Inflation, Interest Rates & Employment - Episode 2
April 22, 2024
I speak with Giuseppe Pietrantonio, Associate Portfolio Manager in CIBC’s Multi Asset & Currency group, where he specializes in macroeconomics.
Introduction
Short video of a stock market chart arrow moving in an upward trajectory with upbeat music play in the background. Magnifying glass appears and becomes the “o” in Sherlock’s Clues. Full title comes into focus, Sherlock’s Clues – Insights on Investing & Economics with the investment philosophy below “Investing Success: Powered by Process, Fueled by Discipline, Rewarded by Patience.”
Aaron (00:01)
Welcome back to another episode of Sherlock's Clues. I am your host, Aaron Sherlock. And on today's episode, we are going to talk inflation, interest rates, and employment. I have with me today Giuseppe Pietrantonio. Did I butcher that or was that all right? Excellent. Giuseppe is an associate portfolio manager in our multi -asset and currency group. He talks all things macroeconomic. And Giuseppe, I'll hand it over to you to give a quick background on who you are and your experience and then we will dive into a few of the topics.
Giuseppe (00:33)
Thanks Aaron. So I've been with CIBC for 12 years, a number of different roles. And so right now I represent the multi -asset and currency team as a client portfolio manager. And so when we think about multi -asset and currency, at least in our view is it's very much thematic global macro view, largely embedded with the economy. You know, let's say our biggest, our flagship is our currency strategies, obviously. If you're investing in different currencies, you need to have that very strong global macro team. And so we also have a global bond, emerging market debt, and a multi -asset team that really the preface or the foundation of this team is looking at economies and trying to find the drivers of financial markets relative to economic data and our intuition.
Aaron (01:25)
All right, excellent. Thanks for a little bit more information on that. With that said, we're going to tackle some of the larger macroeconomic trends and something that's been on everyone's mind or their credit card bill is inflation. Over the past several years, we've seen it skyrocket to high single digit, low double digit, depending on how you measure it. But more recently, we saw a downside surprise in Canada. Came in at 2 .8 % in February, below expectations. While the US still remains a little bit hotter than economists are forecasting, there's lots of things which go into CPI or consumer inflation. Can you unpack a little bit of that for us and how the average person should think about it?
Giuseppe (02:08)
Yeah, I think for the average person, obviously when we think about inflation, I myself go to the grocery stores or Costco, for instance, and say, oh, those prices are higher and higher every time I come, that bill is getting higher and higher. And so I'm hoping that that bill kind of flatlines right now, trying to relate that back to this lower than expected inflation numbers. And so when we dive deeper into that inflation figure that we saw that 2 .8 that you mentioned in Canada, the component that's brought it down, has been really like good section, the good component of it. And so what we do as investors is think about, okay, well, what's the next level? Is inflation gonna, is this goods continuing, gonna come down or what part of the inflation basket is a bit more sensitive? And so I think we all understand where rates have gone, rates have gone up. Think about our mortgage, the cost to our mortgages are. You know, if we were refinancing or buying a house presently in Canada, it's more expensive than it was three years ago, more expensive than five years ago. And so there's a shelter component within the CPI that it's still sticky. That's the component within the CPI that's remained sticky. Services and shelter. And so you got to think about shelter as two components, obviously home prices, you know, mortgage rates, how much the mortgage costs individuals or Canadians, but also the rental inflation. And so if it's costing property owners more money to hold the house, to have a house and think about, you can think about all the different components and, you we think about mortgage rates, but just think about your insurance bill, right? As prices, as prices go up, well, insurers are also increasing their prices. And so what homeowners have to do is that they have to increase rents. And so you're getting this double whammy, right? You've got home prices that are coming up because of inflation other costs like insurance and you've got rental prices coming up as well. And so that's what's been the stickier part of this inflation report. So we do expect inflation to come down over, you know, medium to longer term. You know, we're not saying the next report is going to come down again, but that shelter component is really where we're focused because it's a large portion of the CPI basket.
Aaron (04:27)
And I find some components of CPI have an outsized impact on people's psychology when they're thinking. It's the daily things that you purchase. Sometimes the larger components are the things that you don't go out and buy every day like a house or a car. But one interesting detail which came out in the last inflation print was that food prices started to flatline. They stopped seeing the continuous march upward. Now obviously it's more volatile along with your energy prices, which is why sometimes they're excluded from some measures. But it is nice to see that these large purchases are starting to come down. Now, I know Canada and the U .S. are a little different. We have Canada's got a very homogenous economy versus the U .S. is a little bit different. Can you talk to how Canada and our Southern cousin differ a little bit?
