Developed Markets Income Strategy September Commentary

Key Takeaways

• Listed infrastructure outpaced global equities in the third quarter as a growth scare, coupled with high valuations for AI-related tech stocks, catalysed a market rotation to a mixture of defensive and rate-sensitive securities.

• A 50 basis point cut to the U.S. federal-funds rate also helped defensive and yield-oriented sectors such as communication towers, the leading sector in terms of absolute returns.

• Given the prospect of slowing growth from elevated levels as well as declining interest rates, we believe the defensive and income-producing qualities of infrastructure will become more apparent, as was evident in the third quarter.

Market Overview

Listed infrastructure outpaced global equities in the third quarter as a growth scare, coupled with high valuations for AI-related tech stocks, catalysed a market rotation to a mixture of defensive and rate-sensitive securities. Signs of slowing growth also raised hopes for an interest rate cut in the U.S., and the Federal Reserve delivered with a larger-than-expected 50 basis point cut to the federal-funds rate in September.

The rotation toward a risk-off market sentiment, driven by a combination of weak economic data from Europe, disappointing technology-related earnings results, softer than expected job reports from the U.S. and an interest rate hike by the Bank of Japan, helped showcase the defensive nature of infrastructure, which should continue to receive a tailwind from further interest rate cuts in the quarters ahead.

On a sector basis, the rate cut in the U.S. was positive for a range of infrastructure sectors, with electric, water and gas utilities performing well, along with longer-duration communication towers and renewables. More economically sensitive sectors made solid gains but trailed the group, as airports, rails and toll roads coped with concerns of slowing economic activity and lower oil prices, due to rising inventory levels in the U.S. and lacklustre demand from China, weighed on energy infrastructure.

Portfolio Highlights

Our global listed infrastructure strategies outperformed global equities and relevant infrastructure benchmarks for the month.

On a regional basis, the U.S. and Canada (+3.27%) was the top contributor for the month, with U.S. electric utilities Constellation Energy (+0.83%) and Entergy (+0.47%) the lead performers. Constellation Energy (Constellation) is primarily a nuclear generation company and is the largest producer of carbon-free electricity in the U.S., serving states including New York, Illinois, Maryland, Pennsylvania and New Jersey. The company’s combined generation capacity is more than 32 GW and 90% of annual output is carbon free. Constellation signed a landmark virtual PPA deal with Microsoft which will lead to the reopening of one of Constellation’s previously closed nuclear plants. Pricing for the deal was seen as accretive.

Entergy is a pure regulated electric utility, providing services to approximately three million people in Arkansas, Louisiana, Texas, Mississippi and New Orleans. Entergy’s share price rallied due to positive regulatory outcomes and a solid storm response, with storm activity bolstering the need for further resiliency investment.

French airport operator Aeroports de Paris (-0.06%) and U.S. rail operator Union Pacific (-0.15%) were the largest detractors.

Aeroports de Paris (ADP) owns and operates three airports in Paris, including Charles de Gaulle (CDG), Orly and Le Bourget, as well as minority stakes in several global airport groups, including TAV in Turkey and Schiphol in Holland. French risk assets in general were under pressure, following proposals by the government to raise corporate taxes in order to alleviate the country’s budget deficit situation. For ADP, we note they are able to pass on higher tax rates in their aeronautical charges through their regulated cost-of-service model, smoothed over a 2-3 year period, which should mitigate some of the impact. Operationally, the company continues to enjoy favourable traffic trends and commercial spending at their terminals.

Union Pacific is the largest listed railroad company in North America. Union Pacific’s Analyst Day was slightly underwhelming with some investors hoping for higher growth targets relative to what was guided. Additionally, re-emerging macro concerns impacted Union Pacific’s share price.
During the month, we initiated a position in Italian gas utility Italgas. We also used the opportunity to crystallise some gains by exiting our position in Spanish toll road operator Ferrovial.

All returns are in local currency.

Positioning and Outlook

We remain defensively positioned as impacts of tightened financial conditions continue to impact the economy and ultimately corporate earnings, but we have added some select GDP-sensitive exposure as an easing cycle now appears to be underway. We are expecting bond volatility to reduce and market breadth to continue to broaden — as that occurs, we expect that the market will increasingly recognise the strong fundamentals and long-term themes of infrastructure. Utilities should continue to benefit from themes of electrification, renewables growth and more recently higher electricity demand from data centres, and we remain constructive on the sector. Given the prospect of slowing growth from elevated levels as well as declining interest rates, we believe the defensive and income-producing qualities of infrastructure will become more apparent, as was evident in the third quarter.