investment in infrastructure, the globe has no chance of reaching the Paris Agreement goal of Net Zero carbon by 2050. While the speed of ultimate decarbonisation remains unclear, there appears to be a real opportunity for multi-decade investment as every country moves towards a cleaner environment. Energy transition and decarbonisation of the power sector is an obvious thematic and will have the greatest impact on countries looking for Net Zero. However, other forms of infrastructure, namely transportation, also have a key role to play.

Demographic trends support infrastructure investment

Longer-term global demographic trends further support the infrastructure asset class and the need for investment. While the COVID-19 pandemic may lead to a temporary pause in these thematics, we believe they will re-assert themselves once the crisis is behind us.

The emergence of the middle class, particularly in emerging markets (EMs), is a theme 4D finds exciting and one we believe will provide enormous opportunity for investors. Given the potential size of the middle class in EMs (China, India and Indonesia alone account for 40% of the global population), changes in spending and consumption patterns will have significant implications for global business opportunities and investment for decades to come.

Importantly, one of the clear and early winners of the emergence of the middle class is infrastructure, which is needed to support the evolution.

When you combine all these factors (i.e. developed market replacement spend, population growth (largely driven by the EMs), environmental considerations and the emergence of the middle class in EMs, the need for global infrastructure investment over the coming decades is clear. It is also clear that governments, the traditional providers of infrastructure, are simply not going to be able to fully fund this need – thereby creating a huge investment opportunity for the private sector over the coming years. That opportunity is a key thematic to which investors can gain exposure, and a thematic not derailed by COVID-19 – in fact, it is in all likelihood enhanced.

Current investment opportunities in the sector are very attractive

COVID-19 pushed an otherwise generally robust international economy into recession and saw the global equity market collapse. As an equity asset class, listed infrastructure was not immune to the COVID-19 market selloff. Unfortunately infrastructure hasn’t, as yet, fully participated in the subsequent cyclical market bounce as depicted in the chart below. We believe this has created a very attractive and unique investment opportunity in global listed infrastructure.

Separating the equity market moves from the investment fundamentals, the earnings of the asset class have proven to be far more resilient than the share price sell-off implies. Through a tumultuous 2020, the asset class has proven its defensive characteristics with solid earnings momentum underpinned by strong balance sheets. The chart below depicts EBITDA growth expectations for the infrastructure sector (including the hard-hit airports) and the broader equity market. The MSCI World is expecting an EBITDA contraction of close to 20% in the 2020 earnings year relative to infrastructure’s flat. At the same time the MSCI World index has fully recovered from its March lows, ending 2020 +5.8% for the full year while infrastructure has lagged with the indices finishing the year down 12-15%^[2] in AUD.

This is a significant disconnect and, we believe, it is only a matter of time before the market recognises the infrastructure opportunity.

To better describe the current opportunity offered by the listed infrastructure asset class, we have briefly revisited some of the key features and core themes that support the investment thesis in the current environment.

Firstly, infrastructure comprises two quite distinct and economically diverse subsectors.

• Essential Services are the regulated utilities in the power, gas and water space. These assets are largely immune to economic shifts (up or down), as a function of them being:
  • a basic need; and
  • the structure of their regulatory/business environment, which means returns are measured independent of volumes.

These assets are more ‘bond proxy’ in nature, particularly over the shorter term. They are more immediately adversely impacted by rising interest rates/inflation and are slower to realise the benefits of economic growth. At the same time, they are less exposed to economic contraction and benefit from lower interest rates. These assets are attractive overweight portfolio positions in depressed economic environments as they can offer earnings growth and yield support, even in a year like 2020.

Indeed, over the past few months utility companies around the world have largely reiterated their full-year earnings guidance and dividend policies, despite the COVID impact. Fundamentally, they are holding up as expected (very well) and we did increase our exposure in April 2020.

• In contrast, User Pay assets such as airports, toll roads, rails and ports are positively correlated to GDP growth and inflation. These stocks capture GDP growth via volumes, but with inflation protection through their tariffs. As such, these assets are well suited to growth environments or the recovery phase of an economic cycle.

User Pay assets will see sharp earnings shifts this year, particularly in the airport space. But even in their case, the negative valuation impact of a harsh 2020 does not justify the share price falls that we have seen to date. Many of these User Pay assets are offering significant fundamental value at these price levels and we believe they will rebound strongly as vaccines come into play – pent-up demand for travel is huge. Further, as discussed above these assets are well positioned for any return of inflation with explicit hedges in tariffs and direct correlation to economic activity. As such we remain overweight.

Secondly, infrastructure investment also offers geographic diversity. This allows investors to capitalise on in-country domestic demand, in-country stimulus and position accordingly. To this end we are currently overweight Europe and EMs.

Finally, as discussed above the structural infrastructure growth opportunity remains intact. The advent of COVID-19 hasn’t changed this dynamic. We believe the long-term infrastructure investment themes have actually been enhanced by the current pandemic – government stimulus programs are fast-tracking infrastructure investment, increasingly stretched government balance sheets will see a greater reliance on private sector capital, and a ‘lower for longer’ interest rate environment is supportive of infrastructure investment and valuations.

Meanwhile, solid well-managed infrastructure companies are in robust financial positions. Balance sheets were in strong starting positions, and few have reported any liquidity issues as a result of COVID-19. Management teams are also taking advantage of open credit markets and low market interest rates to secure attractive, long-dated debt financing to ensure ongoing liquidity and support growth profiles (see previous table ‘Recent debt raisings by GLI companies’). Despite near-term uncertainty around economics and the duration of the pandemic, the underlying fundamentals of these assets remain attractive to debt investors, which should go some way to reassuring equity investors. This is particularly true given that, during the GFC, debt markets were generally far better indicators of pending market problems than were equity markets.

We believe the combination of attractive investment fundamentals, long-term structural thematics that remain intact, the COVID-19 response and currently very attractive stock prices represents a unique buying opportunity for listed infrastructure – an opportunity we are looking to capitalise on as we move into the economic recovery phase and a hopefully prosperous 2021.

What could derail our outlook?

While we are optimistic regarding 2021, there is no doubt 2020 has been a tumultuous year. There are a number of residual factors that could adversely affect our view, including:

• whether the COVID-19 vaccine(s) are effectively deployed globally, and in a timely manner, delivering the expected health benefits leading to subsequent economic recovery;
• governments and central banks prematurely take their feet off the ‘go’ pedal before the global economy has the opportunity to properly get back on its feet;
• the actual shape of the economic recovery, which is crucial, remains to be seen (V, U, L or W);
• President Biden is unable to make diplomatic progress and we see renewed Chinese/US tensions on a variety of issues: trade, Hong Kong, South China Sea, COVID-19 origins.
• a ‘hot’ India/China confrontation emerges;
• longer-term attention will turn to how all the massive global fiscal stimulus, much of which will be sourced from central banks, is paid for;
• the question of whether ‘Modern Monetary Theory’^[3] will earn its stripes; or will too many dollars chasing too few goods see currencies devalue and inflation escalate (‘Monetarism’^[4] and Milton Friedman’s economic theories)?; and
• whether inflation comes back faster than anticipated, forcing central banks to act ahead of plans through increasing interest rates

Conclusion

Despite a tumultuous 2020, as infrastructure investors we remain excited about the listed infrastructure investment opportunity in 2021 and beyond. The combination of infrastructure’s attractive fundamentals (supporting earnings resilience), the economic and geographic diversity within the sector and prevailing long-term structural thematics (e.g. the emerging middle class in EMs and the green energy transition to renewables), represent a unique investment opportunity in listed infrastructure. We believe this opportunity has actually been enhanced by the current pandemic – government stimulus programs are fast-tracking infrastructure investment, stretched government balance sheets will see a greater reliance on private sector capital, and a ‘lower for longer’ interest rate environment is supportive of infrastructure investment and valuations.

