Market update

Equity markets continued a recovery in the third quarter of 2020, with global equities (in USD terms) up 7.93%. Listed infrastructure lagged during this period, with the FTSE Global Core Infrastructure 50/50 Index (USD) up 2.02%.  The fund under-performed the infrastructure sector, being up 0.27%.     

Performance across the infrastructure sectors was generally mixed during the quarter.  There was ongoing out-performance by assets which are viewed as being better positioned from an environmental perspective, and particularly as the energy transition gains a broader acceptance.  Electric utilities that have strong opportunities to invest in renewable energy have been rewarded by investors, whilst gas infrastructure assets have generally been de-rated.  Our detailed stock analysis in this report focuses on Duke Energy, a US based regulated utility who is just commencing what we believe will be a large decarbonisation process of its electricity generation over the next 10 to 15 years.  Overall the Fund’s greater weighting to regulated utilities was a small positive to performance this quarter.

Transportation infrastructure assets saw mixed performance during the quarter, including due to there being a stronger recovery in the movement of goods than there has been in the movement of people.  The Fund’s  overweight positions in European transportation infrastructure were generally weak, and so detracted during the quarter.  In contrast the North American railways, which focus on the transport of goods not people, recovered strongly.  These companies are constituents within the FTSE infrastructure index but are not included in our definition of infrastructure, as in our opinion they do not sufficiently possess the investment characteristics that we seek including strong strategic positions and predictable cashflows.

It has been very disappointing to us that during 2020 the infrastructure sector has been weak relative to global equities, considering that the underlying performance of the vast majority of the companies has held up well (with the notable exception of the few that were directly impacted by COVID-19).  Notwithstanding the tough start to the year for the sector, we remain confident in our strategy of investing in core infrastructure assets.  We believe that there are compelling reasons to be optimistic about the attractiveness of listed infrastructure equities as a long-term investment – including the ongoing increase in demand for long-dated, stable income streams by various investor types, the growing need for further infrastructure investment, and the role that the private sector will play in this. 

Downloads
Quarterly update
Fund fact sheet
Monthly commentary

Portfolio discussion

At 30 September the Fund held 31 high quality infrastructure securities across 11 countries.

The largest individual country exposure remains the United States of America at 48%, which had increased over the quarter. The United Kingdom (12%) was our next largest, followed by France (10%), which had increased over the quarter.

From a sector perspective, our largest holdings continue to be in regulated assets (57%), which increased during the quarter as we continued to rotate the fund into regulated utilities. Our holdings of contracted assets were reduced at 19%, whilst our transportation concessions (such as airport and toll-road assets) was little changed
at 19%.

The investment team are continually looking on a bottom-up basis for further attractive investment opportunities to add to the fund. This we expect will result in a fairly low level of fund turnover, as individual stocks fluctuate between being over-sold or over-bought.

Performance

The rates of return for the Fund's Institutional share classes and movement in the Benchmark as at
30/09/2020 are as follows:

Institutional US Dollar (in USD)


1 month

%

3 months

%

YTD

%

1 year

%

2 years

% p.a.

3 years

% p.a.

Since inception

31/12/2015

 % p.a.

Institutional US Dollar-2.440.27-13.82-8.860.76-1.904.48
Benchmark0.851.454.996.757.267.647.51
Relative performance to benchmark-3.29-1.18-18.81-15.61-6.50-9.54-3.03
Reference Index^-1.172.02-11.55-8.293.832.637.26
S&P Global Infrastructure Index-3.061.37-18.58-14.59-1.55-2.304.24

Institutional Sterling (GBP)


1 month

%

3 months

%

YTD

%

1 year

%

2 years

% p.a.

3 years

% p.a.

Since inception

31/12/2015

 % p.a.

Institutional Sterling1.04-4.17-11.69-13.121.20-0.687.40
Benchmark0.851.454.996.757.267.647.51
Relative performance to benchmark0.19-5.62-16.68-19.87-6.06-8.32-0.11
Reference Index^2.35-2.49-9.36-12.584.283.9010.26
S&P Global Infrastructure Index0.40-3.12-16.57-18.59-1.13-1.097.16

Institutional EURO (EUR)


1 month

%

3 months

%

YTD

%

1 year

%

2 years

% p.a.

3 years

% p.a.

Since inception

12/12/2016

% p.a.

