Our Company and Sites
April 2018

In need of an upgrade:
The U.S. infrastructure opportunity

There is widespread agreement that the United States needs significant investment in infrastructure in order to sustain long-term economic growth. The concept of infrastructure spending has bipartisan support, but there has been little progress to date. However, it could have a major impact if enacted thoughtfully and in coordination with the private sector. The U.S. ETF Investment Strategy team considers the potential implications for investors.

Key points:

    • Large scale investment in transportation, energy, water and other infrastructure systems is important to the U.S. economy’s competitive position and future growth. The shift in focus from monetary to fiscal stimulus in the U.S. raises the prospect of this long-needed injection flowing through.
    • In our view, politics will be a key return and risk driver for infrastructure this year. However, interest in the sector is being driven by governments and private investors alike.
    • Infrastructure investment outcomes are highly dependent on the vehicle selected. In our view, investing broadly across the value chain allows investors to target a potentially pro-cyclical growth profile in the medium term and a more secular growth profile in the long term.

    1. Maintenance required:
    why immediate infrastructure spending is imperative

    In the latest of its quadrennial scorecards since 1988, the American Society of Civil Engineers (ASCE) graded the U.S. infrastructure system a D plus last year.1 The composite grade was unchanged since 2013, and suggested that the system was poor and vulnerable to risk of failure across segments including aviation, dams, drinking water, energy, roads, hazardous waste and transit. The ASCE calculated that the U.S. needed to invest $4.59 trillion by 2025 to bring the infrastructure to an adequate B minus. Current spending levels at the time of the report suggested a $2 trillion shortfall by 2025.2 The percentage spending gaps across the system are depicted below:

    The funding gap across U.S. infrastructure systems based on current trends, for 2016-2025

    The funding gap across U.S. infrastructure systems based on current trends, for 2016-2025

    Source: American Society of Civil Engineers, 2017 Infrastructure Report Card:
    A Comprehensive Assessment of America’s Infrastructure,
    2017.


    Apart from maintaining systems to allow growth and curtail future costs, infrastructure is crucial to the global competitiveness of the U.S. economy. The World Economic Forum’s 2016-2017 Global Competitiveness Report found the U.S. 3rd in the overall competitiveness index, but only 27th in the world in the ”basic requirements” sub-index comprising infrastructure, institutions and health and primary education, stating that the U.S. had been falling in these departments in absolute and relative terms since 2007.3

    2. The opportunity:
    public and private tailwinds

    Infrastructure policy in the U.S. currently remains on hold, but we believe that prospects look positive, particularly with the backdrop of a robust macroeconomic environment.4 Infrastructure spending was a key pillar of the Trump administration’s electoral campaign. Both parties agree on the need for investment and appear to be targeting packages of at least $1 trillion. However, they presently differ on many of the details; a key issue being how to fund the investment. If a bipartisan approach were to be achieved and passed by the legislature, this could provide a much-needed injection and lend support to investment opportunities in the sector in 2018. The issue is also high on the global agenda. At a recent G20 meeting, delegates endorsed initiatives to promote infrastructure as an asset class as a priority of the Argentine G20 presidency.5

    The limitations of government finances mean that private capital will also likely be essential to filling the infrastructure gap, in our view. The public-private partnership (PPP) model is increasingly being used across U.S. states. For example, LaGuardia airport’s 2016 $4.5 billion development project was financed with $3.9 billion of private sector debt and equity, and could be a model replicated nationally.6

    From an investor perspective, a 2017 survey of institutional investors responsible for $7 trillion of assets found that 90.3% of asset owners intended to increase their investment in infrastructure over the next 3-5 years, an increase from 65% the previous year. Most respondents identified the U.S. as the “next big infrastructure market”.7 Across all regions, infrastructure focused ETFs have seen inflows of $448 million in the first three months of 2018, representing asset growth of 4.5% and the second highest category of thematic ETF inflows after socially responsible ETFs.8

    The key risk to the outlook is politics: Without bipartisan leadership to raise spending to necessary levels, private infrastructure investment is unlikely to bridge the U.S. infrastructure spending gap alone. We believe that success with an infrastructure package on Capitol Hill should be constructive for infrastructure equities.

    3. The toolkit:
    how to play infrastructure

    Infrastructure assets have traditionally been characterized as long-lived, with high development costs (barriers to entry) and the potential for steady income streams, often linked to inflation. Investors have historically accessed infrastructure through private debt and equity markets. The below graphic summarizes the key structures and the implications of investing using them. Investors taking on greater capital requirements, time horizons or liquidity risks would expect to be compensated with a higher rate of return. The rate of return also varies with the riskiness and life stage of the project invested in: "greenfield projects", requiring new construction, carry greater risks than those involving upgrading assets that are already established and producing predictable cash flows ("brownfield"). The increased appetite for infrastructure assets means that greater focus is now turning to listed exposures.

    Capital requirement, political and regulatory risk.

    Source: Adapted from CAIA, Alternative Investment Analyst Review, Risk, Return and Cash Flow Characteristics of Private Equity Investments in Infrastructure, 2012. For illustrative purposes only.


    Exchange traded funds (ETFs) have made it easier for investors to invest in infrastructure with relatively minimal capital outlay, greater transparency9 and liquidity; while giving up the "complexity premium"10 offered by private structures. In addition to ETFs that target the traditional segments of utilities, transportation and energy, some ETFs also allow access to the listed equity of companies that operate or participate in the infrastructure value chain. The infrastructure value chain can include companies that directly operate or manage existing infrastructure assets, or companies that supply goods or services to existing or new infrastructure operations. We believe that a significant fiscal injection into the sector would give it a pro-cyclical appeal in the medium term for infrastructure operators as well as various other companies across the value chain. Over the long run, the regular cash flows traditionally associated with established infrastructure projects give the sector a secular appeal.

    The bottom line

    A deteriorating public infrastructure system threatens the ongoing competitiveness and future economic growth of the U.S. However, the recognition across both sides of the aisle of the need for bold action provides grounds for optimism. Listed infrastructure equities provide a flexible way to seek both medium term capital appreciation as well as income streams in the long term.

    Christopher Dhanraj
    Director
    Head of iShares Investment Strategy