As noted at the outset, infrastructure in all its forms will be integral to the economic recovery and returning society to ‘situation normal’. There is no global recovery without roads, railways, pipelines, power transmission networks, communication infrastructure, ports and airports. Indeed, the pandemic may have actually reinforced and enhanced some of the key drivers supporting the asset class.

Annexure

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[1] Australian Financial Review, ‘We are more resilient and adaptable than we ever imagined’, 18 Dec 2020
[2] FTSE Global Core Infrastructure Index -12.6% in AUD, Dow Jones Brookfield Global Infrastructure Index  -15.2% in AUD and the S&P Global Infrastructure Index -14.8% in AUD on a 1 year view to 31 December 2020
[4] Modern Monetary Theory (MMT) is a macroeconomic theory that, for countries with complete control over their currency, government spending cannot be thought of like a household budget. Instead of thinking of taxes as income and government spending as expenses, MMT proponents say that fiscal policy is merely a representation of how much money the government is putting into the economy or taking out. This means that any government spending can be paid for by the creation of money, with the purpose of taxes being to limit inflation, by controlling the money supply. This means that spending shouldn’t be determined by deficit levels, but by whether or not spending is keeping the economy at full employment and at a reasonable level of inflation. (Investopedia)
[5] Monetarism is an economic school of thought, which states that the supply of money in an economy is the primary driver of economic growth. As the availability of money in the system increases, aggregate demand for goods and services goes up. An increase in aggregate demand encourages job creation, which reduces the rate of unemployment and stimulates economic growth. However, in the long-term, the increasing demand will eventually be greater than supply, causing a disequilibrium in the markets. The shortage caused by a greater demand than supply will force prices to go up, leading to inflation. (Investopedia)

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Populism poses a real threat to democracies for a number of economic, social and governance reasons.

Populism is spreading rapidly and globally, and becoming more aggressive in its implementation and execution. It traverses national borders and can infiltrate all political affiliations. It represents a huge challenge for modern liberal democracies, as the risk of populism is severe political and economic disruption and stagnation.

Much has been written on populism over the years. In this article, Greg Goodsell of 4D Infrastructure, a Bennelong boutique, gives a contemporary, global perspective on what populism represents, what it looks like today and where it is headed in the modern world. This includes defining populism; assessing how big a problem it really is; looking at examples and impacts; and finally, addressing the key question: what can be done about it?

Populism: easy to see but hard to define

Populist policies and political parties are evident all over the world. However, coming up with a comprehensive definition that captures the concept is not so easy. Three definitions that resonate with us at 4D are:

• ‘An ideology which pits a virtuous and homogenous people against a set of elites and dangerous ‘others’ who are together depicted as depriving (or attempting to deprive) the sovereign people of their rights, values, prosperity, identity and voice.’ (Albertazzi & McDonnell (2008, p3))
• ‘A thin-centred ideology that considers society to be separated into two homogenous and antagonistic groups: the ‘pure people’ and the ‘corrupt elite’, and argues that politics should be an expression of the volonte generale (general will) of the people.’ (Kaltwasser and Taggart (2016, p24))
• ‘Populist rulers are those promising to defend the people against corrupt elites, offering common sense solutions versus complex policies, and advocating national unity over cosmopolitan inclusion or international engagement. Based on that definition, Brazil, India, Italy, Mexico, Turkey and the US fall into the populist camp.’ (Bloomberg (2019))

While there is an element of subjectivity in relation to all the definitions, what is clear from the above is that a fundamental tenet of populism is the separation between the ‘good’’ and ‘bad’ in society, with the ‘bad’ enjoying a state of privilege or preference which should be challenged.

Within a political context, populism can be represented by the following diagram.

Four-way classification of political parties

Populism doesn’t necessarily attach itself to either the traditional ‘Right’ or ‘Left’ of the political spectrum, but it does exhibit or embrace a number of important principles as below. We’ve included examples from the current US administration.

• Typically a strong/popular leader: Donald Trump during the 2016 US Presidential election;
• Nationalism: Mr Trump’s ‘make America great again’ slogan (also Brexit’s key slogan of ’give us our country back’);
• Traditional values:Mr Trump has endorsed these on numerous occasions since being elected, including a consistent lack of action on gun control.

Populism drivers

The two key drivers of populism are typically immigration and globalisation/international trade. [^1]

• Immigration: generally speaking, populist leaders argue that immigrants compete with local workers, robbing them of jobs, depressing wages and become a burden on the welfare state. For example, immigration was a key issue in the Brexit vote; while arguments surrounding the construction and funding of the US/Mexico Border Wall have been consuming US politics for the past 12 months.
• Globalisation/international trade: is blamed by populists for uncertainty and destroying jobs. Foreign countries are accused of dumping goods in domestic markets and engaging in unfair trade practices. The US/China trade wars are a perfect example of this.

Using our previous example, Mr Trump was elected on the back of promises on immigration, international trade, taxation, public spending and healthcare. Not surprisingly, he has acted (or tried to act) on all of these issues.

The spread of populism

Populism in politics has become very widespread, especially over the past decade. We have identified Mr Trump’s 2016 Presidential election campaign as being decidedly populist, while Bloomberg suggests that Brazil, India, Italy, Mexico and Turkey also fall into the populist camp.

More broadly, the spread of populism is represented by the following 2016 chart by Inglehart and Norris. They used the 2014 Chapel Hill expert survey to classify nearly 300 political parties along the ‘Economic Left’ and ‘Economic Right’ spectrum shown in the previous chart. They then identified the populist parties among them. Their classifications show a tide of populism across the political spectrum running from left to right.

And populism continues to spread. In a March 2019 Global Insight research piece, Ben Baris of Bloomberg concluded that:

• 68% of G-20 GDP is under the governance of either populist rulers in democracies or non-demographic regimes. This is up from 65% in 2017 and 33% in 2016;
• in contrast the share of G-20 GDP being run by mainstream democratic parties has fallen to 32% in 2019, down from 67% in 2016;
• the major change has been the rise of populist leaders, with such leaders now responsible for 43% of G-20 GDP up from 8% in 2016;
• while populist governments have grown, the mainstream parties have left the ‘door ajar’ for them via policy and governance failures;
• the UK’s ’Brexit’ pains and France’s ‘yellow vest’ protests both reflect the difficulty mainstream parties have in accommodating populist demands; and
• India, arguably a populist regime under PM Modi, may be bucking the trend with sensible reformist policies. Brazil is also targeting much needed reforms.