Giuseppe (05:21)
Yeah, so I think in terms of we have a lot of similarities and in terms of inflation, in terms of we have the same issues in terms of it being sticky, right? That shelter component in Canada and the US is the component that's a little stickier. But obviously the US has one large benefit to them is that their currency is not pro -cyclical. What I mean by that is that...in any recession or in any period of time where there's stress in the environment, the US dollar does very well. So for instance, if we take COVID as an example or 2022 as an example, when markets did poorly, the US dollar did strong. And so that also helps an economy that imports, because if your dollar is stronger, obviously you can buy more with that dollar. And so it kind of helps the inflation figures come lower than relative to Canada. That being said, I think the biggest dynamic between or the difference between Canada and the US in terms of inflation is that housing component. And so for Canadians, the risk is that five year refinance. So on average, Canadians refinance or not refinance, but we negotiate their mortgage rates every five years. Well, in the US, they have 30 year mortgages that they lock in for 30 years. And so if you were in the US and you had a home and you're able to refinance in 2020, 2021 beginning of 2022, and you've locked in a really low rate for 30 years, well, that's not in five years, you have no issues of refinancing. Those costs are defined, they're not gonna move up. And so that's a little bit of a challenge that we see in terms of Canada where this renewal of rates may keep inflation a little bit higher over long term.
Aaron (07:09)
Okay. I think that's a, that's actually pretty good segue into the next topic of conversation around interest rates and maybe a little bit of a fun fact for some of the listeners. I'm, I'm half American. My father was born in the U S so I've got plenty of family members south of the border who have 30 year mortgages set at three, 4%. You don't need to worry about it again. It sounds like a pretty good idea to me, but I'm not the one making the rules at the bank. Uh, onto the interest rate side of things, uh, as inflation goes up, Central banks historically raise interest rates to combat that. Interest rates are used as a mechanism or a lever for them to pull when it comes to an economy which is overheating or an economy they want to stimulate. I know here in Canada, we came from near 0 % to now 5 % and all the prognosticators out there were expecting an interest rate cut by March so far this year. It seems like things have been pushed out a little bit a similar situation in the US with the Federal Reserve. Their rates have not seen this level in a decade and their economy still continues to be strong. What do central banks need to see in order to start cutting those interest rates? It seems like the first round of forecasts have been incorrect so far.
Giuseppe (08:26)
And so that's a really good, great point. And so I think the advantage to have, to be able to look at economies globally is that you get to see what different markets or different countries have done, different central banks have done to combat inflation. And so I think about the Canada and the U S one's the last time that we've got, we've had, you know, over two, three double digit inflation. We're looking back at the ninth, at the eighties, right? And so for central banks to combat it in, let's say, developed markets, um, you know, their hesitant, they want to keep rates higher. But if you look at Latin America, Latin America were the first central banks to increase rates. And so in developed markets, Canada, US, Europe, we were kind of saying, okay, well, we don't want to deteriorate the economy. Let's do this slowly. Let's increase slowly. And you can argue that the increase of rates was done too slow, you know? And so what happened is that you did it really slowly at the beginning and then you had to ramp up and so the magnitude that that shock was what was large in a very short amount of time. Whereas Latin America was saying we need to, we know, we always deal with inflation. It's nothing new in Latin America and peripheral Europe. It's nothing new. We got to raise rates right away to come to bring inflation down as quickly. And so globally, what we're seeing right now is very consistent with what we expect to see in the DM. We look at EM markets, emerging markets like Latin America where they're starting to cut rates, inflation is coming down. The goods component, like I mentioned, in Latin America, for instance, is coming down. So they're starting to cut, but it's not a broad -based cut to, hey, let's get back to levels of COVID levels. No, it's, okay, 50 basis points, 25 basis points, and make the market digest that. In the US and Canada, what happened is in the fourth quarter of 2023, you had Powell, chair of the Federal Reserve, talking about, changing his sentiment to be more dovish saying, okay, economy is doing well, inflation is coming down. Let's, you know, we're, we're, we're thinking more and more participants within the federal reserve, the committee you're talking about reducing rates. And so the market got excited. The market got excited and says, okay, well six, there's going to be six rate cuts in 2024. And I think the market got ahead of ourselves. And I think like, you know, obviously some of the Intel on our side, we're kind of calling for three rate cuts and so what you saw in the first quarter of 2024 is a repricing. And so those six rate cuts are now closer to three, can argue two, two to three rate cuts. And so what drives that change in sentiment for investors is really the inflation data that's coming out. Also the comments made by Federal Reserve Committee Chairs. And so what do we need? That was one of your questions, right Aaron? What do we need? We need inflation to get closer to 2% and so when they're looking at inflation dynamics, like we talked about, goods are coming down. That's great. But once again, that shelter component, the services component are still high. Labor is still very, very tight. When you think about unemployment, it's still historically low. So to get that portion of inflation to come down is still very challenging for central banks.