Institutional EUR (EUR)-0.50-3.96-17.50-15.270.28-1.64-0.75
Benchmark0.851.454.996.757.267.647.71
Relative performance to benchmark-1.35-5.41-22.49-22.02-6.98-9.28-8.46
Reference Index^0.79-2.28-15.33-14.743.332.913.57
S&P Global Infrastructure Index-1.14-2.91-22.06-20.60-2.02-2.04-0.08

Institutional Canadian Dollar (CAD)


1 month

%

3 months

%

YTD

%

1 year

%

2 years

% p.a.

3 years

% p.a.

Since inception

10/01/2017

 % p.a.

Institutional Canadian Dollar0.01-1.67-11.23-8.052.430.281.79
Benchmark0.851.454.996.757.267.647.70
Relative performance
to benchmark
-0.84-3.12-16.22-14.80-4.83-7.36-5.91
Reference Index^1.310.06-8.89-7.485.554.906.61
S&P Global Infrastructure Index-0.62-0.58-16.13-13.830.08-0.142.62

*OECD Total Inflation Index + 5.5% p.a.

^Reference Index (relevant currency): FTSE Global Core Infrastructure 50/50 Net of Tax Index

The Fund’s performance is based on the movement in net asset value per share and is before tax and after all fees and charges. Tax credits are not included in the performance figures.

Past performance is not a reliable indicator of future performance. Source: Maple-Brown Abbott Ltd, OECD website, FTSE, S&P as at 30/09/2020.

Institutional Euro (EUR) - Hedged


1 month

%

3 months

%

YTD

%

1 year

%

2 years

% p.a.

3 years

% p.a.

Since inception

18/03/2016

% p.a.

Institutional Euro Hedged-1.30-1.75-13.87-11.36-0.24-2.281.53
Benchmark0.851.454.996.757.267.647.62
Relative performance to benchmark-2.15-3.2-18.86-18.11-7.5-9.92-6.09
Reference Index^-0.410.63-11.55-9.972.311.484.30
S&P Global Infrastructure Index-1.87-0.70-19.57-17.54-2.84-3.111.47

*OECD Total Inflation Index + 5.5% p.a.

^Reference Index:  FTSE Global Core Infrastructure 50/50 Hedged to EUR Net of Tax Index.

The Fund’s performance is based on the movement in net asset value per share and is before tax and after all fees and charges. Tax credits are not included in the performance figures.

Past performance is not a reliable indicator of future performance. Source: Maple-Brown Abbott Ltd, OECD website, FTSE, S&P as at 30/09/2020.

Performance contribution (USD)

The stocks that made the largest contribution (positive and negative) during the quarter.

Best contributing stocks%
Worst contributing stocks%
Duke Energy Corp                                 0.64
Kinder Morgan-0.49
Ameren Corporation                               0.58
Vinci-0.47
Hydro One                                        0.51
Getlink-0.30
Vopak                                            0.29
Fraport-0.21
Williams Companies                               0.24
Allete-0.18

Principal transactions

The main purchases and sales in the Portfolio during the quarter were as follows:

PurchasesSales
AlleteCMS Energy Corp
American Electric PowerHydro One
VinciWilliams Companies
Dominion EnergyAtmos Energy Corp
NiSourceNiSource

Top ten holdings

SectorPortfolio %
Duke Energy Corp6.20
Getlink4.94
Vinci4.73
National Grid4.69
Ameren Corporation4.61
Severn Trent4.58
Sempra Energy4.50
Vopak4.48
NiSource4.47
American Electric Power4.15

Analysis of portfolio

The value and balance sheet characteristics of the Fund as at 30 September 2020 are as follows:

 Portfolio
Number of Stocks31
Dividend Yield (%)3.9
EV/EBITDA* (%)12.9
Gearing (net debt/EBITDA)(x)5.1

*Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortisation

These figures are based on estimates for the next twelve months which include assumptions that may not hold true. Actual outcomes may differ. Source: Maple-Brown Abbott Ltd internal estimates, Sentieo, and Bloomberg.