Why is populism so dangerous?

Put simply, populism leads to poor or inappropriate public policy formulation and execution. From an economic policy perspective the EEAG^[2] definition of populist economic policy is instructive:

‘The populist economic agenda is characterised by short termism, the denial of intertemporal budget constraints, the failure to evaluate the pros and cons of different policy options as well as trade-offs between them. It often focuses on single and salient political issues, overemphasises negative aspects of international economic exchange and immigration and blames foreigners or international institutions for economic difficulties. The populist economic agenda rejects compromise as well as checks and balances and favours simplistic solutions.’

Populist economic agendas are often very expansionary, emphasising the benefits of public spending or lower taxes. Dornbusch and Edwards (1990) suggested the economic consequences of these policies typically evolve in four phases:

• Phase 1: In the first year, the new populist policies seem successful. Output and employment growth accelerate, while inflation remains under control.
• Phase 2: Shortages begin to occur and FX controls reduce supply. The government budget deficit soars and inflation increases.
• Phase 3: Shortages increase, inflation accelerates and capital flight sets in.
• Phase 4: A new government takes over with conventional stabilisation policies.

 Populism examples

There are a number of examples of populism around the world.

• US Trump Administration: As noted above, Mr Trump was elected on the back of extensive tax cuts and immigration controls. He has enacted significant income tax cuts and looked to control migration and imposed tariffs. Arguably the US is approaching Phase 2 above.
• UK: The Brexit vote was substantially held on the issue of immigration and the nationalistic agenda of getting ‘control of the UK back to the UK’. However, a populist economic agenda has not yet fully emerged in the UK – arguably because all members of parliament are totally consumed trying to deliver, so far very unsuccessfully, a Brexit outcome.
• Italy: The 2018 coalition government between the 5-Star (far Left) and League (far Right) parties was a textbook populist campaign, with a highly expansionary fiscal policy combined with immigration controls and the rejection of the influence of supra-national organisations such as the EU. However, subsequent to gaining power the Italians have found it necessary to negotiate with the EU.
• Ukraine: In April 2019 Volodymyr Zelenskiy, a comedian whose only political experience was playing a president in a TV series, won a landslide victory in Ukraine’s presidential election. Mr Zelenskiy’s promised agenda is limited – fighting corruption and ending the war with Russia.

Central banks are increasingly becoming the target of populist leaders

Central bank monetary policy separation and independence from government over the past 25 years has been one of the great success stories of global economic policy. As The Economist^[3] notes, over that period billions of people around the world have grown use to low and stable inflation with interest rates under control. However, we now have Mr Trump demanding interest rates be slashed, and speculating on sacking the head of the US Federal Reserve. Brexiteers discredit the competence and motives of the Bank of England in delivering alarming post Brexit growth forecasts, in Turkey President Erdogan has been clashing with the central bank, and in India a competent central bank chief has been replaced, with interest rates then cut ahead of the election.

These are difficult times with global growth potentially slowing, so a genuine need for considered, independent central bank policy responses may be approaching.

What does populism mean for infrastructure investment globally?

As indicated above, the rise of populism is fundamentally an over-arching political concern that leads to poor policy, with the direct impact on infrastructure and other asset classes secondary. Populous rhetoric is bad for policy across the board, or more accurately ‘attempted’ policy. For us at 4D, as infrastructure investors, the politics of populism is one part of our analysis and has driven some country downgrades (leading to reduced portfolio exposures). But more importantly, in terms of infrastructure we focus on the strength of the judiciary in that country. When looking at long-dated assets, governments and government policy will come and go, but we need the judiciary in that jurisdiction to be stable throughout to uphold the sanctity of contract and regulation in place.

However, infrastructure has certainly not been immune to the populist curse. Recent populist political actions having a direct impact on infrastructure owners and operators has included the following:

• France: toll road operators were adversely impacted by the ‘yellow vest’ protests and Macron’s resulting concessions;
• Italy: post the Genoa bridge collapse in August 2018, segments of the Italian government threatened to take back privately held assets in what was seen as a move to shift blame and appease an angry populous. This attempt has failed due to recourse to EU law;
• Mexico: the new government in October 2018 cancelled the partially built new Mexico City airport post a very poorly conducted ‘referendum’. President AMLO was able to do this as it was to be a government asset, and he promised compensation to financiers;
• UK: there is an ongoing threat of nationalisation of utility assets if Labour under leader Jeremy Corbyn is elected. While this would face significant legal challenges and be very expensive, it remains a key Corbyn policy;
• Brazil: under the former government, toll roads suffered due to changes in policy around truck traffic. However, importantly the toll road operators were compensated due to the strength of the underlying contracts and judiciary in Brazil; and
• Australia: infrastructure projects have been proposed or cancelled as part of political agendas with no view on the execution, or viability of said projects, or the impact such actions have on Australia as a credible place to do business.

Where does Australia fit on the populist spectrum?

With a Federal election looming, it is worth reflecting on the influence of populism in our back yard. Our observations include:

• The policies of both Liberal and Labor are expansionary and incorporate populist features. Both election pitches incorporate substantial tax cuts and big spending initiatives. There is a real question over whether these policies can be funded as they rely on significant growth in tax revenues, with little coming from expenditure restraint. Any disappointment on economic growth may see these revenue forecasts struggle to be achieved;
• We discussed above the impact of populism on Australia’s infrastructure development;
• More generally Australian voters often reflect disrespect and a lack of confidence in mainstream parties and leaders – a fertile environment for a populist cause; and
• The minor parties in the upcoming Federal election are all populist, but with limited agendas. However, in a close election, they may well play a key role in new government formation.

So Australia is certainly not immune to the populist plague. 

Is it too late?

Has populism progressed to democracy’s new era of ‘Tear-it-all-down?

Recent activity and research has identified an alarming new trend – the tendency to oppose everything without compromise^[4] or alternative. Governments throughout the western world are struggling to govern. The UK parliament recently voted down a multitude of options for a Brexit, with chaos the result. British voters are similarly inclined to support the negative – with a ‘No’ vote to PM May’s Brexit deal, but equally strongly supporting a ‘No’ to leaving the EU without a deal.

France’s ‘yellow vest’ protests are a further example of this, seemingly only able to agree on a rejection of the status quo and distrust of institutions. According to Steven Levitsky of Harvard University, this is happening everywhere and represents a collapse of the ‘Schumpeterian democracy’ (named after the Austrian theorist Joseph Schumpeter). This has long been the basis of modern democracy in which the establishment managed popular will and sought the common good.

So what can be done to stop the march of populism?

Political scientists^[5] generally suggest the solution to populism lies in three areas.

• Militant democracy: This implies democratic institutions do not tolerate parties or political movements that aim to destroy democracy and the rule of law, replacing it with an authoritarian order. The problem here is that firstly, most current populist movements seek to achieve power within the existing political system. Secondly, such a militaristic response would be alien in most working democracies. However, it could be argued that the military coup in Thailand in 2014 was a response along these lines, while President Duterte’s election in the Philippines and his promise (subsequently acted upon) to shoot drug dealers is a further example of such a response (although it could also be seen as a populist initiative!).
• Regain the narrative and integrate populistic issues into mainstream politics: For this to occur, the major parties would need to ‘regain the narrative’ and look to address key populist issues within mainstream rhetoric and policy. For example, well thought through policies directed at better sharing of wealth and broader income re-distribution could help to shrink the populist support base, and bring voters back to mainstream.

