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This interview was recorded on March 5.
Larry Antonatos, managing director and portfolio manager, Brookfield Asset Management.
Interest rates moved dramatically lower in early 2020. In January and February, the long end of the yield curve moved lower driven by growing macroeconomic concerns. Equity markets moved dramatically lower in late February. In early March, central banks, including the U.S. and Canada, responded by cutting policy rates, driving the short end of the yield curve lower.
In falling rate risk-off environments like this, the real asset equities on which we focus, real estate and infrastructure, have historically outperformed traditional equities due to the defensive characteristics of real estate and infrastructure. Real estate cash flows are derived from contractual leases — typically five to 10 years in duration — which provides visibility to the real estate cash flows. Infrastructure cash flows are supported by attractive supply, demand and pricing fundamentals. Supply of infrastructure assets is generally constrained because many infrastructure assets are monopolies or semi monopolies. For example, the only electric utility in town or the only water utility in town.
Demand for infrastructure services is generally steady, whether the economy is good or bad, because infrastructure provides essential services which are needed whether the economy is strong or weak. For example, electricity, water, cell phone communication. And the pricing of infrastructure services is generally governed by regulation or by long-term contracts with increases in pricing frequently tied to inflation. With the visibility of real estate and infrastructure cash flows, what we see is that in times of weakness they do tend to outperform other sectors.
Now, within real estate and infrastructure, in times of weakness, sectors with less economic sensitivity tend to outperform sectors with more economic sensitivity. For example, within real estate, office buildings with 10-year leases tend to outperform hotels which have one-night leases. And within infrastructure, monopolistic utilities tend to outperform the GDP-sensitive transportation sectors such as airports, seaports and toll roads. In the most recent down markets, accompanied by falling interest rates, which was late February 2020 and also fourth quarter of 2018, real estate and infrastructure equities were down roughly 60% the amount of global equities generally, providing very good downside protection.
Much of what I’ve said so far deals with down markets that coincide with falling interest rates. If we think about interest rates generally, movement up in rates generally coincide with economic acceleration, improving growth, and movement down in interest rates tend to coincide with weaker economic environments.
The performance of any investment asset class is driven by the headwinds and tailwinds that you see in an economic environment. For real assets, which tend to have significant dividends paid out, what we see in a rising interest rate environment is improving economic fundamentals. So, the potential to grow your cash flows faster. To some extent, that is offset by the rising interest rate, which creates a headwind to valuation by increasing the discount rate. What we really look for here is if the tailwind from improving economic growth is greater than the headwind from rising discount rates, real assets can perform well in rising rate environments.
In general, what we see is modest increases of interest rates are good for real assets. Dramatic increases of interest rates, perhaps real assets will underperform broad equities, because in that kind of environment, other equities may have the potential to grow their cash flows faster. As much as I’ve talked about the defensive characteristics of real assets, the contractual rental agreements, the regulated cashflow for infrastructure, that can prove to be an impediment to growth in an accelerating economy.