Sector and country weightings

The sector and country weightings (%) in the Fund are as follows:

Selected infrastructure news items

  • In July, fund holdings Dominion Energy and Duke Energy announced the cancellation of the Atlantic Coast Pipeline (ACP) due to ongoing delays and increased cost uncertainty caused by a series of legal challenges to the project’s permitting. The ACP was intended to be a 600 mile pipeline transporting natural gas from West Virginia to utilities in Virginia and North Carolina. The continued demand for gas in these states is now largely expected to be met through expansions on the existing Transco pipeline, owned by fund holding Williams Companies Inc. Alongside the cancellation, Dominion Energy also announced that it had agreed to divest substantially all of its Gas Transmission and Storage segment assets for $9.7 billion to Berkshire Hathaway Energy. The transaction will enable Dominion Energy to repurchase $3 billion of common stock in 2020; and the company will derive 85-90% of its earnings from state-regulated utilities with an expected 6.5% growth rate. Separately, Duke Energy was rumoured to have been approached by NextEra Energy in a takeover approach, which Duke Energy had turned down. The potential combination between two of the largest US utilities would be unprecedented in size but would also likely face intense regulatory scrutiny.
  • On 15 July, fund holding Flughafen Zürich concluded negotiations on flight operation charges. The mutual agreement with airline customers extends the current charges period with a 10% reduction in charges for 2021 to facilitate the restart of operations for airlines. The new charges regulations come into force on 1 January 2021 and is expected to remain through to end-2024.
  • On 16 July, fund holding Hydro One received a positive decision from the Ontario Divisional Court on its appeal of the Ontario Energy Board’s (OEB) decision on its C$885m of deferred tax assets generated at the time of its IPO. The OEB had ruled that a portion of the deferred tax assets was for the benefit of ratepayers, but the court specifically noted that “no portion of the Future Tax Savings should be allocated to ratepayers”.
  • In September, fund holding National Grid submitted its responses to Ofgem’s RIIO-2 draft determination for electricity and gas transmission for the 2021-2026 regulatory period. The company raised serious concerns with the draft determinations, specifically the low proposed base equity (real) return of 3.95%, in that it:
  • Reduces the reliability and resilience of the UK’s electricity supply and gas network;
  • Jeopardises the pace of progress towards a net zero energy system;
  • Create unnecessary complexity and volatility in the framework; and
  • Erodes regulatory stability and investor confidence in the sector.

The company will continue to engage with Ofgem at all levels, including through CEO and Chair meetings, and October's open hearings, prior to Ofgem’s final determination at the end of the year.

Listed vs unlisted infrastructure

The paper challenges the assumption that listed and unlisted infrastructure are two different asset classes by analysing examples of actual assets owned by these two distinct investor classes. The Global Listed Infrastructure (GLI) team at Maple-Brown Abbott (MBA) believe that inherent in this debate are a number of factors including fees, liquidity and portfolio rebalancing requirements, risk exposures, diversification, cashflows, opportunity sets and perhaps most importantly, risk-adjusted valuations. The paper also takes a quick look at the impact of COVID-19 on the outlook for the infrastructure sector as well as the importance of ESG, which we view as being more integrated in listed infrastructure.

On COVID-19, there is no doubt that the resultant global pandemic has impacted the recent price performance of listed infrastructure assets, but basic infrastructure is essential to our societies now and into the future. We believe that the current crisis has opened up an enormous opportunity for listed investors given that the intrinsic value of these assets, in some sectors, has fallen far less than their current stock prices may suggest. We think people will fly again, they will drive again, and the Chinese experience shows that “V shaped” recovery is possible with virus control. Infrastructure has an important role to play in the current global economic recovery and investors can consider listed exposure as part of their overall infrastructure portfolio, real asset exposure or as a complimentary low-beta global equity diversifier.

Stock research and investment process

Why we are currently attracted to US regulated utilities?

Despite having a strong start to the year, US utilities have underperformed the broader market since the COVID-19 pandemic broke out in mid-February. We believe this is unwarranted, as the current market environment, with low interest rates and low growth, is one in which we believe utilities should be outperforming. This is particularly the case when considering the highly regulated nature of earnings, as well as the fact that demand for utility services are relatively insulated from broader global economic conditions.

Relative valuations for the sector are now at decade lows (as measured by the price-to-earnings ratio of US utilities versus global equities), and dividend yields trade at some of the widest spreads in over a decade relative to both US treasuries and Baa-rated corporate bond yields.

We remain highly attracted to these businesses: they provide essential services to customers through the delivery of a basic need (access to electricity, gas, and water); are highly monopolistic; and due to the regulated nature of returns, provide stable and predictable cash flows. With this in mind, we have taken advantage of the recent sector underperformance, and have increased our position in US regulated utilities from approximately 19% of the portfolio at the end of 2019 to 37% as of the end of this quarter.