In this vein French President Emmanuel Macron recently completed a three-month-long ‘national conversation’^[6] taking him on a town hall tour of the country, involving two million responses from ordinary citizens. He presented his conclusions on 25 April, noting a sense of injustice, abandonment and lack of respect; and a suspicion of elites. He said policy had to be more ‘human’. No more schools or hospitals would be closed on his watch; modest pensions will be inflation-indexed; unpaid alimony payments to single parents will be enforced; a single public-service office is to be set up to simplify dealings with the French bureaucracy; and there will be lower taxation. He will also reduce the number of elected representatives and abolish a civil service training college the Ecole Nationale d’Administration.

The key unanswered question, however, is how Mr Macron will fund these initiatives given France’s budget is already under pressure.

Whether all of this is enough to pacify the ‘yellow shirt’ protesters remains to be seen. However, early signs were positive with the number of protesters on the street at approximately 28,000, down from 280,000 last November. The majority of the French people now want the protests to stop, having initially sympathised with the protesters. Perhaps Mr Macron has provided a road map to a solution.

• Integrate populist parties, potentially even letting them be part of governing coalitions. Australia’s Westminster political system may well facilitate this at the upcoming Federal election with a major party possibly requiring the support of a minor, populist party to form government. The problem here is how much the major party has to compromise its principles, values, views and policies in order to accommodate the minor populist party. The answer to that may come on May 18, but if Italy is an example (where the 5-Star (Left) and League (Right)) joined to form a coalition government) the answer could be a long way!

Conclusion

Populism poses a real threat to democracies for a number of economic, social and governance reasons. From an economic perspective the key issue is that populism leads to the development and attempted implementation of poor economic policy. Populism is bad for all asset classes and society in general. It sets the ground work for increasingly violent confrontations, such as the French ‘yellow shirts’.

There are no easy answers. Major parties globally need to recapture the narrative by being seen to address classic populist issues (eg. wealth distribution) and communicate/educate as to why the traditional liberal democratic system has worked well for so long and remains the best governance option known to society.

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The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. The commentary in this article in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader. In particular, this newsletter is not directed for investment purposes at US persons.

Sources

The Economist. The independence of central banks is under threat from politics, That is bad news for the world. 13 April 2019
The Economist, The French president responds to the gilets jaunes, 26 April 2019
The European Economic Advisory Group (EEAG) report on the European Economy 2017. No. 16
The New York Times: Brexit Mess Reflects Democracy’s New Era of Tear-it-all-down, 29 March 2019
Bloomberg, Global Insight: How much of World Economy is run by Populists? March 2019
AFR Editorial, Populist Tantrums, political impasse, March 2019
AFR, Democracies trapped in political dead ends, 12 December 2018
AFR Editorial, Populist governments challenge economic orthodoxy, 30 October 2018

[1] The EEAG report on the European Economy 2017. No. 16
[2] Ibid, p53
[3] The Economist: The independence of central banks is under threat from politics, April 2019
[4] The New York Times: Brexit Mess Reflects Democracy’s New Era of Tear-it-all-down, 29 March 2019
[5] The EEAG report on the European Economy 2017. No. 16, p61
[6] The Economist, The French president responds to the gilets jaunes, April 2019

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“The most important development, I believe, of the 21^st century will be the rise of Asia. China has already trebled its share of world GDP over the past two decades and India has doubled it. Both these giant economies of Asia are bound to (re)gain a considerable part of their share of world GDP that they lost during the two centuries of European colonialism …”

In this paper Greg Goodsell, Global Equity Strategist at 4D Infrastructure, examines the central tenets of this quote and how they suggest we are truly living in the Asian century.

Introduction

A consistent theme of our research over the past two years has been the emerging strength, changing character and relative importance of the economies of our northern neighbours in developing Asia. We have examined different elements of this thematic in a number of Global Matters papers, including: Young tiger stalks ageing dragon (September 2016); Inside the tiger’s den (November 2016); The emerging middle class and its implications for global investment (April 2017); and All aboard the new Silk Road (June 2017).

In this paper, we both consolidate and develop on those themes. Sustained higher rates of economic growth, an expanding middle class, compelling demographics, improved education and major policy initiatives like the new Silk Road will continue to propel Asia forward, driving infrastructure investment for decades.

1. Asia has changed significantly over the past 20 years

The Asian region has changed enormously since the turn of the century. At a macro level, this is illustrated in the divergence in GDP growth rates between the East and the West. Chart 1 shows this growth for China, India and Indonesia (East) versus that of the United States, Germany and France (West).

It is clearly illustrated that over the past decade, the East has manifestly out-performed the West.

The trends in economic growth of the past decade look likely to continue into the future, as shown in Chart 2. A combination of Bloomberg consensus and IMF forecasts strongly suggest that, in GDP growth terms, the East is expected to significantly outgrow the West to 2020 and beyond.

This rapid GDP growth in Asia is seeing a change in Asia’s share of world output, which has grown from ~15% in 1950 to ~35% in 2010—at the expense of the developed world (see Chart 3^[2]).

China and India have almost tripled their share of the global economy over the past 20 years. The bubbles in Chart 4 reflect the GDP size for Asian economies, adjusted for purchasing power parity in 2011.

As Asia’s relative share of GDP growth increases, the global centre of economic activity will migrate from West to East, with India and China dominant. By 2025, the Asian region as a whole is expected to account for nearly half the world’s output.

2. Positive demographics provide a tail wind for the East

The western world, which enjoyed a long post-World War II economic upswing, has been seduced by increasingly hedonistic lifestyles which accompanied that long period of wealth accumulation. Society has changed, and it seems this has meant there is less room for children. As a result, the western world’s demographics are in a tailspin.

As shown in Chart 6, in both Western Europe and North America global fertility rates are well below the 2.1 children/women required to maintain the population. In contrast, both South East Asia and Central and Southern Asia have fertility rates above the key 2.1 metric.

The exception to this is China (East Asia), the dominant nation in the East, which exhibits a low fertility rate and deteriorating demographics by virtue of its longstanding, but now relaxed, one-child policy. This is shown in the centre pyramid of Chart 7, where a bulge generation is followed by a much smaller cohort. However, at present China has a very large working-age generation which will help boost growth over the next few decades.

3. Asia catching up in education investment: facilitates ongoing GDP growth

Asian countries have long recognised the crucial role education will play in their development. In developed Asian nations such as Hong Kong, Singapore, Japan and Taiwan (as well as China), education was often compulsory and by 1960 was prevalent. This trend has continued, with improved access to education across the region—primary school enrolment rates are nearly 90% in the Philippines, and close to universal in Cambodia and Indonesia^[3].

However, it is the overall growth in the level of formal education in the key developing Asian nations that is most encouraging, as shown on the right-hand side of Chart 8. Malaysia, China, Indonesia and India all show ongoing significant improvement in the level of formal schooling.