Aaron (11:36)
Central banks do not have an envious job. Their tools are very blunt. It is interest rates. They need to wait for them to filter through the economy. You generally do not want to see a lagged effect which has an outsized impact on something like employment. I am sure you keep track of all the data discussing the number of housing starts that are happening. It seems like they are coming on at quite a pace. Everyone moved in at once. They still need to see what that looks like central banks' objective is to keep stable inflation and full employment. Right now, you're seeing inflation come down. Employment is at record highs. In the next topic, we can discuss some of the labour issues that are arising both in Canada and the US. Maybe we'll hop into that here right now. Watching Canada's employment market and the employment data come out is like watching a ping pong match. It seems like it bounces from one side to the other massive underperformance, massive overperformance or one month it's entirely government employees or part time or full time. Trying to unpack some of the trends in Canada is a must be an aggravating task at best. What are you seeing in the inflation market or sorry, the employment market in Canada and where do you think it can go? Cause there's certainly not many more people to put to work.
Giuseppe (12:59)
Yeah, so that's a really good point and I'll try to unpack of that, unpackage that. So there's a lot of cyclicality or seasonality as well to some of this data that we get. And so we tried to smooth that data out and stats can do some of that as well. We've got some sources who kind of also provide this eliminating seasonality. And so when you think about employment, you're absolutely right. It's been very strong. Unemployment levels are really low, employment levels are high and you brought in, Canada in general has brought in 1 .6 million, and that's an arguable number, but immigrants. But you're looking at the workforce. So we use hard data, obviously, but also some data that we use surveys and what not. And it seems that the labor market is still tight in Canada. Business owners are still looking for employees. And so we've...for us to kind of relate that to markets or to inflation, if that's still happening at these days, well, people within the labor market have the power to negotiate salaries. So salaries can push up, which is gonna, once again, impact inflation. I think that's what we saw in the past few years when another factor of why inflation was stickier last year was the labor market. And so I think now we're getting to a closer part where, you know what, there might be, I'm not saying in the next three months, but maybe towards the end of the year, where we'll say, okay, now all jobs are full or most of the jobs that are full and just still peripheral jobs that are all be available. But maybe the market can not necessarily soften, but be less tight than what it is right now. And so that's definitely very difficult to impact on a quarter to quarter basis, but something that we're definitely tracking.
Aaron (14:50)
I find it interesting to watch the wage growth because I guess a couple of the old adages around inflation is cost push or demand pull. It seemed like early COVID we had demand really pulling inflation up. Then cost push started moving it upwards with wage growth. Wage growth was pointed to top out at 6 -7%. Now it's down to the 4 % range.
Giuseppe (15:10)
That's correct.
And so once again, that's still high. All right? So.
Aaron (15:20)
Historically what is wage growth generally trended like over a you know a rolling 24 month period
Giuseppe (15:27)
Probably around 2%, probably around that 2 % number. So...
Aaron (15:31)
Okay, so just in line with inflation, it's not wildly above or wildly below inflation as it generally makes sense to think about it like that. Now, Canada's job market seems very strong. The US, I just traveled down there last week. It is crazy. Help wanted signs everywhere. Couldn't go inside a McDonald's because the dining room was closed and it was only drive through. Are there any different expectations for the US versus Canada? Because it does seem like their inflation is a little bit more persistent and maybe that's driven by their economy not having the same level of cyclicality to it. Maybe add a little bit more light to that.