Individual stock review: Duke Energy

Duke Energy (‘Duke’) is one of the largest regulated utilities in North America. In fact, they are the largest utility when measured by rate base ($77 billion), electric customers (7.8 million), and total assets ($160 billion)[1]. The company’s primary focus is on delivering affordable, reliable (and increasingly cleaner) energy to all of its customers. It is predominantly a regulated electric and gas utility (95% of earnings), but also operates a commercial renewables business (5% of earnings). The company operates across 7 states (North Carolina, South Carolina, Florida, Ohio, Indiana, Kentucky, Tennessee), and serves 7.8 million electric and 1.6 million gas customers.

The company’s medium-to-long term growth will be predominately driven by regulated investments in electric generation, transmission and distribution, as well as gas distribution, which we view as low risk, as these investments generate predictable, regulated returns. Over just the next 5 years the company expects to invest $56 billion, which results in an asset growth rate of around 6% per annum through this period.

Since the beginning of last year, the stock began to de-rate as the market became concerned about a number of lingering uncertainties, including: potential delays or cost over-runs on the Atlantic Coast Pipeline project (an inter-state natural gas transmission pipeline); uncertainty with respect to a number of upcoming rate cases in the Carolinas and Indiana; and the company’s ability to recover coal-ash remediation costs in rates. We believe that these concerns were over-done, and viewed short-term share price weakness as a buying opportunity. We first initiated a position in Duke at the beginning of the year, and it now represents an approximate 6% position in the Fund (the Fund’s largest holding).

A key recent development for the company was the release of Duke Carolina’s 2020 Integrated Resource Plan – which has increased our conviction on the stock.

Duke Carolina’s 2020 Integrated Resource Plan

Utilities regularly prepare Integrated Resource Plans (IRPs) which are highly detailed, lengthy, technical documents that help outline a utility’s resource needs in order to meet expected electricity demand over a long-term (10 to 20 year) planning horizon. These documents are critical to resource-planning, and help relevant stakeholders – as well as the utility themselves – understand what investments need to be made to ensure that affordable, reliable energy can be provided to all customers.

On 1 September 2020, Duke filed its 2020 Carolinas Integrated Resource Plan (IRP), outlining six pathways that it could take to meet forecasted electricity demand over the next 15 years. In alignment with the company’s climate strategy, as well as with input from relevant stakeholders, the 2020 IRP provides for a diverse range of alternatives that span from a least-cost “base plan without carbon policy” portfolio (which projects very little change from their current pathway), to portfolios that would allow for 70% CO2 reduction (through significant investments in solar and onshore / offshore wind), as well as those that include no new gas generation.

While Duke’s “base plan” would help the company achieve its current target of a 50% reduction in CO2 emissions by 2030, North Carolina’s current Clean Energy Plan targets an even greater 70% reduction in greenhouse gas emissions by 2030. Therefore significant changes need to be made to Duke’s system portfolio in order to meet the state’s environmental goals. Two of the six scenarios in the IRP better aligns Duke with this 70% reduction target. While there are slight differences between the two scenarios (one includes a higher proportion of offshore wind, whilst one includes additional capacity from small modular reactors), importantly both envision Duke adding approximately 16 GW of new solar, 4 GW of storage, and 6 GW of new gas by 2035, whilst also accelerating coal retirements to the earliest practicable date.

Together, North and South Carolina represent more than half of Duke’s business. We believe that significant changes to Duke’s Carolinas’ generation fleet will be needed over the next decade due to the substantial amount of legacy coal assets they own, and the need to accelerate decarbonization to meet existing state renewable targets. The opportunity extends beyond generation, as further investments in both the transmission and distribution network will also be required to accommodate new renewables / storage. A lot of this spend is currently not being included in the company’s capital plan, and so in our view there is an upwards bias to Duke’s existing growth targets that we believe is currently being under-appreciated by the market.

Potential takeover by NextEra

After market close on 29 September 2020, a news article was published by the Wall Street Journal,[2] reporting on rumours that NextEra Energy (“NextEra”) – the largest US utility by market capitalization – had made a takeover approach for Duke. The article indicated that Duke had re-buffed the approach, but that NextEra remains interested in pursuing a deal.