India as a case study in improving education

Like the rest of Asia, an important catalyst for continuing growth in India’s wealth is improved educational outcomes. Chart 9 shows India’s education levels have generally been improving over the past 20 years.

Indian Prime Minister Narendra Modi understands the critical importance of improved educational outcomes to India’s future prosperity. In July 2016, he initiated two skill-development programs involving total spending of US$3.3 billion, aiming to equip 15 million people by 2020 with the skills necessary to bring more high-grade manufacturing to the country.

To further help close the skills gap, Western companies in India are stepping up their own training. Boeing completed training for its first group of 30 recruits in the basics of aircraft assembly in early 2016, in collaboration with India’s National Skill Development Corp. All these graduates have been hired by an Indian supplier to Boeing. France’s Alstom sent 80 Indian nationals for training in Brazil and trained a further 250 in India to work at Alstom’s metro train manufacturing plant. In a similar vein, state-run Hindustan Aeronautics, a local Indian JV partner for many foreign defence and aeronautics firms, led the launch of the Aerospace Aviation Sector Skill Council to train hundreds of thousands of aerospace factory workers and 6,000 instructors over the next 10 years.^[4]

4.    The new ‘Silk Road’ will transform Asia and propel its growth

The new Silk Road in Asia, or more formally the Belt and Road Initiative (the ‘BRI’), is a major foreign policy and economic strategy of the People’s Republic of China. The term derives from the overland ‘Silk Road Economic Belt’ and the ‘21st-Century Maritime Silk Road’, concepts introduced by Chinese President Xi Jinping in 2013. These are the two major axes along which China proposes to economically link Europe and China through countries across Eurasia and the Indian Ocean. The BRI also links to Africa and Oceania.

Formally, the BRI emphasises five key areas of international co-operation. However, it is the huge investment in infrastructure needed to facilitate the BRI’s trade objectives that has received the most attention. While the quoted numbers tend to vary, in broad terms China is spending roughly US$150bn a year in the 65 countries that have signed up to the scheme^[5], with potentially up to US$1 trillion^[6] to be invested over the next five years.

BRI projects already stretch widely across Asia^[7]. From Bangladesh to Belarus, railways, refineries, bridges, industrial parks and much else is being built. A new city is taking shape in Colombo, near Sri Lanka’s main port, with the total investment estimated at US$13 billion spanning about 25 years. China Merchants Port Holdings Company (CMH, a Chinese government majority-owned, listed port operator) owns the Colombo port and is backing a much-needed second terminal. A freight route linking China’s east coast and London has already commenced operations. Stretching over 12,000 kilometres and passing through nine countries, the railway allows cargo to travel across the Eurasia continent in less than 20 days.

Chinese President Xi has described the BRI as ‘the project of the century’ that would ‘add splendour to human civilisation’. We have no reason to doubt his conviction—it will be the signature policy of his presidency. The BRI will involve a huge amount of infrastructure spending, which will create investment opportunities, jobs and wealth for decades to come. It will reshape Asia and propel its growth and transformation.

5.    What are the consequences, rewards and risks from the evolution of Asia?

The emerging middle class in Asia: consumption patterns change to services

As Asian wealth increases, we believe the emerging middle class will be one of the most enduring investment themes of the next 30 years, and it will be accompanied by a fundamental shift in consumption patterns. This is illustrated in Chart 11, which shows that as GDP per person rises in Asia, the expanding middle class’s spending on services will become more significant, following the path of almost all advanced economies.

The opportunities in Asia will be immense

As the ascendancy of Asia continues and individual wealth expands, opportunities for all nations to participate will grow—particularly for those fortuitous enough to be located in the region, such as Australia.

As observed above, consumption patterns in Asia will change towards services and experience-driven spending:

• Demand for education, health and aged care services to grow

As wealth expands in Asia, so will society’s demands for a better quality of life—starting with the education of children, ongoing healthcare and ultimately aged care services. 

• Overseas and domestic travel to continue to grow: airports and ports needed

Chart 12 shows that, as disposable income has grown in China, so too has the amount of travel undertaken by Chinese residents, both domestically and overseas. We expect this trend to continue and be exhibited more broadly across Asia.

• Modest level of passports on issue confirms the potential for travel growth

A further reference point for the potential for overseas travel growth is that, at present, around 10% of the Chinese population (and only around 5% of Indians) has a passport, and is therefore capable of travelling overseas. This compares with around 50% in the United States or Australia. If incomes continue to grow in China, there are likely to be a lot more international Chinese tourists.

• Increased motor vehicle penetration: improved road infrastructure demanded

Chart 13 shows a natural correlation between growth in GDP per capita and vehicle ownership. China, India and Indonesia all have very low levels of vehicle ownership penetration. However, as each nation’s GDP per capita climbs, so too will each country’s level of vehicle ownership. As a result, demand for new cars can be expected to be strong, as will demand for new and improved road infrastructure.

• Quality infrastructure will be a must

As our Asian neighbours’ standard of living increases, so too will their demand for more and improved infrastructure—be that airports to facilitate a higher propensity to travel, roads to drive new cars, or better basic utility services such as clean water, waste water management, and a reliable supply of electricity and gas. Construction and investment opportunities in these sectors will abound.

The geo-political dynamics from the advance of Asia cannot be ignored: Chinese ascendancy

The key geo-political issue arising from the advance of Asia, and the BRI in particular, is the rise of Chinese power and influence. The Chinese Government has stated that the BRI is not a strategic initiative and does not represent a form of ‘alliance’. However, the BRI may well lead to a seismic shift in the balance of global economic, and hence political, power between East and West.

As shown in Chart 14, for the foreseeable future the US will retain its absolute global military hegemony by virtue of the massive amount of funds it spends on the military. However, the ascent of China on the global political stage comes just at a time when a new Trump administration in the US is forging a ‘Make America great again’ or ‘fortress USA’ foreign policy—ripping-up the Trans-Pacific Partnership free trade agreement, revisiting the North American Free Trade Agreement and building walls with Mexico. In contrast, the Chinese Government under President Xi is heading in exactly the opposite direction. China is actively seeking to be recognised as the world’s leading advocate for free and open trade—a long-held position of the US, but one which they now appear to be vacating. Even though China states that the BRI has no strategic goal, with economic influence comes global political power.

Conclusion

In October 2012 the Australian Federal Government released a research paper titled ‘Australia in the Asian Century’, excerpts from which we reproduce in this paper. The foreword to that paper stated, inter alia:

‘…..Whatever else this century brings, it will bring Asia’s rise. The transformation of the Asian region into the economic powerhouse of the world is not only unstoppable, it is gathering pace. In this century, the region in which we live will become home to most of the world’s middle class. Our region will be the world’s largest producer of goods and services and the largest consumer of them. History teaches us that as economic weight shifts, so does strategic weight. Thriving in the Asian century therefore requires our nation to have a clear plan to seize the economic opportunities that will flow and manage the strategic challenges that will arise…’

We concur fully with this view, and believe it accurately reflects the arguments we make in this paper. Sustained higher rates of economic growth, an expanding middle class, compelling demographics, improved education and major policy initiatives like the BRI will continue to propel Asia forward, driving a huge amount of infrastructure investment. Indeed, we believe the biggest risk to Asia’s rise is that the infrastructure investment needs emanating from this rapid expansion are not adequately met.

