The World Economic Forum estimates the world underinvests in infrastructure each year to the tune of a US$1 trillion. Commuters everywhere will not be surprised.
Infrastructure spending not only improves convenience and safety, but also productivity, as poor roads and delayed flights hold back economic growth. With such obvious benefits, why the underinvestment?
Years ago, governments found it far easier to approve infrastructure projects. After WWII a strong public consensus developed everywhere as to the desirability of undertaking large projects that would stimulate growth and put people to work, while modernizing the infrastructure asset base to support a rapidly changing industrial society.
The U.S. Interstate Highway System (built out over 35 years from the late 1950s), high-speed auto routes across Europe, bullet trains in Japan followed by high speed trains in Europe, and massive airports everywhere—these projects were not only sources of national pride, but added substantially to wealth and productivity.
But in today’s world, long development times mean politicians who authorize infrastructure projects often take criticism for massive budgets, possible cost overruns, and disturbance, but seldom remain in power long enough to take any credit for the benefits. In the U.S. and elsewhere, the complexity of infrastructure projects is compounded by the required involvement of regional, local, and national governments, which often have conflicting priorities.
The need to overcome these challenges is clear to all, and the need to boost infrastructure spending is one of the few areas of bipartisan agreement in the U.S. Yet a split Congress may make it difficult for any substantial infrastructure bill to pass.
Tangible plans to increase infrastructure commitments are emerging in other countries, as shown in the box below. We expect more national infrastructure initiatives in the future. Fiscal policy will likely play a larger role in counteracting the next recession, given interest rates are unlikely to have room to fall far enough to lever the economy higher unaided. Central banks could conceivably play a role: the Bank of England, Bank of Japan, or the European Central Bank could buy infrastructure bonds, or bonds issued by a state-controlled infrastructure bank.
The changing face of infrastructure investment
Two big changes have occurred within infrastructure investment over the past 40 years: firstly, the expansion of the private sector’s role; and secondly, the considerable broadening of the asset class.
Faced with the increasing scale, complexity, and financing needs of infrastructure projects, governments have sought more private sector participation. Meanwhile pension funds, sovereign wealth funds, and insurance companies have found long life infrastructure assets often match the long-term liabilities they deal with. Infrastructure projects also offer a reliable cash flow once up and running, often including an inflation adjustment mechanism.
China’s ambitions dwarf others’ plans
Key national infrastructure plans
Source - RBC Wealth Management
The traditional universe of infrastructure projects—bridges, roads, and power generation—has expanded to include rapid transit systems, high speed rail, airports, electricity transmission grids, harbours, and hospitals. Newcomers include: student housing; assisted living accommodation allowing retirees to live closer to healthcare and hospitals; the build-out of 5G, the fifth generation of mobile internet connectivity bringing greater speed and the ability to connect many more devices simultaneously; construction and maintenance of cell tower arrays; and networks of charging stations for electric vehicles.
Infrastructure investing and the economic cycle
Infrastructure investments should perform relatively well in the economic environment we foresee prevailing over the coming decade. Most infrastructure sectors benefit from economic growth and inflation to some extent, while demand tends to be relatively resilient in downturns.
Higher interest rates may make the investment environment more challenging as infrastructure assets tend to be financed by debt, but the impact will depend on the capital structure and return potential of each project.
A diversification tool
Infrastructure investments can offer valuable diversification benefits. Most deliver an income stream from low-risk, stable assets that would be less affected by an economic downturn. This should mean infrastructure investments will hold up better than the overall market in a downturn.
Transport can benefit most from the current environment
Impact of economic growth and inflation
|Sector / Subsector||Higher GDP growth: Impact on revenues||Higher inflation: Impact on revenues||Impact on costs|
|Communications: Traditional||Pricing pressures offset impact from higher growth||Tariffs tend to be linked with inflation||Established cost base|
|Communications: 5G infrastructure||Consumers expected to pay for additional connectivity||Tariffs tend to be linked with inflation||Established cost base|
|Energy: Natural gas & electric lines||Increased competition from Renewables puts pressure on traditional energy||Prices tend to increase with inflation||Established cost base|
|Energy: Renewables (e.g. solar, wind)||Secular growth & regulation are biggest drivers||Subsidies tend to increase with inflation||Greater efficiency drives costs down|
|Social: Hospitals, institutions||Little impact||Most tariffs are linked to inflation||Costs increase|
|Transport: Road, rail, airports||Volumes affected by GDP growth||Most tariffs are linked to inflation||Established cost base|
|Utilities: Regulated (electric, gas, water)||Little impact||Tariffs tend to be linked to inflation||Costs increase|
|Utilities: Unregulated (e.g. waste services)||Demand & prices tend to increase||Tariffs linked to inflation, but capped by competition and political pressure||Costs increase|
|Positive impact||Neutral impact||Negative impact|
Source - RBC Wealth Management
How effective a diversification tool they are will depend on the investment. Like all asset classes, infrastructure projects are subject to a broad spectrum of risks. At one end are less risky projects, such as conventional power generation in developed economies where costs can be controlled, demand can be more confidently assessed, and the regulatory environment can be relied upon. At the other extreme are unconventional “greenfield” projects in emerging economies where costs can escalate, contracts can be more difficult to enforce, sponsoring governments can change abruptly, and currency volatility can make returns unpredictable. Riskier infrastructure investments behave more like risky equities, potentially reducing or eliminating the diversification benefits of the asset class.
Investing in infrastructure
Infrastructure investment options include individual stocks, funds, or a combination of both. For single stocks, investors could focus on listed utilities, pipelines, or railways; industrial companies providing equipment, engineering services, or materials for projects; or companies that manage infrastructure assets.
For funds, the most significant benefit is the ability to diversify across industries, geographies, and the risk spectrum. Experienced fund managers are well-placed to assess not only each project’s complexities, but also political, regulatory, and currency risks. Some factors to consider when choosing a fund include:
- What assets is the fund invested in?
- Long-life assets with stable cash flows, or riskier assets with projects that are less regulated and may be more exposed to demand risks?
- Listed, or less-liquid unlisted projects located in developed economies, or in emerging ones with higher risk profiles?
- Physical assets or service providers or raw materials suppliers that may add cyclicality to returns and variability to any income stream?
- Established projects, or start-ups that may be riskier but offer higher returns?
- Does the fund look to harvest a long-term income stream, or does it buy undervalued assets to capture its returns via capital appreciation over a shorter time frame?
Infrastructure as an investment theme has a long life ahead of it. The demand for repair, replacement, and upgrading of existing infrastructure assets is immense across the developed world. Emerging economies need equally massive infrastructure investment to achieve economic and social goals.
The private sector has become an important source of infrastructure financing. Long-lived assets that provide a predictable stream of income, often inflation-adjusted, offer an attractive alternative for the trillions earning little or nothing in bank accounts ($9T in U.S. bank accounts alone), or for the trillions more that have flowed into lower-quality corporate and emerging market debt in recent years. We expect individual investors will discover the attractions of this asset class to a much greater extent over the coming decade.
Non-U.S. Analyst Disclosure: Frédérique Carrier, an employee of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (UK) Limited; contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since she is not an associated person of RBC Wealth Management, she may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.