By Daniel Chu, Charles Hamieh, Shane Hurst, & Nick Langley
Defense Might Be the Best Offense
Market Overview
Global equity markets ended the quarter up strongly, albeit with highly varied sector returns, with tech stocks driving gains, especially given the enthusiasm around AI. The ClearBridge Global Infrastructure Income Strategy outperformed infrastructure benchmarks such as the S&P Global Infrastructure Index, while both trailed the MSCI All Country World Index during the risk-on quarter. Global yields continued to push higher, meanwhile, with some large yield curve inversion now common, especially in the U.S.
AI has been a major theme in broad equity market returns in 2023, and the technology has several applications in infrastructure as well. In gas distribution, AI can use analytics to identify issues such as leaks or structural deficiencies, rather than a utility continuously allocating maintenance capex. In the electricity grid, AI can assist with grid dispatch — the allocation of electricity through the network according to market needs — in terms of timing and location. In renewables, AI can improve safety by predicting and preventing issues while ensuring timely maintenance and emergency response; for example, it can monitor the structural integrity of wind turbines and the temperature of solar panels to identify potential problems before they cause damage or failure. Traffic flow on toll roads can also benefit when there is very high penetration of autonomous vehicles, which use AI.
In terms of second-quarter portfolio performance, on a regional basis, the standout performer was Latin America, in particular Brazil, where moderating inflation is suggesting rates may be cut sooner than expected. Brazilian electric utilities Centrais Eletricas (EBR, Eletrobras) and CPFL Energia (OTC:CPFEY) rose sharply. Eletrobras, one of Brazil’s largest integrated utilities, saw a rebound in share price as the chances of re-nationalization now appear increasingly unlikely. This will allow Eletrobras to continue as a private company and give it the chance to deliver on its lucrative turnaround plans.
CPFL Energia is one of Brazil’s largest distribution and generation companies, with a 13% market share in distribution and a 3% market share in generation. CPFL’s distribution assets include eight separate federally regulated concessions and generation assets consisting of a mix of hydro and renewable assets that are underpinned by long-term take-or-pay contracts. CPFL saw favorable tariff reviews granted by the regulator this quarter and was a beneficiary of a general market rebound in Brazil.
The renewables sector, meanwhile, had a challenging quarter, where Energias de Portugal (OTCPK:EDPFY) was the lead detractor. EDP is an integrated utility based in Iberia, operating electricity distribution, generation and energy supply businesses. It has a growing exposure to global renewables, through its 83% owned subsidiary EDPR, which is primarily onshore wind farms. EDP also operates electricity distribution and generation businesses in Brazil through its 50% owned EDP Brasil. EDP’s share price was dragged down by weakened global renewables sentiment, which hurt EDPR’s performance and in turn EDP, which has about two-thirds of its value coming from EDPR. In addition, drought across Portugal in April and May caused concerns over power output for EDP’s hydropower plants there. Brookfield Renewable (BEP), a pure-play renewables operator and developer headquartered in Canada, focused on international hydro, solar, wind and storage technology, also traded down amid weakened global renewables sentiment.
U.K. water companies also underperformed as concerns about some specific operating issues among unlisted water companies, Thames Water in particular, impacted the listed sector. The main detractor here was Pennon (OTCPK:PEGRF), a U.K. water and waste services company, which pulled back primarily on the back of rising bond yields in the U.K. This was accompanied by rising concerns of political and regulatory scrutiny on the U.K. water sector on sewage overflows and pollution. Pennon, in particular, faced more uncertainties around the ongoing investigations by the Water Services Regulation Authority (Ofwat) and the Environmental Agency on pollution issues with unclear timelines, as well as a new investigation by Ofwat on data accuracy. There is no material change to our thesis here as we monitor Ofwat’s investigations around the sector.
Outlook
The combination of peaking interest rates and inflation continues to cause volatility as investors weigh the probability of a global recession against reasonably strong economic data, while China is experiencing volatility as its economy reopens post the easing of COVID-19 restrictions.
Inflation continues to moderate, but remains at an elevated level, with recent data showing economic strength is making it difficult for central banks to loosen policy quickly. Although maintaining a tightening position is common across most economies, varying economic circumstances may see monetary policy diverge in the extent of tightening. Consensus remains divided on recessionary expectations, with the duration and depth of a recession remaining the largest risk to investors.
Against this backdrop, we maintain our defensive positioning. Across regulated utilities, fundamentals are still very strong with strong asset base growth driving very attractive free cash flow and cash flow that is being deployed into capex or being paid out to investors. We are also looking for more select opportunities to increase exposure to high-quality user-pays assets in sectors such as airports, passenger and freight rail, and toll roads.
The outlook for infrastructure remains positive. Infrastructure’s focus on cash flows and underlying earnings make it a very attractive sector as economic conditions deteriorate. With inflation elevated and its path uncertain, the sector continues to act as a strong inflation hedge, where the pass-through of inflation is enshrined in regulation or concession agreements. And longer term, infrastructure’s exposure to decarbonization, onshoring of industry and the explosion of data demand bodes well for the long-term asset base growth and the nearer-term cash flow generation and dividend story.
Portfolio Highlights
We believe an absolute return, inflation-linked benchmark is the most appropriate primary measure against which to evaluate the long-term performance of our infrastructure strategies. The approach ensures the focus of portfolio construction remains on delivering consistent absolute real returns over the long term.
On an absolute basis, the Strategy saw positive contributions from five of the eight sectors in which it was invested (out of 11 total) in the second quarter, with the electric utilities sector the standout contributor. The renewables, communications and water sectors were the detractors.
On a relative basis, the ClearBridge Global Infrastructure Income Strategy outperformed the S&P Global Infrastructure Index during the quarter. Overall stock selection and sector allocation were positive, with stock selection in the electric utilities and toll roads sectors and a lack of exposure to the airports sector contributing the most. Stock selection in the renewables and water sectors and a communications overweight, meanwhile, were the main detractors.
On an individual stock basis, the top contributors to absolute returns in the quarter were Eletrobras, CPFL Energia, SSE, TC Energy (TRP) and Constellation Energy (CEG). The largest detractors were Energias De Portugal, Crown Castle (CCI), Pennon, Entergy (ETR) and Brookfield Renewable.
During the quarter we initiated positions in U.S. electric utility NextEra Energy (NEE) and Italian electric utility Enel (OTCPK:ENLAY). We closed positions in U.S. renewables utility Clearway Energy (CWEN) and U.S. gas utility Southwest Gas (SWX).
Daniel Chu, CFA, Director, Portfolio Manager
Charles Hamieh, Managing Director, Portfolio Manager
Shane Hurst, Managing Director, Portfolio Manager
Nick Langley, Managing Director, Portfolio Manager
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