We are living in the Asian century and Australia needs to be ready.

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[1] Quote sourced from the 2010 OECD Development Working Paper 285
[2] The definition of ‘Asia’ varies between some of the charts due to data constraints in the source document. Where possible, the constituents of Asia are defined in individual charts.
[3]Australia in the Asian Century, Australian Government, October 2012
[4]Wall Street Journal, 8 August 2016
[5] Economist, What is China’s Belt & Road Initiative, 15 May 2017
[6] UBS, Patronomics; Does the Belt and Road Matter, September 2017
[7] Bloomberg, Chinese spending lures countries to its Belt and Road Initiative, 10 May 2017

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The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. The commentary in this article in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader. In particular, this newsletter is not directed for investment purposes at US persons.

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Greg Goodsell

The Federal Budget handed down on Tuesday is a very exciting one for infrastructure spend and should create numerous opportunities for investors over the next few years and indeed decades, says Greg Goodsell, global equity strategist at 4D Infrastructure.

“The pipeline of new projects that may find their way to private investors in the future just got even bigger, and the boost they create for the economy should not be underestimated.

“Any sensible infrastructure investment, particularly in road or rail such as those announced by the Government, is going to be good for business productivity as it improves the essential ‘arteries’ of the economy, allowing business, and the economy more generally, to operate more smoothly, efficiently and productively.

“In addition, it creates strong investment opportunities as private sector funding will also be required to complete the projects. Listed infrastructure companies, which investors can hold in their portfolio, are set to benefit from these major projects.

“For instance, the $5.3 billion investment in Badgerys Creek Airport is great news for private infrastructure investors and potentially a fantastic project.

“Given the rate at which Sydney and Australia is growing there is no doubt this project is needed, and the scale of the project is enormous.

“By taking on the development and initial traffic risk, we believe the Government is performing exactly the role it should be in developing infrastructure projects that will be crucial to economic growth over the next 50 years.

“Ultimately we would expect ownership of this asset to find its way to the private infrastructure market just as all the other major airports in Australia have.

“When you include the new infrastructure that will be needed to service the airport (rail/road links) and the scope for those to be privately developed and or owned, the opportunity becomes even clearer.

“It will be a clear positive for business productivity, especially in terms of air freight services. Not only will the new airport be an important new export hub, conveniently located in western Sydney, it will also provide competition for Sydney Airport which essentially has a monopoly position on international air freight export from Sydney at present. A clear and direct competitor for Sydney Airport which is all good for cost competitiveness and improving business productivity.

“Another massive project, which will include private financing, is the inland rail connecting Brisbane with Melbourne, Adelaide and Perth, with $4.8 billion to be put forward by the government.

“When completed it would be truly nation building, completely reshaping towns en-route.

“A massive project like this would have a huge impact on the regions in touches because it will provide a new, close and cost effective gateway to market for goods produced in those regions.

“It would be expected that a project like the inland rail will see new business regions develop and evolve along the route which will be great for regional employment,” Mr Goodsell said.

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How will the growth of the middle class in emerging markets like China shape the investment environment over coming decades?

In our recent article Young tiger stalks ageing dragon we compared and contrasted India and China in terms of their economic and social development. What was clear from that paper was the exceptional rates of economic growth achieved by both nations over the recent past.

A product of that growth is the emergence of a more affluent middle class within each society. If you add an equally rapidly advancing Indonesia, you have three emerging nations, all with expanding middle classes, with an aggregate population of almost 3 billion, or ~40% of the people on this planet. The growth of the middle class in these three mighty countries will have profound implications for global business opportunities and investment for decades to come.

In this paper, Greg Goodsell, Global Equity Strategist at 4D Infrastructure, looks at how the middle class is expanding, especially in emerging markets, and how this will shape the investment environment over coming decades.

The growth of the middle class^[1], especially in emerging markets (EM), is a very important ongoing investment theme. This is because, as individual wealth increases in a country – as reflected by a growing middle class – consumption patterns tend to change towards more services/experience based spending (such as healthcare and travel). Given the potential size of the middle class in EMs this change in spending patterns will have profound implications for global business opportunities and investment for decades to come.

In this paper, we look to bring together some recent research on the growth of the middle class to establish a construct of how the broad global society could look in 10, 20 or 30+ years. We then look to address the question of what that new paradigm might mean for global investment.

 1. Sustained economic growth ultimately drives individual wealth creation

China, India and Indonesia are three of the world’s four most populous nations. All three have experienced strong GDP growth (see Chart 1) which has led to huge economic expansion.

This economic growth has also lead to growth in GDP/capita – a broad measure of individual wealth. While all three countries are coming from very low starting points in terms of personal wealth, a long period of sustained economic growth is beginning to have an impact, with each country’s GDP/capita more than doubling over the past 10 years (see Chart 2 below). A middle class has been established and is growing.

2. But it is still early days in each nation’s evolution of a middle class

However, even after a decade of sustained GDP growth, China, India and Indonesia are still in the early days of a middle class evolution. This is illustrated in Chart 3 below which shows the relatively low vehicle ownership in each nation. The point here is that the potential for middle class growth in each country remains enormous.

3. What could the Chinese middle class look like in 10 or 20 years’ time?

While the middle class is still evolving in EMs, it is interesting to consider what its profile may look like over coming decades. Focussing on just the main EM – China – some excellent recent research from Morgan Stanley^[2] suggests the Chinese middle class consumer could evolve over the next 10 or 20 years to be richer, older, more tech-savvy, and with a significantly different consumption pattern from today (as shown in Chart 4 below).

By 2030, Chinese middle class consumers could have significantly increased disposable income due to ongoing GDP growth, but be older by virtue of China’s deteriorating demographic profile. China’s long standing one-child policy has punched something of a hole in its demographics, which will see a gradual ageing of the population over coming decades.

Increasing internet penetration is a natural adjunct to increased wealth and greater use of computers.

Looking at population wealth segmentation, Morgan Stanley sees China’s society evolving as shown below – income levels increasing, consumption patterns changing.

4. How Chinese consumption could change, and what that would mean for investment?

Growth in the Chinese middle class should lead to increased services and experience driven consumption, with generally less product driven spending as illustrated below.

Overseas and domestic travel to continue to grow

Chart 6 shows that, as disposable income has grown in China, so too has the amount of travel undertaken by Chinese residents, both domestically and overseas. We expect this trend to continue.

Modest level of passports on issue confirms the potential for travel growth

A further reference point for the potential for overseas travel growth is that, at present, just around ~10% of the Chinese population has a passport (and only around ~5% of Indians), and is therefore capable of travelling overseas. This compares with ~50% in the United States or Australia. If incomes continue to grow in China, there are going to be a lot more international Chinese tourists.

Motor vehicle penetration

Chart 7 below shows that there is a natural correlation between growth in GDP per capita and vehicle ownership. China, like India and Indonesia, still has a very low level of vehicle penetration. However, as each nation’s GDP per capita continues to climb, it would be expected that so too will each country’s level of vehicle ownership, so car production can be expected to be strong, as will the demand for new and improved roads.

