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Larry Antonatos, managing director and portfolio manager, Brookfield Asset Management.
With inflation having run “higher for longer,” global central banks, including the U.S. and Canada, have begun a tightening cycle, reducing monetary stimulus by raising benchmark interest rates and also tapering asset purchases. This will slow inflation, but will also slow economic growth. And the risk is that economic growth will slow too much resulting in a recession. In response to this recession risk, the global equity market has moved lower in early ’22 and many investors are thinking about recession proofing their portfolios. Real assets, both infrastructure and real estate, offer attractive defensive characteristics that can contribute to this recession proofing. Relative to many other businesses, many infrastructure businesses and real estate businesses offer more predictable revenues and predictable cash flows. For infrastructure, predictable revenues are due to long-term contracted or regulated pricing. For real estate, these predictable revenues are due to long term leases. Broadly speaking, infrastructure is even more defensive than real estate because real estate and infrastructure have different business models.
Real estate is generally a free market business, driven by the traditional interplay of supply demand and pricing. Supply growth is cyclical and it’s driven by the optimism of property developers. Demand for real estate space is also cyclical, driven by economic activity. It goes up in a growth environment and demand goes down in a recession. Pricing or the real estate rental rate can be volatile because it is determined by negotiations, free market negotiations, between landlords and tenants. And this is impacted by the levels of supply and the strength of demand at the time of the negotiation.
Infrastructure, in contrast to real estate, is generally a regulated business where governmental involvement can play a role in the drivers of supply, demand, and pricing. For infrastructure, supply growth can be limited by government regulation, a first mover advantage, or the required functional location of an infrastructure asset. Accordingly, many infrastructure assets benefit from limited competition. Demand for infrastructure services is generally very steady because infrastructure provides essential services that generally have limited sensitivity to economic activity. And pricing for infrastructure services is generally predictable because it is as frequently regulated or contracted with price escalations that are tied to inflation.
Now in an environment characterized by modestly slowing economic growth, both real estate and infrastructure should deliver moderate returns and both should outperform traditional cyclical businesses. This is due to the defensive benefit of predictable revenues and cash flows from both real estate and infrastructure.
In a true recessionary environment characterized by negative economic growth, infrastructure with less sensitivity to economic growth should outperform real estate and also outperform traditional cyclical businesses. Going just a bit deeper, I want to highlight that within both real estate and infrastructure, there are sub sectors and property types with a range of sensitivities to economic growth. This creates more granular investment opportunities. Within real estate, growth sensitivity is higher for property types with shorter lease durations. Such as hotels, which have nightly leases or self storage with monthly leases or residential with annual leases. So these are sectors you may want to avoid in a recession. Growth sensitivity is lower for property types with longer lease duration, such as industrial and office. And these are sectors that you may want to emphasize in a recession.
Shifting to infrastructure, the one area of infrastructure where growth sensitivity is higher is the transport sectors. That is airports, seaports, and toll roads. And this is because of volume sensitivity. There are more passengers, more volumes of goods, moving through the airports, seaports, and toll roads in a growing economic environment and less in a shrinking economic environment. Other than those transport sectors, the other sectors of the infrastructure space, utilities and communications generally have steady demand and are good places to be in a recessionary environment. So accordingly within both real estate and infrastructure, there are property types and sub sectors that are attractive in any market environment. Cyclical growth environments, as well as recessionary environments.
Now regarding our economic outlook for a recession, over the next year, I want to give you three levels of probability. First, there is a high probability of slowing growth, but no recession. In that environment, slowing growth, no recession, infrastructure and real estate should both perform well and both perform well relative to traditional businesses.
Second, we think there is a moderate probability of a short, but shallow, recession. Again, infrastructure and real estate should both perform well and well relative to traditional asset classes. Third and finally, we think there is a low probability of a deep and prolonged recession. This would be essentially a policy error by central banks prompting a recession. In that environment we think infrastructure should continue to perform well, but real estate may be impacted by that long, deep recession. In particular cash flows that are predictable while leases are in place are great to have. But when those leases expire, if there is no tenant to renew or a tenant to replace an expiring lease, cash flows can fall off.
So in that order, we think the highest probability is slow growth with no recession. And we feel good about the performance of both real estate and infrastructure in that environment.