At this stage, this is only media speculation, and there are challenges both parties would need to work through in order to successfully complete a transaction of this size,[3] including but not limited to the obtaining of relevant shareholder and regulatory approvals. Notwithstanding this, we believe there are a number of positive read-throughs: firstly, this is an endorsement for Duke’s business and its existing growth opportunity; secondly, the re-buffed offer confirms our view, and most likely reflects management’s view, that the stock is under-valued; and thirdly, M&A now represents an additional near-term catalyst for potential value realization.

Regardless of whether the transaction eventuates, we continue to have a high level of conviction in the stock.

ESG integration

Over the quarter, Maple-Brown Abbott was once again awarded the highest grade of A+ by the UN Principles for Responsible Investment (UN PRI) for our approach to responsible investing. As early signatories to the UN PRI dating back to 2008, we have consistently been recognised as a leading investment manager for our approach to strategy and governance, integration and active ownership. Further to this, we were also recognised by the Responsible Investment Association Australian (RIAA) as a leader in responsible investment as part of their annual benchmarking report. These assessments reflect our deep consideration of ESG factors in the investment process and we are honoured to be recognised for our leadership.

ESG spotlight: US energy infrastructure & the “net zero” club 

The transition to a low carbon world continues unabated and – if anything – has accelerated during the COVID-19 pandemic. The US has been a surprising standout this year, with a swathe of regulated utilities and midstream pipelines announcing ambitious emissions reduction targets and commitments to “net zero” by 2050. But what does this all mean? Where are the investment risks and opportunities?

Watch Global Listed Infrastructure team’s ESG Analyst, Georgia Hall, in conversation with Duncan Hodnett, Head of Global Distribution, about how investors can make sense of it all and why carbon emissions are key to the team’s research and engagement process.

ESG themes and engagement

The transition to a low carbon world continues unabated and – if anything – has accelerated during the COVID-19 pandemic. Governments around the world are pursuing emissions reduction targets and carving out substantial capital to invest in and/or subsidise renewables and low carbon technology and solutions (for example, green hydrogen). In September, the European Commission presented its plan to reduce EU greenhouse gas emissions by at least 55% by 2030 (relative to 1990 levels) by fast-tracking renewables uptake, implementing energy efficiency standards, strengthening emissions trading schemes and incentivising electric vehicle penetration, amongst other measures. In the same month, and much to the market’s surprise, China pledged to become carbon neutral by 2060. While the details of China’s carbon neutral roadmap are yet to be announced, the pledge puts pressure on the US as the largest global emitter without a carbon neutral target.

In anticipation of, or in reaction to, these developments; we are seeing utilities, pipelines, tollroads, airports and other transportation companies – particularly in Europe and the US – embrace the opportunities of the transition to a low carbon economy and implement emissions reduction programs. Over the quarter, we engaged with a number of utilities and pipeline companies to gauge the robustness and breadth of their “net zero” pledges alongside their approach to climate risk and governance, disclosures, and ESG policies. We believe companies’ emissions reduction strategies are important from an investment perspective, as an increasingly carbon-constrained world will likely create longer-term challenges from a regulatory, legal, stakeholder and market standpoint. 

ESG engagement case studies

Two examples of engagement worth highlighting are ALLETE, the second largest North American utilities company by installed renewable capacity as percentage of market cap (circa US$2.5bn), and Williams Companies, a midstream company which handles 30% of US natural gas through its pipeline networks.

ALLETE has an enviable renewables portfolio compared to other US utilities and is set to have more than 1GW of operating wind assets by the end of 2020. Despite its strong renewables strategy, we believe ALLETE’s emissions and climate risk reporting can be improved to better reflect its green credentials and augment its standing in the market as a leader of innovative and sustainable energy solutions. In meeting with ALLETE, we also encouraged them to implement an environmental policy to help drive accountability and governance of emissions reduction measures and climate risk management. While ESG reporting and policy is a resource-intensive undertaking for companies, these improvements will support ALLETE’s overall strategy, provide investors with more decision-ready information, and equally prepare for potential regulatory change and stakeholder pressure that can be expected going forward. ALLETE was receptive to our views and we continue to engage with the company.