Giuseppe (16:14)
Yeah, so I think in the US, there's one dynamic, one key dynamic that's different, it's immigration policy in the US. In Canada, the number of immigrants that we've been able to bring over is roughly the same that the US has, and we're, you know, there are 10 times the population we are. And so to fill these jobs, how are we going to fill these jobs? And so the way that we're thinking about this is a little bit more political. And we've got a big election this year in the US. and to say, okay, well, what are the dynamics or some of the dynamics with, you know, either a Biden continuity or, you know, a Trump back in power. And so that's, that's a big, a big determinant on labor and labor concerns, right? So if you do have a Trump presidency, the likelihood of having more immigration to kind of fill these jobs is less likely. We think about on -shoring, something that's very, very, very close to our minds right now, our friend -shoring. So, you know, the US wants to be less dependent on China. And so the Vietnam's the world, Thailand the world, India the world, Mexico's are the ones that have benefited or seek to continue to benefit it, and potentially the US too. And so, but with that adds higher inflation costs potentially, because, you know, China is the market leader in terms of cost, right? But it also has, you also have potential issues with the labor market, continue issues on the labor market. Like you said, you know, the US just like in Canada, we're still looking for employees or, you know, workers. And so if you're trying to onshore, friends shore, let's say onshore for the US, you still need these workers and you need capital and you need workers. And that's the US is a bit of a tough situation regarding those two, those two components.
Aaron (18:09)
Okay, thanks for that. And I guess we'll wrap it up with the usual question I ask. And that's the outlook. It's the million dollar question, the hardest one to answer. Most of these three topics, inflation, interest rate, and employment are intertwined. Do we have a bit of an outlook on them for the next, we'll call it medium term?
Giuseppe (18:35)
Yeah, you know, I know we talked a lot about like factors why inflation is stickier. Don't get me wrong, being sticky doesn't mean that inflation is, you know, continuing to come higher. We're expecting a slow ground, a slow grind, where inflation is going to come down slowly. It's going to eventually get to close to its 2%, maybe 2.3%. Maybe it won't get all the way down, but it's going to get to a level where central banks are going to be more comfortable to start cutting rates. Like I said, you see it in Latam, peripheral Europe. The euro the the European Union is talking about cutting rates to Canada might be a place that will begin you know shortly in can argue the next three months to cut at least point 25 percent or 25 basis points and so looking ahead we do expect a slow move down in yields and Positive growth and so you've you've had this you know that we think about Asia and China and then the US you know China US the biggest the biggest drivers of the economy or GDP, growth in the US is continuing to be strong. Retail sales are strong. Many metrics that we're looking at continues to be strong. China is having a tough time stimulating, absolutely. But doesn't mean that that'll continue. We still think that there's still strong growth from China, Asia, India, for instance, very strong growth in India. And so we might not see this double digit growth that we've seen historically in Asia that's kind of helped the rest of the world but we do expect, you know, slowly, slowly that growth, global growth is going to continue to improve. Rates are going to come down. So when we relate that to financial markets, what's that, that's benefit, that benefits obviously the bond market, but also benefits any risk assets. So any equity markets as well. And so that's, you know, obviously we have probabilistic scenarios and so that's one of our scenarios. So stickier inflation, but still trending downwards and some growth kind of a little bit of a resurgence for growth. Are there risks? Absolutely, there's risks. We can't not mention the risks, there are risks. But right now with the data that we're getting, let's say, you know, cautiously optimistic.
Aaron (20:42)
It's a breath of fresh air to look at the markets and think that good news is good for the markets. Over the past couple of years, markets were rallying on job losses because that meant interest rates were going to go down. I prefer markets to be correlated with strong employment, strong economic growth, and it seems like that's a bit of the picture you're painting.
Aaron (21:06)
Well, I think we'll wrap it up there today Giuseppe. Giuseppe is going to be a regular on the webcast. Next time maybe we'll dive into the emerging markets segment as well as fixed income and how to place that in your portfolios. If anyone watching this webcast has any questions, you can email me directly at aaron.sherlock@cibc.ca or Google the Sherlock Group to get in contact with me. Thank you very much. Have a good day.
Outro (21:42)
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Understanding Global Infrastructure and Its Characteristics - Episode 1
April 11, 2024
I speak with guest Andrew Maple-Brown, co-founder and managing director of Maple Brown Abbott, where we discuss globally listed infrastructure.
Introduction
Short video of a stock market chart arrow moving in an upward trajectory with upbeat music play in the background. Magnifying glass appears and becomes the “o” in Sherlock’s Clues. Full title comes into focus, Sherlock’s Clues – Insights on Investing & Economics with the investment philosophy below “Investing Success: Powered by Process, Fueled by Discipline, Rewarded by Patience.”
