It was six months ago that team Infradebt was just settling into working from home and putting the finishing touches on our March quarter newsletter. An article in that newsletter gave our take on how we expected Covid-19 to impact Australian infrastructure assets. Six months on, some things have changed – we are back working from the office for one. It is interesting to look back at our predictions and see how we did.
At the time, we saw Covid-19 impacting infrastructure projects as two overlapping shocks:
· A revenue/volume shock – as COVID19 shutdowns (and the associated economic downturn) hit volumes/revenues. The most classic example of this would be the hit to passenger volumes from the virtual shutdown of the airline industry.
· A credit shock as lending conditions for all assets (not just infrastructure) tighten resulting in higher credit margins and lower leverage levels.
Within this framework we ranked PPPs, regulated utilities and highly contracted energy assets at the low risk end of the spectrum and placed patronage and merchant energy assets at the high risk end.
By and large, this framework has worked. The key points we would make are:
· The hit to volumes/revenues for patronage assets – particularly airports – has been larger and longer than we would have expected. The extended imposition of state border controls isn’t something we contemplated. These have had a massive impact on domestic passenger travel (both business and leisure). This has resulted in a much more substantial hit to passenger numbers for airports than we would have predicted. In our view, some of this is likely to be permanent, as meetings that previously were undertaken face to face are replaced with video conferences. Once borders re-open, face to face business meetings will resume. However, I think there will be a permanently higher bar for a meeting to justify the time and cost of an interstate trip, and this means that business travel won’t return to previously levels quickly. Clearly the extent and speed of a return for international travel will depend on medical technology (ie testing, vaccines and treatments).
· The credit shock has been smaller and shorter than we expected. In March and April, credit markets (and financial markets in general) were quite disorderly with credit spreads blowing out (see charts under markets update above). However, there has been a tremendous policy response to Covid-19. This response covers:
o policy interest rates - cut to near zero, with yield curve control in Australia and a restart of QE offshore;
o intervention in credit/funding markets – for example, the RBA facility to support banks providing SME loans, or in the US the Fed’s purchase of investment grade bonds and ETFs; and
o fiscal policy – programs to support employment and spending (ie Jobkeeper) as well as the broader efforts to prevent a wave of insolvencies (for example, encouraging mortgage payment holidays and eviction moratoriums).
· These efforts have mitigated the credit shock and prevented – despite the largest recession since records began – a spike of insolvencies (which usually is associated with a spike in credit margins/credit rationing). In fact, in the 13 fortnights to 6 September there were 8,262 bankruptcies 20% lower than in the prior 13 fortnight period. Time will tell whether this outcome is a spectacular example of timely government intervention or a King Canute style exercise in delay. However, at the moment, credit spreads have recovered, and while somewhat higher than pre-Covid, are not at painful levels. In particular, given the fall in base rates, most borrowers would face lower all-in interest rates compared to pre-Covid.
Risk Free Rates
In past recessions/financial crises, falling long-term interest rates have provided a substantial cushion to infrastructure asset valuations. Where the crisis has hit revenues, volumes and credit costs, these impacts have been mitigated by falling long-term interest rates boosting the value of the long-term cash flows inherent in infrastructure assets. For example, in the GFC 10 year bond rates fell by around 300 basis points compared to pre-crisis levels.
Our March quarter article didn’t dwell on this issue, but given the low level of interest rates, and in the absence of negative interest rates in Australia (which I wouldn’t rule out – but I think the RBA are trying to avoid), it reduces the capacity for base rates to act as a shock absorber for infrastructure valuations in the current crisis. Base rates have fallen by around 40 basis points compared to pre-crisis levels (1.3% to 0.9%). This will help – but is small compared to previous episodes.
Most infrastructure assets are positively exposed to inflation (for a detailed discussion see the article discussing this topic in our June 2020 newsletter). That is, revenues are indexed to inflation and higher rates of inflation lead to higher cash flows.
The short-term impact of Covid-19 has been sharply deflationary, with the June quarter CPI falling 1.9% quarter on quarter (or minus 0.3% on rolling 12 month basis). This is the largest quarterly fall in the CPI in the 72 years of the series.
However, it is important to recognise that the government decision to make childcare free during the pandemic had a substantial impact on the CPI. This effect, combined with the fall in petrol prices, is the main reason CPI was negative. The impact of the childcare decision will largely net out over the quarters ahead – given the government has already unwound this decision.
Taking a longer-term view, market breakeven inflation expectations – using the 2040 CPI bond as a proxy - collapsed from around 1.5% pre-Covid by more than a percentage point to around 0.4% at the peak of the crisis. However, they have basically fully recovered since.
It is interesting to note that the market is still pricing in a difference between near-term versus long-term inflation, with the five year breakeven inflation rate only 0.9% (and still significantly below pre-Covid levels). This is consistent with the current output gap/unemployment position providing a substantial deflationary headwind for the next few years. Infrastructure investors should be prepared for near-term revenue disappointments – particularly given that most financial models we see assume inflation runs consistently at 2.5%.