In August, Williams Companies became one of the first midstream pipelines to announce ambitious emissions reduction targets, aiming to reduce scope 1 and 2 emissions (direct emissions) by 56% by 2030 and achieve net zero emissions by 2050. While an important step, we believe this should be extended to include scope 3 emissions (the full value chain), as this is the most material part of their emissions profile. Williams Companies agreed, and whilst acknowledging the challenges of doing so, they explained this next step is under consideration. To tackle indirect emissions, we are seeing many oil and gas majors explore industry initiatives to improve customer energy efficiencies, implement policy for suppliers (gas flaring, methane reductions etc.), and purchase offsets. Scope 3 emissions are the most difficult to abate segments for most industries, particularly for midstream pipelines where they do not have control of the full value chain. However, as businesses with similar targets start to coalesce around these ambitions, it is likely that these emissions reduction measures will have a mutually beneficial flow on effect across supply chains and smooth out the transition. From the social perspective, we also discussed Williams Companies’ approach to Indigenous consultation when planning new pipeline projects. We were pleased to hear that they follow the best practice principle of Free, Prior and Informed Consent and have oversight of this engagement through a Board sub-committee.

Proxy voting activity

We engage the services of an independent Proxy Advisory to help inform, but not dictate, our decision making. Where we vote against a company resolution, we advise the company management prior to the AGM or EGM with our rationale for doing so. Over the quarter, we voted on all resolutions and did not abstain from any votes; 87% of votes were in favour and 13% were against. Where we voted against, our concerns mostly related to Board appointee independence, executive remuneration, voting rights, and the separation of the Chair and CEO roles.

Inflation review

In August, the US Federal Reserve Bank released a revised Longer-Run Goals and Monetary Policy Strategy Statement which adopts a new flexible form of average inflation targeting. Specifically, the Fed will seek to achieve inflation that averages 2 percent over time, rather than targeting a 2 percent inflation rate. The subtle shift implies a willingness to allow inflation to rise above 2 percent following periods of below-target inflation, as is currently the case. All else equal, this would suggest that interest rates are likely to stay lower for longer than would otherwise be the case.

In fact, the Fed’s average inflation target is not too different from some other central banks’ targets. For example, since the early 1990s the Reserve Bank of Australia (RBA) has targeted an inflation rate of 2-3 percent, on average, over time; and since 2016 the Bank of Japan (BOJ) has introduced an inflation-overshooting commitment with the goal of core CPI exceeding its 2 percent target and staying above that target in a stable manner. Despite these targets, both the RBA and BOJ have failed to meet their inflation objectives in the recent years.

Similarly, the Fed’s shift in policy target on its own is unlikely to materially affect near-term inflation outcomes in the US. This is because it has effectively reached the limits of its policy tools that are able to stimulate higher inflation outcomes, as both interest rates are at its effective lower bound and incremental asset purchases are having little impact on the real economy. Instead, for the target to be reached, fiscal policy will need to continue to be expansionary.

Near-term inflation in the US is expected to remain low due to the economic impact of the COVID-19 pandemic. The pandemic has resulted in a large reduction in aggregate demand, and the recovery is expected to be gradual, thus creating extended periods of excess spare capacity in the economy that will weigh on inflation. The latest economic projections of Fed members support this outlook and indicate that inflation is only expected to reach 2 percent by 2023 (Figure 1).

Figure 1: Median inflation projections of Federal Reserve Board Members, September 2020

Source: Federal Reserve

In the medium- to long-term, while the risk of higher inflation exists, there is a low likelihood that it will be structurally sustained at an above-target level. We believe that there a number of factors that are likely to place downward pressure on inflation beyond the COVID-19 pandemic:

  • We see sustained fiscal stimulus as necessary to drive long-term inflation higher. The expected winding back of some of these measures could be disinflationary.
  • The large fiscal stimulus has resulted in high levels of public sector debt, which at some point could be seen as unsustainable. In anticipation of this, the government may introduce austerity measures and/or markets may drive up borrowing costs.
  • Inflation expectations have been strongly anchored to below-target levels for many years, which may be difficult to change until the Fed can credibility demonstrate its ability to hit its new average inflation target going forward.
  • Some regions may struggle to lift inflation for various structural reasons (e.g. the EU and Japan), which can become a drag on US inflation through trade and foreign exchange rates.

We do not see high inflation being a major risk to the portfolio, but we continue to monitor inflationary developments closely.