6. The consequences from this burgeoning middle class for global investment is huge

Clearly, if per capita incomes in China, India and Indonesia et al continue to grow, and a middle class continues to evolve, then global consumption patterns will change. As noted above, these three huge nations account for ~40% of the world’s population so their combined middle class will be a very powerful consumer group. The provision of value adding services, such as IT, education, health and aged care will be in demand. Similarly, travel and recreational services could also gain significant tailwinds, while some more traditional industries such as car production could also boom.

Infrastructure investment, by necessity, will be huge

From an infrastructure investment perspective the potential is enormous. For example, this could include:

• international (and domestic) airports: greatly increased overseas travel leading to demand for new or expanded international airports;
• toll roads: increased motor vehicle penetration will be matched by increased demand for new and enhanced roads, including user-pay toll roads. The data in Chart 7 above tells the potential investment story here: in 2015 China had ~100 cars per 1,000 people, Indonesia ~50 and India ~30. In contrast the US had ~800. As wealth builds, and these numbers increase in EMs, so too will the need for new and better roads;
• port infrastructure: increased import demand will ultimately necessitate enhanced port infrastructure; and
• utility services: more generally, a new more affluent, more demanding middle class will require an improved standard of living across the board which will pressure the basic utility services such as water, electricity, gas and telecommunications to improve their offering.

Governments are cash constrained…. private sector funding essential

Given the budget and balance sheet pressures facing governments around the world, inevitably much of these new and enhanced infrastructure demands will have to be met from private sector funding including the listed and unlisted infrastructure equity markets.

6. But wait… aren’t the middle classes in the US and Germany in decline?

As shown in Chart 8 below, the middle class in both the United States and Germany has been in decline. However, it is important to note that this trend has been underway for some time, and much of the drift out of the middle class has been into the upper-middle and high-income groups.

However, what is significant is that, from an infrastructure perspective, both the US and Germany face huge investment tasks as a result of a long period of under investment in their infrastructure stock.

2017 US Infrastructure Report Card: Grade D+

For example, in the US this need for investment is clearly reflected in the 2017 Infrastructure Report Card from the American Society of Civil Engineers (ASCE). The results from the Report Card are summarised in Table 1 below.

The ASCE gave US infrastructure an overall Grade of D+, which was unchanged from the last Report Card in 2013. The highest individual grade was a ‘B’ for Rail, which is largely privately owned, while all the other individual category grades ranged from C+ to D-. Clearly, President Trump’s planned US$1 trillion (~5% of GDP) investment in US infrastructure is urgently needed.

US$300 billion 15-year German infrastructure spend

Similarly in Germany, in August 2016, the government announced a plan to spend €269 billion (US$300 billion, or ~9% of GDP) on construction and modernisation of the country’s infrastructure over the next 15 years. This is reputedly Germany’s largest ever infrastructure investment program. Much work and investment needs to be done in Europe as well.

Conclusion

The evolution of the middle class, especially in emerging markets, will be one of the most enduring investment themes of the next 50 years. Individual consumption patterns in countries such as China, India and Indonesia are set to change dramatically over the coming decades. Inevitably, there will be winners and losers from this transition. However, one constant will be the need for more and improved infrastructure around the world in order to meet the needs of this new, powerful and demanding consumer.

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[1] The definition of ‘middle class’ can vary significantly but for the purpose of this paper is best thought of in a general sense as the broad social group between the upper and working classes, including professional and business people and their families.
[2] Morgan Stanley Research, Blue paper: Why we are bullish on China, February 2017

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Disclaimer: The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. The commentary in this article in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader. In particular this newsletter is not directed for investment purposes at US persons. This information is issued by Bennelong Funds Management Limited (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the 4D Infrastructure Fund. The information provided is general information only. It does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at 28 March 2017. 4D Infrastructure Pty Ltd (ABN 26 604 979 259) is a Corporate Authorised Representative of Bennelong Funds Management Limited (BFML), ABN 39 111 214 085, Australian Financial Services Licence No. 296806

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In this paper, 4D Infrastructure’s Greg Goodsell (Global Equity Strategist) and Mark Jones (Senior Investment Analyst) compare and contrast NZ’s economic fortunes over the past decade with that of cross-ditch rival, Australia, asking the question: what can politicians in Australia learn from the NZ experience?

The NZ economy has matched or outperformed its Australian cousin on virtually every major metric over the past decade. This is despite the Kiwis facing some very substantial challenges, while Australia enjoyed a huge resources boom tailwind. Below we examine some of those key economic metrics while briefly reviewing the headwinds faced by the Kiwis. Finally, as a case study in the varied approaches to common challenges, we compare the Kiwis’ approach to delivering a national broadband network with that of Australia.

1. Economics: New Zealand (6) defeats Australia (0)

As evident in the charts below, after a slow start New Zealand’s GDP growth has just about matched that of Australia over the past decade. This includes the 2011 period of the Christchurch earthquake. Significantly, in growth in GDP per capita, the Kiwis now have their noses in front, although they still trail in absolute dollar terms.

Inflation in each country remains modest and manageable, while in the key metric of unemployment NZ narrowly takes first place.

From a budget perspective, NZ has now returned to a position of sustainable fiscal surpluses (Chart 5). Realistically, this is not even on the political horizon in Australia. These outcomes are reflected in the public debt positions shown in Chart 6 below, with NZ now having a lower public debt/GDP position.

Currency movement and direction is often a good reflection of a nation’s economic performance. This is evident in Chart 7 below, with the A$ and NZ$ close to parity versus the US$. This outcome would not have been thought a remote possibility as little as three or four years ago. NZ’s relative political stability versus Australia’s is reflected in Chart 8 with a consistently lower EIU[1] risk score, although both countries have very low scores especially relative to most other countries.

2. Tailwinds and headwinds

Australia and NZ both had to confront the GFC. However, over much of the last decade, Australia has benefitted from a once-in-a-lifetime resources boom while the NZ economy has had to confront some substantial impediments to growth including:

2011 Christchurch earthquake

The effects of the tragic Christchurch earthquake are still being felt in the NZ economy. Full rebuild could take five to 10 years and the reconstruction cost is estimated at NZ$40 billion, or around 20% of GDP, over 80% of which is expected to be covered by insurance. While the re-build spend would also contribute to growth, it won’t supersede the damage and economic dislocation caused by the event. The recent 7.8 magnitude November 2016 earthquake in the North Canterbury region was more powerful but much deeper in the earth’s crust and in mostly rural areas. The damage bill will therefore not be as large.

Dairy price weakness offset by increased tourism

Weak dairy prices (Chart 9) have been prevalent for some time now. This has been a significant drag on the NZ economy. In 2014 31% of NZ exports were dairy, but this had dropped to 23% by 2016. This impediment to economic growth has been partially offset by a boom in tourism (Chart 10) and net migration, which has contributed to boosting economic growth.

