ClearBridge Global Infrastructure Income Strategy Q4 2022 Portfolio Manager Commentary

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Global telecommunication network, nodes connected around earth, internet, worldwide communication — NicoElNino

By Daniel Chu, CFA | Charles Hamieh | Shane Hurst | Nick Langley

Stabilizing Energy Prices Bolster Utilities’ Defensive Strength

Market Overview

Infrastructure saw a pretty strong run into the end of 2022 with energy prices stabilizing and even declining across Europe and the rest of the globe. This took some pressure off both utilities and households and allowed the market to get a little more comfort in the utility sector, which recovered a little. We also saw economic data that was not as bad as the market expected, and more GDP-sensitive infrastructure stocks also rallied into the year end. The S&P Global Infrastructure Index returned 10.83% for the quarter, outpacing the 9.76% gain of global equities, per the MSCI All Country World Index.

On a regional basis, Western Europe was the top contributor to quarterly performance, where Spanish electric utility Iberdrola (OTCPK:IBDSF) and U.K. electric utility SSE (OTCPK:SSEZF) were the lead performers.

Iberdrola is a multinational integrated electric utility company engaged in energy networks, renewables and wholesale and retail operations. The company has expanded internationally with operations in the U.K. (via Scottish Power), the U.S. (via Avangrid, AGR), Brazil (via Neoenergia) and Mexico. The market received its strategic plan update positively, as it emphasizes protecting the balance sheet and more skew toward regulated networks than before. In addition, the appointment of a new CEO, separated from the chairman role, signified improvement in corporate governance.

SSE is a diversified energy utility headquartered in Scotland. It is vertically integrated, operating over the entire supply chain in the U.K., with generation (including hydro, wind, combined cycle gas turbine), electricity networks, and retail businesses (primarily B2B). It is the U.K.’s largest renewable energy generator. Shares were up as there was more clarity over an energy profit levy for electricity generators announced in the U.K.; SSE also announced a minority sale in its transmission network at multiples more attractive than the market expected.

Turning to North America, U.S. electric utilities Public Service Enterprise Group (PEG) and Entergy (ETR) also performed well during the quarter. Public Service Enterprise Group operates the largest utility business (~90% of earnings) in New Jersey, along with a generation business (~10% of earnings) comprising nuclear and gas turbine facilities. Entergy is a pure regulated electric utility, providing services in Arkansas, Louisiana, Texas and Mississippi. Shares of both were higher as broader utilities outperformed as rising long-term bond yields took a pause in the quarter.

Canadian electric utility Emera (OTCPK:EMRAF), meanwhile, was the largest detractor. Emera generates 95% of its earnings from its regulated operations in Florida and Nova Scotia. Shares declined after the Premier of Nova Scotia introduced legislation that places a cap on electricity rates, effectively circumventing a well-established independent regulatory framework.

Communications companies have also come under pressure from higher interest rates in 2022, which weigh on earnings in the form of higher costs. Needing to finance continued fiber rollouts in a higher interest rate environment, portfolio holding Crown Castle (CCI) continued to feel some pressure.

Rising interest rates remain the key risk to renewables utility Brookfield Renewable (BEP), an underperformer in the fourth quarter, though we view Brookfield’s stable fundamentals (with >90% of contracted cash flows having an average term of 14 years), inflation protection (~70% of power purchase agreements are indexed to inflation) and long-term growth opportunities as relatively attractive in the current environment. Brookfield’s balance sheet is also relatively well-protected against rising rates given it has 97% fixed-rate debt with an average term to maturity of 12 years.

Outlook

The outlook for interest rates and inflation continues to cause volatility in markets as investors digest expectations of a global slowdown in growth in conjunction with central bank tightening, with elevated volatility in the U.K. and Europe as a result of sustained high energy prices.

Inflation continues to sustain itself at higher levels, making it difficult for central banks to loosen policy even as the economic outlook deteriorates. Although maintaining a tightening position is common across most economies, varying economic circumstances may lead monetary policies to diverge in the extent of tightening.

As a recession continues to be part of consensus expectations, the duration and depth of the recession remains the largest risk to investors. We expect the market to be increasingly concerned with a potential earnings recession through 2023. At present, however, the market does not seem to be expecting a significant impact, so there could be a surprise to the downside in general equities.

Across infrastructure, however, we believe we are pretty well-positioned. We have moved to more defensive positioning, adding more utility weightings and reducing exposure to renewables, which are more sensitive to higher bond yields. We expect utilities to have strong earnings through 2023 as they invest in their underlying asset bases and receive solid returns from regulators. We believe we’ve seen peak inflation and quite possibly peak hawkishness from central banks moving into 2023. That should provide a tailwind, particularly for longer-dated assets. Likely through the course of the year, we will look to tilt the balance of the portfolio back toward more-GDP sensitive infrastructure stocks as the market starts to look through potential recessions across major developing markets and starts contemplating a recovery.

One area we are tracking closely is regulatory risk, such as the legislation of price caps for Emera, which affect revenue for the company. Generally, we don’t see that around the world and we’re quite careful to invest in areas where there is a separation between the legislature and regulation. But it is an area that we’re tracking very closely, in particular the impact of rising energy prices and rising capital expenditure costs on customer bills. As customer bills get too high, it puts pressure on households, and that’s an area where regulators start to take a look. In that environment we may see some capital expenditure projects pushed out for a year or two, although this actually extends the runway of growth for many of these companies and ameliorates the regulatory risk.

Portfolio Highlights

We believe an absolute return, inflation-linked benchmark is the most appropriate primary measure against which to evaluate the long-term performance of our infrastructure strategies. The approach ensures the focus of portfolio construction remains on delivering consistent absolute real returns over the long term.

On an absolute basis, the Strategy saw positive contributions from eight of nine sectors in which it was invested (out of 11 total) in the fourth quarter, with the electric, gas and water sectors leading and the communications sector the sole detractor.

On a relative basis, measured against the S&P Global Infrastructure Index, the ClearBridge Global Infrastructure Income Strategy underperformed during the fourth quarter. Overall stock selection and sector allocation detracted from relative results. Stock selection in the gas and electric sectors contributed the most, while stock selection in the renewables sector detracted. Overweights to the renewables and water sectors contributed positively, while an underweight to the airports sector and overweights to the gas and communications sectors weighed on relative results.

On an individual stock basis, the top contributors to absolute returns in the quarter were Iberdrola, SSE, APA, National Grid (NGG) and Snam (OTCPK:SNMRF). The largest detractors were Emera, Brookfield Renewable, Crown Castle, TC Energy (TRP) and Centrais Elétricas Brasileiras (Eletrobras, EBR).

During the quarter we initiated positions in U.S. electric utilities Edison International (EIX), Southern Company (SO) and Constellation Energy (CEG), Japanese rail operator West Japan Railway (OTCPK:WJRYF), U.S. gas utility Southwest Gas (SWX) and Brazilian electric utility Eletrobras. We closed positions in French toll road operator Vinci (OTCPK:VCISF), French rail operator Getlink (OTCPK:GRPTF) and Emera.