Economic review

The MSCI AC World Index, led by the US, increased by 8.1% in USD terms during the quarter recovering to pre-pandemic levels as many countries began to unwind social distancing measures. Investors factored in expectations of a prolonged period of low interest rates and a rebound in corporate profitability from the sharp declines experienced during the height of the pandemic. India, China, US and Germany were among the better performing markets increasing by 15.0%, 12.5%, 9.5% and 8.3% in USD respectively.

The International Monetary Fund (IMF) did not provide an update to economic forecasts during the quarter with the next release being due in October. Some market commentators anticipate positive revisions to the last forecast made in June, which expected 2020 economic output to contract by 4.9%. While recent economic data has proven better than originally feared, forecasts will continue to be heavily influenced by the trajectory of COVID-19 infections and resulting government responses.

The US printed the biggest quarterly fall in GDP[4] on record at 31.7% as the country lost control of the virus leading to a temporary shut down of the economy. The unemployment rate improved to 8.4% in August from the highs experienced in April of 14.7%, as economic activity gradually resumed. Unlike many other countries, the US enacted wage support through unemployment benefits rather than wage subsidies which resulted in the data showing higher unemployment rather than fewer hours worked. Unemployment benefits were set at the level of average full-time earnings until July, which meant many workers were temporarily financially better off being unemployed. Having reviewed its monetary policy framework, the Federal Reserve announced it would pursue a flexible average inflation target, increasing its emphasis on achieving maximum employment.

Prolonged below target inflation has prompted central banks to review policies, allowing flexibility for periods of higher inflation to compensate for past low inflation

Source: Reserve Bank of Australia (Consumer price index; Year-ended change), European Central Bank (HICP - Overall index, annual rate of change); Federal Reserve (12-month inflation rate for headline PCE)

Europe similarly reported dramatic falls in GDP with declines of 9.7% in Germany, 13.8% in France and 19.8% in the UK. European governments have been pro-active in supporting the recovery phase with the EU announcing additional fiscal stimulus of around 5% of GDP (Next Generation EU Recovery and Resilience Facility), funded through the issue of EU bonds. In addition, the German government announced a temporarily 3% broad-based reduction in consumption tax, while the UK introduced temporary VAT reductions of 15% targeted at the hardest hit hospitality, accommodation and attraction industries. Similar to the Federal Reserve, the European Central Bank is currently reviewing its inflation targeting policy objective, amidst a wide debate around central banks explicitly making up for inflation falling below target for prolonged periods of time. Meanwhile the Bank of England highlighted they were considering the possibility of negative policy rates.

Chinese GDP rebounded by 11.5% as the country appeared to successfully contain the spread of COVID-19. Significant government stimulus has been successful in stimulating fixed asset investment and industrial production, which have now returned to pre-COVID levels. Consumption growth lagged as the level of income transfer to households by the government has been modest. Japanese GDP declined by 7.9% as consumption was significantly impacted by the declaration of a state of emergency in April, while exports were impacted by shutdowns of major trading partners. GDP in India declined 25.2% as strict lockdowns led to sharp falls in production and consumption. Ratings agencies downgraded India’s sovereign rating to the lowest investment grade rating, potentially limiting the amount of additional fiscal stimulus.

Australian GDP fell 7.0% as household consumption was heavily impacted by social distancing measures. Since then, consumption has improved due to substantial fiscal stimulus, reduced outbound travel and early access to superannuation. Meanwhile, re-introduced lockdowns in Victoria are expected to impact September quarter GDP by 2%. Unemployment is expected to increase from the current 6.8% level to peak at around 10% later this year as wage subsidies (which are estimated to have supported more than a quarter of all workers) are gradually wound back. The Australian dollar continued to appreciate during the quarter to levels consistent with expectations given the terms of trade and interest rate differentials. During the quarter the Reserve Bank of Australia kept policy rates on hold and reaffirmed the prior package of stimulus measures, including an extension of the term funding facility. The RBA also reaffirmed its commitment to maintain the cash rate at or below current levels until it is confident inflation will be sustainably maintained within the target 2-3% range, on-average over time.

[1] Duke Energy – September 2020 Investor Presentation

[2] https://www.wsj.com/articles/nextera-renewable-energy-giant-seeks-greater-scale-with-a-duke-takeover-11601501637

[3] As of market close on 29 September 2020, NextEra and Duke had market capitalizations of $139 billion and $61 billion, respectively.

[4]  GDP data is based on June quarter-on-quarter growth rates.

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