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By Charles Hamieh | Shane Hurst | Nick Langley | Simon Ong
U.S. Utilities Get Legislative Boost
Market Overview
The third quarter was dominated by central banks’ efforts to fight inflation through tightening monetary policy. As the Fed and other central banks continued to raise rates, bond yields rose across the globe. In addition to challenges from high inflation, high gas prices due to falling Russian gas supply caused all types of restrictions to be imposed in Europe, while a new U.K. prime minister introduced a number of unfunded tax cuts, causing bond yields to rise and the pound to fall. Drought is also coming to be a larger issue in Europe. China, meanwhile, continues to be pressured by COVID-19-related lockdowns.
Nearer-term macroeconomic concerns tended to outweigh one major development for infrastructure and global decarbonization during the quarter: the U.S. Inflation Reduction Act was announced in August and should be a major tailwind to our contracted renewables and utilities globally. We believe this is going to be industry transformative. One thing it accomplishes: from an economic perspective there is no reason to build anything other than renewables from now on. Much of this is due to tax credits. Production tax credits ((PTCs)) for solar/wind are available until 2032 or until a 75% reduction in greenhouse gases is achieved (based off 2022 numbers). Either way, this is expected to be a tailwind for investment for well over a decade.
Portfolio Performance
U.S. electric utilities dominated top contributors in the quarter, with Constellation Energy (CEG), PG&E (PCG) and NextEra Energy (NEE) at the top of the list.
Constellation Energy is primarily a nuclear generation company and is the largest producer of carbon-free electricity in the U.S. Shares are performing well as the market is beginning to understand the potential for consolidation in the nuclear sector, where there is also potential upside from hydrogen.
PG&E is a regulated utility operating in central and northern California that serves 5.3 million electricity customers and 4.4 million gas customers in 47 of the state’s 58 counties. PG&E outperformed over the quarter after two pieces of California legislation passed that were seen as constructive and supportive of the company’s investment plans. There was a further positive announcement at the end of the quarter when S&P decided to add the company to the S&P 500 Index, opening the door for broader ownership.
NextEra is an integrated utility business with a regulated utility operating in Florida and the largest wind business in the U.S. NextEra’s regulated business includes Florida Power & Light, which serves nine million people in Florida. NextEra’s share price rose along with the passage of the U.S. Inflation Reduction Act, which considerably expands support for renewable energy.
Also in the U.S., Cheniere Energy (LNG) performed well. Cheniere is an energy infrastructure company that owns and operates U.S. liquefied natural gas export facilities along the U.S. Gulf Coast. Shares benefited from the continued tightness in global LNG markets as a result of Russia/Ukraine tensions as well as a well-received capital allocation announcement and Cheniere’s revising guidance above expectations.
From a regional perspective, Western Europe was the main detractor for several reasons. In addition to rising bond yields, an ongoing energy crisis, recession fears and pressure from the war in Ukraine, utilities suffered from fear of sector intervention amid several economic and political uncertainties, such as in Italy, where upheaval from Mario Draghi’s resignation and the subsequent election of a right-wing government led by Giorgia Meloni has also weighed on electric utility Terna (OTCPK:TERRF).
Political uncertainty in the U.K., amid negative headlines of high costs of living and drought, also combined to create risks for water companies, the most severe of which is nationalization. This environment weighed on U.K. water utility Severn Trent (OTCPK:SVTRF).
Detractors outside Europe included U.S. communications company American Tower (AMT), which underperformed as higher interest costs and a stronger U.S. dollar will likely result in earnings and cash flow growth being weaker than the market was expecting. The main detractor, yield-sensitive Australian toll road operator Transurban (OTCPK:TRAUF), was lower as bond yields rose.
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, requiring central banks to refrain from loosening policy even as the economic outlook deteriorates. A recession continues to be part of consensus expectations, and its timing and extent remain the largest risk to investors.
Amid these challenges, there is no change to our view that while the rough road continues for equities, user-pays infrastructure and utilities, which provide essential services with stable cash flows and dividends and have a number of strong tailwinds, such as the U.S. Inflation Reduction Act, will remain attractive to investors in the months and years ahead.
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 negative contributions from eight of the nine sectors in which it was invested (out of 11 total) in the third quarter, with the energy infrastructure sector the only positive contributor and detractors led by the toll roads, electric, communications and water sectors.
On a relative basis, measured against the S&P Global Infrastructure Index, the ClearBridge Global Infrastructure Value Strategy outperformed during the third quarter. Overall stock selection was positive, driven by stock selection in the electric, rail and renewables sectors, while stock selection in the water and airports sectors detracted. In allocation, underweights to toll roads and ports was beneficial, while a communications overweight detracted.
On an individual stock basis, the largest contributors to absolute returns in the quarter were Cheniere Energy, Constellation Energy, PG&E, NextEra Energy and Sempra Energy. The largest detractors were Transurban, Severn Trent, Terna, American Tower and Cellnex Telecom (OTCPK:CLNXF).
During the quarter, we initiated positions in Japanese rail operator Central Japan Railway (OTCPK:CJPRY), Australian toll road operator Atlas Arteria (OTCPK:MAQAF), and U.S. electric utilities OGE Energy (OGE), PPL Corp. (PPL) and Southwest Gas (SWX). We also exited U.S. communications company SBA Communications (SBAC) and U.S. electric utilities CMS Energy (CMSA) and Exelon (EXC).
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Past performance is no guarantee of future results. Copyright © 2022 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Standard & Poor’s. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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