3. Where has this All Black like performance come from?

We believe NZ’s superior economic performance versus Australia’s over the past decade is fundamentally a product of better policy development, selection, execution and governance. The centre/right government of the now outgoing Prime Minister John Key, elected in November 2008, has been very successful at policy development and execution, as well as effective communication and being able to take the electorate with them. Their success meant they remained popular and were therefore able to govern and deliver reforms without having to deal with the stupefyingly populist, limited agenda, independent parliamentarians that have confronted successive Australian governments.

In addition to the strong economic outcomes described above, key policy successes of the Key administration include:

• tax reform: lifting the GST rate to 15% and allowing both the top income tax rate to be cut from 39% to 33% and the company tax rate to be cut from 33% to 28%. These changes have been credited with ‘turbo charging’ NZ’s economic growth. Reforms similar to this were abandoned by the Australian Government in early 2016, as they would not have been able to get them through the Senate;

• electricity asset privatisations: implementing a policy taken to the 2011 NZ election, the Kiwi Government overcame a referendum rebuke to partially privatise the electricity system with the proceeds re-invested in new infrastructure assets. This policy has been largely adopted by the Baird Liberal Government in NSW; and

• reform of the welfare state: involving the adoption of an actuarial approach to determining the cost of welfare allowing targeted intervention.

4. National broadband networks: a case study in the different approaches to public policy implementation in NZ versus Australia

The differing philosophical approaches to delivering public policy between Australia and New Zealand is clearly evident in the alternate ways each country has sought to deliver a national broadband solution. While the vast differences in the respective country’s land masses would have been an important factor in the varied policy choices, the differing philosophical approaches are quite stark. We compare the two strategies in some detail in the Annexure below.

Key points of difference include:

• technical solution: NZ has adopted a ‘fibre to the premises’ model whereas Australia is adopting a hybrid approach. Fibre to the premises is technically a superior solution;

• ownership structure and funding solution: Australia’s NBN business is wholly government owned and funded. In contrast NZ has immediately imposed private market disciplines on its NBN via structuring its funding through a publicly listed communications infrastructure company (Chorus Limited (CNU NZ)) with access to debt and equity markets; 

• exit plan: the only plausible exit for Australia from NBN Co is via a privatisation at some uncertain point in the future, subject to the performance of NBN Co and the political/economic climate of the time. In contrast the NZ Government’s equity and contributions are structured to be repaid out of the operating cashflows of the Chorus business, depending on how successful it is with the rollout and take-up.

It is the NZ philosophy of, from the outset, imposing private market disciplines, objectives and targets on the rollout of the broadband solution which, we believe, is superior to the traditional government funded solution adopted in Oz. We believe the NZ approach will lead to more disciplined control of costs and capital expenditure, ultimately improve the chances of the business surviving and succeeding, and NZ taxpayers seeing their hard earned tax revenues that were invested in the broadband business returned at a profit to government coffers.

Essentially, the Kiwis look at the broadband project as a national investment with expected financial returns, whereas the Australian Government largely treats NBN Co’s funding as a ‘grant’.

Conclusion

The NZ economy has delivered a decidedly better outcome than its cross ditch cousin over the past decade despite facing substantial economic headwinds. We believe this has been the case because of stronger, more focussed governance and better policy development and implementation in NZ. This is well illustrated in the two countries’ alternate approach to a national broadband solution. Much can be garnered in Australia from the Kiwi approach and experience.

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[1] The Economist Intelligence Unit (EIU) is a division of the British Magazine The Economist. It provides economic forecasting and country risk ratings.

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Sarah Shaw

SQM Research has rated the 4D Global Infrastructure Fund, which was launched in March 2016, as ‘Favourable’.

The Fund is managed by 4D Infrastructure, headed up by Sarah Shaw and Greg Goodsell, with support from two investment analysts and the backing of Bennelong Funds Management.

SQM states that the team is “…knowledgeable, experienced and passionate about infrastructure equities, with a proven track record in growing funds under management in previous roles.” Whilst still in its infancy, the fund has “experienced healthy inflows since inception”.

SQM’s approved investment grading deems the Fund can be considered for APL inclusion as the Fund “may outperform its peers and benchmark the majority of the time or SQM believes this is a fund that has potential to be an outperforming fund over the medium term”.

4D is a boutique asset manager investing in listed infrastructure companies, globally. 4D aims to identify quality infrastructure companies, trading at or below fair value with sustainable, growing earnings combined with sustainable, growing dividends. The Fund is index agnostic as 4D look for the best opportunities globally in regions including North America, Europe, developed Asia and emerging markets.

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Greg Goodsell

Listed infrastructure offers real potential for investors looking for long-term, defensive investments with an attractive yield, and the opportunity will expand rapidly over coming decades, says Greg Goodsell of 4D Infrastructure.

“Recent estimates suggest that around US$60 trillion needs to be spent globally over the next 30 years on infrastructure – just to bring existing assets up to standard and keep pace with growth. And it isn’t all going to come from the public purse,” Mr Goodsell says.

“Several factors are coming together to put infrastructure spending firmly on the agenda around the world.

“Firstly, there has been a major underinvestment in infrastructure for the past three decades – and in some cases, even longer – which has created a huge backlog in the need for new spend.

“This underinvestment in infrastructure is prevalent in both developed and emerging economies.

“For instance, some water pipes in the US are over 100 years old and in obvious need of replacement. US water utilities are progressing with an accelerating infrastructure replacement program but the task is huge and will stretch over decades not years. This replacement program will require ongoing private sector investment.

“Secondly, despite the demand, governments are unable to step in and fund all this much-needed infrastructure. Most governments are in weak fiscal positions following the financial crisis and simply don’t have the funds available without pushing up already high levels of public debt.

“There is therefore a tremendous opportunity for privately financed infrastructure to fill a big part of the void, via both the listed and unlisted infrastructure markets.”

Listed vs unlisted infrastructure

Listed infrastructure has the advantage of liquidity as compared with unlisted, allowing investors to move into and out of positions more easily.

With unlisted infrastructure, it’s not uncommon for investors to have their money waiting for a considerable period until an acceptable infrastructure asset becomes available, allowing the cash to be deployed for investment.

“At 4D Infrastructure,” said Mr Goodsell, “we also believe listed infrastructure’s daily pricing movements create opportunities for outperformance”.

Utilities vs user pay assets

Mr Goodsell says there are two broad classifications for infrastructure assets – regulated utilities (such as gas, electricity and water) and user-pays (including airports, toll roads and railways).

“At the moment, we prefer ‘user pay’ assets over utilities and believe this is where the best opportunities currently lie.

“We are in a global growth environment, albeit a sluggish one, and this type of macro backdrop should still be conducive to growth in use of user-pays assets.

“The growing middle class in emerging markets, combined with the economic recovery theme, all contribute to growing demand for the ‘product’ user-pay assets deliver: be it a tollway or an airport.”

The key infrastructure investment characteristics include:

• visible and resilient cashflows, often underpinned by contract or regulation;
• often a monopolistic position, or at least one with high barriers to entry;
• as an investment, it acts as an inflation hedge; and
• while there can be high upfront capital costs, this is usually followed by low maintenance costs.

“From an investor’s perspective, infrastructure is a defensive asset class, with higher visibility of earnings and lower volatility compared to general equities, and a higher dividend yield – something many investors would find very attractive,” said Mr Goodsell.

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