Aaron (00:11)
Thanks for joining me today, Andrew. I know we've had a little bit of an issue lining up our schedules. We're just a couple of time zones apart. For the listeners here, Andrew's based in Australia. While I'm in Australia's much colder cousin, Canada, we've just now cracked zero degrees. So woohoo, spring's coming on the way. A little background on Andrew. He is co-founder and managing director of Maple Brown Abbott.
global listed infrastructure. He's got over 20 years of experience financing and investing in the infrastructure space. I'm personally very excited to discuss Infrastructure today with Andrew as full disclosure, it's a core holding of almost all of my clients' portfolios and I don't think it's as understood as well as it should be. And hopefully Andrew can unpack some of the questions that I have and provide some expert insight to the space.
I guess with that, Andrew, I'll lead into the first question. I usually try to just define things out of the gate so people have a broader idea of what we're discussing. And that's what makes up infrastructure. Here in Canada, we've got pretty limited infrastructure. You think power lines, pipelines, and utilities. That's about it, but it is a much broader category to provide a little bit of context around that and the broader definition of infrastructure itself.
Andrew Maple-Brown (01:25)
Thank you.
Yeah, absolutely and thank you Aaron for having me here today. In terms of instructor, instructor assets generally have certain key characteristics. So specifically, they're assets which provide central services, so assets used by a large number of people on a regular basis. Secondly, they're assets with a very strong strategic position. So we like monopoly assets, we like
Thirdly, their assets are very predictable and stable cash flows. So our methodology, we're forecasting those cash flows over a number of years to come up with our valuation. So it's critical that they have that stability and predictability in cash flows. So in terms of the types of assets that we're investing in, globally, we view about 110 companies on the listed stock exchanges as well fitting those definitions. Typically, about half of those companies are regulated utilities, so regulated water gas and electric utilities. About a quarter of the companies are transportation concessions, so toll roads and airports predominantly, also some railway tracks. And the final quarter are assets subject to long-term contracts. So these include telecommunication towers, renewable assets and pipelines as you've just mentioned. So relative to the Canadian listed market, as you said, there's a number of pipeline companies and several regulated utilities.
On a global basis, there's a lot more regulated utilities and different types of regulated utilities, so water utilities, as well as gas and electric utilities. There's a number of transportation concessions that you can't access through the listed market, such as toll roads and airports. And there's also contracted assets like telecommunication towers and their renewable assets, in addition to the pipeline companies that you see in Canada.
Aaron (03:12)
Excellent. Thank you for that. With that being said, the world's becoming smaller. You're starting to see more investment abroad. I'll pick on a few of our large institutional money managers and pension funds, which are certainly moving more into the infrastructure space over the last 5, 10, and 15 years. What do you see the reasons for that being? And maybe I'll just cue up a couple areas diversification, hedge against inflation, and reducing volatility. Let's touch on a few of those areas.
Andrew Maple-Brown (03:40)
Yeah, absolutely. I think you've very well hit the key reasons for investing in infrastructure and you're spot on. There has been a significant move, particularly in the private markets, towards focused investing in infrastructure. We think that there are very attractive opportunities in the listed markets and we can talk about the differences between those markets. But ultimately they have the same investment characteristics. They're the same underlying companies which exhibit those same characteristics, subject to the same regulation and contracts and so forth. So the reasons for holding them within the portfolio are the same. And essentially, what we see is those key attractions include that defensive nature of the investments, so the lower cash flow volatility, the natural inflation linkage that a lot of these assets have, the higher income yield, certainly relative to global equities and also the diversification benefits that the assets can provide to a portfolio.
Aaron (04:40)
The diversification benefits certainly were on full display in 2022 when you saw, we won't give out exact numbers, but you were significantly positive while the rest of the market was down drastically as it's not a correlated asset class to the public markets generally. I guess with that, I'd like to lead into what the Maple Brown Abbott process is, what makes you special? How are you different than the market?
Andrew Maple-Brown (05:06)
Yeah, absolutely. And thank you for mentioning 2022. I think that both 2022 and 2023, to be fair, will exhibit some of those differences between holding an infrastructure portfolio. 2022 was a very tough, tough year for global equities, as you've alluded to. And part of that was because inflation was really picking up and the outlook for the economy was weakening. So the infrastructure companies, both are less economically sensitive so less driven by those cyclical factors and also have that natural inflation protection. So it did hold up better in 2022 and I was very pleased to see that significant outperformance. To be fair, I should also say that 2023 was somewhat the reverse. The global markets were extremely strong, the economy turned out to be not as weak as people were fearing. So those other parts of the market, which are more economically sensitive, benefited far more from that stronger economic outlook than infrastructure companies did. So 2023 is very strong for global equities and the infrastructure sector, therefore for lag. So yeah, to your diversification point, absolutely, the asset class does behave quite differently and is far more defensive in most circumstances than broader equities. That's also a good segue into the question you then asked in terms of what we see as our differences. And one of the key differences that we really focus on is we think as to why do investors, why is it logical for investors to hold infrastructure within a portfolio? From our perspective, it's because of those differentiated investment characteristics that make it deserving of a strategic asset allocation. So it only deserves its own allocation if it does have differentiated investment characteristics. And what are those important characteristics?
