Preparing for the next downturn
Favorable markets have made many investors complacent about the risks of a downturn, even as listed equity and fixed income portfolios show signs of pressure. Traditional investments are expensive relative to historical averages across an array of financial metrics.2 Greater risk is often apparent only during market downturns—correlations were much higher during the global financial crisis than more recent averages would suggest. Investors should assess their portfolios’ ability to weather downturns by testing their resilience in the event of recession, higher inflation and interest rates, and technological disruption.
Private core infrastructure’s resilience
Core infrastructure’s resilience to financial stress has strong theoretical underpinnings. The asset class is characterized by stable and forecastable cash flows, with yield making up the majority of total return. These stable cash flows typically derive from some combination of monopolistic market positions, transparent and consistent regulatory environments, long-term contracts with credible counterparties, mature demand profiles and prudent leverage strategies.
Unlisted core infrastructure is a relatively young asset class, and data are by definition private. Consequently, there are no reliable, comprehensive third-party return indices that cover multiple economic cycles. However, the MSCI Global Quarterly Infrastructure Asset Index, the first third-party private infrastructure return index, is a relatively good performance indicator (EXHIBIT 1) Over the life of the index, private core infrastructure has demonstrated relatively low correlations with other asset classes, including both equities (0.3) and fixed income (-0.2).3
Ten years of available data suggest core infrastructure’s resilience in times of stress
EXHIBIT 1: VALUE OF USD1 INVESTMENT THROUGH THE GLOBAL FINANCIAL CRISIS
Source: Bloomberg, National Council of Real Estate Investment Fiduciaries (NCREIF), MSCI World Index, Barclays Global Aggregate Bond Index, NCREIF Fund Index – Open End Diversified Core Equity (NFI-ODCE), S&P Global Infrastructure Index, MSCI Global Quarterly Infrastructure Asset Index*; J.P. Morgan Asset Management; data as of January 2018.
Time series are quarterly, based on gross of fees total return indices, and denominated in local currency. Returns are levered to reflect how institutional investors typically access the representative asset classes.
*The MSCI infrastructure returns are available only from Q2 2008 and so do not cover the beginning of the recession. However, private infrastructure investments would likely have been relatively unaffected at the outset of the crisis, when its full economic impact was not yet clear. The index has a relatively small sample and a bias toward Australian assets, but it continues to evolve and has successfully captured broader trends in core infrastructure.
Stress testing private core infrastructure
No two downturns are the same, and underlying investments can evolve over time—especially when allocations are susceptible to style drift. Investors should not rely exclusively on historical correlations and mean-variance frameworks to assess whether a given portfolio will be resilient in the next downturn. Bottom-up scenario analyses offer a way to test portfolios against a range of outcomes, including those that have never occurred before.
To that end, we applied a scenario analysis tool to an illustrative private core infrastructure portfolio comprising 40% regulated utilities, 30% contracted power generation and 30% transportation. We tested how that portfolio’s cash flows— as measured by its yield on cost—would perform in the event of (1) a global recession, (2) higher inflation and interest rates, and (3) lower power prices.
Observing cash flows directly eliminates the impact of fluctuating discount rates during a market downturn, which can distort returns and is of reduced importance for long-term investors. Cash yield is also valuable in its own right and allows for a more direct comparison with fixed income instruments for liability-focused investors. Yield on cost is a more useful metric than yield on net asset value (NAV): it would be little consolation if an investment registered a strong yield on NAV because the investment’s underlying value had atrophied.
Investors should continuously assess their portfolios’ ability to weather downturns, and today’s relatively expensive asset valuations reinforce the importance of portfolio construction and downside protection. As a fairly young asset class, infrastructure has limited performance data, but what data exist point to robust performance through the global financial crisis. Our study supplements that finding and illustrates how a diversified core infrastructure portfolio can be expected to withstand recessions, higher inflation and interest rates, and power price disruption. Consequently, core infrastructure—in addition to providing institutional portfolios with high and stable yields—may help investors to mitigate negative economic and market surprises.
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1 This paper follows up on the authors’ earlier in-depth overview of the asset class: Serkan Bahçeci, PhD and Stephen Leh, “The infrastructure moment: Core infrastructure’s growing role in institutional portfolios,” J.P. Morgan Asset Management (2017).
2 For example, cyclically adjusted P/E ratios are higher than at any time during the last 100 years, with the exceptions of the dot-com bubble and 1929. Source: J.P. Morgan Asset Management, 2018 Guide to the Markets; data as of January 2018. The prospect of diminishing central bank balance sheets from current record highs also puts expected returns under pressure.
3 Please see earlier research on how the relatively high and stable yield can help offset negative impacts on the capital appreciation component of returns: Bahçeci and Leh, “The infrastructure moment: Core infrastructure’s growing role in institutional portfolios,” J.P. Morgan Asset Management (2017),