To us, it's the low cash flow volatility, so the defensive nature of the asset class. And secondly, the inflation leakage. So our definition of infrastructure only includes the companies with the strongest combinations of those two characteristics. So we're really focusing only on core infrastructure assets. So we use a tight definition of infrastructure and we continue to focus on those characteristics throughout our investment process. And that's why there's only about 110 companies globally using our definition, which will exhibit those characteristics. I'm so that'd be the key difference I'd say to some other infrastructure managers who define infrastructure more broadly. I suppose a couple of secondary differences. Firstly, since our inception, we've set a capacity limit, which we calculate in a consistent manner since our inception 11 years ago, we continue to believe capacity is very important. So to ensure that managers don't become too large, particularly with an approach like ours, who are a high conviction manager, we're building portfolios of our best 25 to 35 ideas. So it's critical that we're able to select those companies, not just from the large cap companies, but also from the mid cap companies and to a certain extent the small cap companies. So if you get too large, you lose your ability to be nimble particularly around those smaller companies. And the other difference I'd highlight is the alignment of the investment team. So our investment team are owned over half of our business. So we're majority owned by the investment team. We've also each significantly invested our personal funds alongside our investors. And the whole team is dedicated to the single list of instructor strategy.
Aaron (08:45)
Okay, thank you very much. That's a lot to unpack there. And you know, you didn't give away all the secret sauce as to what makes you special. I did want to go back and comment on the 2023 lagging, the equity markets. The global infrastructure seems like it's more of a safe haven. It's a place when things get a little bit more volatile. Like you said, you have stable cashflow streams, and you know what you're getting versus something which is more economically sensitive. I'd like to lead that into the next question around what sectors or thematics you're seeing that could provide tailwinds for the infrastructure space. Over the next number of years, we won't go long term because that's an impossible task to try to predict. Do you see any sectors where you have higher conviction than others? What would be the reason behind that?
Andrew Maple-Brown (09:34)
Yeah, absolutely. Firstly, all the sectors we invest in, we think will exhibit the characteristics that we're seeking. So we're always, we'd be pleased to invest in any of those sectors. But the relative opportunity obviously changes through time, depending on the specific growth opportunities for each individual sector at a point in time, and also critically the valuations. A couple of sectors that I'd highlight at the moment.
Firstly would be the regulated electric utilities. We're very excited by the importance of the electric utilities. For a couple of things going forward, firstly there's a big need to decarbonize the electric grids globally. That will involve a lot of investment in renewables but equally will involve a lot of investment into the networks. So into the transmission network and into the distribution network.
Secondly, we're big believers in electrification. We think more and more of the energy globally will switch to electricity. And for the same reasons, that will also require huge investments again into generation and particularly renewables, but equally so into the networks, so into the transmission grid and into the distribution grid. And so just to focus on transmission for a moment, why is that so important? Generation typically has come from single sites, large coal or gas or nuclear facilities into the demand centers and that generation has been available for a hundred percent of the time. One of the key issues with renewables, well firstly that they aren't necessarily located at the same locations where those large historical generation sites have been, so you need new transmission in order to link in those new renewable sites. But secondly, renewables are intermittent. And so how do we solve that intermittency? There's multiple ways, obviously different types of generation helps. But one of the critical pieces is having a broader network. So more transmission enables us to ensure that if the wind's not blowing at one location, then hopefully the sun will be shining in a different state or whatever. So transmission will be critical, both in terms of linking in that as new sources of generation, also firming up the grid, providing a reliable network of electricity. So we think there's very large investment needs in the transmission network and also the distribution network, which is becoming a lot more complex as renewables, as the intermittent nature of the grid and also as we've got residential generation at sites and batteries going into houses. That also increases the complexity of the grid. It's a very large investment needed by the regulators. The regulators need to ensure that the returns are sufficiently attractive to incentivize that regulation. And importantly, two valuations in a number of markets for these utilities we think are looking quite attractive now for a couple of years of underperformance.
Aaron (12:46)
I was just going to say that we're getting just north of four or five hours of sunlight in my part of the world here now. So solar panels might not be the most efficient, but I certainly see wind farms going up on a regular basis.
Andrew Maple-Brown (12:58)
Yeah, it's a really good point actually. It's, you know, we can, you know, you can talk what you like about renewables, but in cold locations like where you sit, the challenge of electrification is much greater. How do you produce and store the volume of energy that you would need through winter to be fully electric? That is still a question to be solved for. But electrification is far easier in more moderate climates like where I sit in Sydney. The need to have gas to residential houses is much more questionable at this point in time. And maybe in the future will be few as well, but for some time, I expect that cold climates will need gas networks, at least as a battery for those very, very cold, cold periods in order to provide the volume of energy required. But yeah so still to be worked on in your neck of the woods.
Aaron (13:52)
Moving in the right direction and trying to take care of the environment while returning value to shareholders, I guess, is a it's a scale that's more easily said than done. I would like to point to one topic which more of the institutional money gets to chase and that's the private infrastructure side of things versus the publicly traded side. Can you speak to the public versus private infrastructure and maybe touch on the valuation difference between the two areas?
Andrew Maple-Brown (14:22)
Yeah, absolutely. You'll have to cut me short on this topic because I could talk for a long time. But in terms of, I suppose, firstly, to summarize, at the end of the day, as I said earlier, they're the same assets. If you own an airport in Vancouver and an airport in Toronto, that's a bad example because they're both government owned. But if you own one private asset versus one listed asset, they're the same assets. They're subject to the same regulation or laws or passenger flows and so forth. We've looked globally and there's no proof that operationally either listed markets or private markets are better. In some cases, the listed markets are better operators. In some cases, the private markets are better operators. There are actually currently more assets and a greater value of the infrastructure assets sitting in the listed markets than there are in the private markets. So the biggest and I'd argue the best infrastructure assets tend to still be in the listed markets.
So the airport example, the largest 10 airports are all either in listed markets or government owned. So some of the largest airports in the world, like Beijing Airport, Frankfurt Airport, Charles de Gaulle Airport in Paris, Heathrow Airport are all in access through the listed markets. So in terms of quality of assets, we think they're very similar. Notwithstanding that, most of the money recently has been flowing more into private market assets and what that has in private market instructor assets. And so what that has resulted in is valuations in the private markets, we believe are significantly higher than the equivalent assets in the listed markets. Based on our calculations over the last 3 years, looking at comparable assets, when assets are traded in the private markets, they've traded about a 35% percent premium to where the equivalent asset trades in the listed market. And from our perspective, that doesn't make sense. Typically, you'd expect an illiquidity premium in the return for investing in private assets. To us, it doesn't make sense to be buying assets at such a significantly higher price and then still expecting an illiquidity premium. In terms of why this is happening, it's really just a flow of money lot of people are trying to acquire assets or invest privately. For some, it's a good reason for the sovereign wealth funds and so forth. They take control of assets and I understand that the control premium argument, but for most investors, there's no control being taken. The far more common reason that we see is investors like the fact that private assets don't get marked to market, they get marked to a model and they get marked less frequently.
So they perceive there's a lower volatility. At the end of the day, we'd argue it's only a perception because they're the same assets and the private markets are actually using higher leverage. So then the private markets have higher volatility, we would argue. But yeah, a real conundrum from our perspective, assets trading, same assets trading at significantly higher values in one markets than the other. And from a listed perspective, we see that as an opportunity though. It's an opportunity for two reasons.
Firstly, there's a huge investment need for the listed infrastructure companies. So that's widening their roads or upgrading their water networks and so forth. And this investment earns attractive returns, but it needs to be funded somehow. Typically, it'd be funded through issuing debt, issuing equity. We encourage that listed companies, instead of issuing equity, it is more accretive to sell non-core assets to the private markets or sell stakes in your core assets. That will make that investment more accretive because you're getting a higher valuation for those assets. And pleasingly, we're seeing a number of listed companies doing that. And it's good for the private markets too, to get further assets going to their markets. The listed infrastructure market will continue to expand because there is so much investment being needed by these listed companies, but they'll be able to fund that expansion through a more efficient lens.
And secondly, hopefully, you know, those high valuations also provides a bit of a floor under listed market valuations. If the listed market valuations ever widen too far, then we do see private players coming in and trying to do M&A, trying to take out bid for those publicly listed instructor companies. So, yeah, wide valuation gap, which we view as a positive for the listed markets.
Aaron (18:56)
Maybe we'll take this conversation offline afterwards, because I've got a bit of a bone to pick with the private equity valuations and the market to market side of things doesn't make sense to me, but we will save that for another conversation. Last topic to discuss and arguably the most difficult and the one which usually puts people's feet to the flames is the outlook. I know you touched on it briefly with the thought around electrification, decarbonization,
Aaron (19:23)
A couple other areas which I think are interesting as well is the age of our current infrastructure. I know at least in North America, it's terrible. We're starting to see brownouts and power outages in areas which you never saw them before. And then you can't talk infrastructure or long duration assets without looking at interest rates, inflation, and then a broad macro outlook.
I'm sure we could put this all into a small university course, but I'll give you a couple of minutes to touch on that.
Andrew Maple-Brown (19:51)
Yeah, excellent. You are spot on. I won't quote you the statistics in terms of age of assets and need of investment, but it is massive. What's most relevant for our opportunity set, and I touched on this previously, but the 110 companies that we look at currently have a market capitalization of about two and a half trillion dollars. So that's a big opportunity set.
Those companies each year are spending nearly $300 billion, so more than 10% of their market cap on just organic capital expenditure. So that's just the investment needed on the existing infrastructure assets. And that's the best investment that they can be doing because only those companies can do that investment. So the returns that they receive are either regulated, and again, the regulator needs to set them sufficiently attractive in order to incentivize them to do that work, or they're negotiated in a bilateral basis. So there's no competition around those returns. So $300 billion a year, just in terms of upgrading those existing assets. So it's a massive investment opportunity, which is going to drive the continued growth as well as the growth in the existing assets, the increasing users on your toll roads or passengers. It's also driven by that further investment which is a big opportunity for our listed market. And that's why we don't care that if assets get auctioned, it is more logical that the winning purchasers will be private structure players because they're willing to pay a higher price. There's a huge amount of investment which the listed companies will be doing regardless of any other incremental opportunities.
So that's one of the most exciting aspects from our perspective is that need for further infrastructure investment and the critical role of these listed structure companies will be playing in providing that investment. In terms of your macro question, I'll try to keep it brief because it is a broad topic. But in terms of the outlook, as I've touched on, infrastructure assets do not have the same economic sensitivity as the broader market investing in assets which are less sensitive to economic cycles. Secondly, infrastructure assets, and particularly our strategy, are intentionally investing in assets which have inflation linkage. So our sector will perform better relative to global equities when economic growth is weaker and or when inflation is stronger. So where do we sit today there has been expectations for some time that the economy will slow and the economy has remained surprisingly robust. It has defied those expectations, but we still think looking forward that the risk is that the economy will slow, that there will be a slowdown. And in that environment, certainly we believe infrastructure assets are better protected because they don't have that economic sensitivity.
Similarly, inflation has come from extremely high levels a couple of years ago. It has come back towards targets. But again, we think that the risk of anything is that the inflation remains sticky. So from both those perspectives, we think infrastructure is well positioned and critically on from a valuation perspective, it's surprisingly cheap relative to global equities. Relative to global equities, it's some of the lowest relative valuations we've seen certainly for a number of years. So overall we're positive on the outlook for the sector.
Aaron (23:26)
One thing I do like to add is infrastructure generally returns capital in the form of dividends as well as share price appreciation. So when I look at dividends, I generally like to think you're getting compensated for being patient if the share price is not moving up and to the right and reinvesting those dividends as well in a portfolio like yourself helps generate long-term returns.
Andrew Maple-Brown (23:50)
Yeah, absolutely. Typically, at the moment, the dividends of the underlying companies with our portfolio is around 4%. And so, yeah, a strong dividend yield relative to broader equity markets. The growth in earnings of our companies is typically around 5% or 6%. So you've got that combination of income yield plus growth, we think is an attractive proposition in what is generally a lower risk sector and particularly with our definition of infrastructure.
Aaron (24:23)
All right, perfect. I think we've covered just what every topic I needed to. I'm sure we could keep this going for another hour at least, but it's what, 8.30 in the morning now. You probably need to get some work done for the day. To all the listeners, I'd like to thank Andrew for joining me If you have any questions, please send me an email at aaron.sherlock @ cibc.ca or you can Google the Sherlock Group at CIBC Private Wealth and I can give you more information on how to position infrastructure within your portfolio.
Outro (24:55)
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