By Saeculum Research
- Don’t believe the hype surrounding infrastructure stocks. As divisive as this election has been, the candidates can agree on one thing: America needs an infrastructure overhaul. This has many investors heralding infrastructure stocks as a safe bet. But this optimism may be short-lived. Investors aren’t taking the post-election political gridlock and the possibility of another economic recession into account. When they do, P/E ratios will drop back down. Paradoxically, a full-fledged recession may actually create a political climate in which large-scale infrastructure packages are once again enacted.
- Invest in the new wave of smart technologies that can make infrastructure more effective. Nowadays, infrastructure is going high-tech. Companies like GridCure use analytics, algorithms, and maximize the efficiencies of electricity management. Private companies like Inrix and Miovision use sensors and cameras to provide analytics regarding commutes and congestion. Others like Valor Water Analytics analyze the traffic of water in cities. While infrastructure tech maximizes efficiencies, it is particularly vulnerable to hackers, which will make cybersecurity increasingly important in the coming years. Earlier this year, for example, an Iranian hacker allegedly tapped into the control system of the Bowman Avenue Dam, which could have caused millions in damage to the surrounding area.
- Keep an eye on the municipal bond market. As we have discussed before (see: “In Municipal Bonds We Trust?“), the future of the muni market is uncertain—even apart from demand for muni bonds. If Clinton wins the presidency and Democrats maintain control of the Senate, marginal tax rates could rise, which would push muni bond prices up. However, Clinton may keep Obama’s proposal of limiting the tax exemption of municipal bonds to 28 percent, which would push them down. Although state and local governments have plenty of infrastructure pressures, the future of the muni market will likely be characterized by heightened uncertainty and volatility.
- Understand that foreign construction companies have a competitive advantage. In New York, Chinese companies have won contracts to renovate subway systems, build a new train platform near Yankee Stadium, and refurbish the Alexander Hamilton Bridge. Even the new San Francisco Bay Bridge was built by a Chinese company. Why is this happening? U.S. construction companies just can’t compete with the economies of scale and expertise offered by foreign companies—particularly from China, which build and spend so much more on infrastructure than U.S. firms. Come the next recession, the government may have to mandate that most infrastructure upgrades must be completed by U.S. companies to prevent fiscal stimulus from leaking abroad.
Last month, infrastructure ETFs rallied in response to Clinton and Trump’s plans to spend billions on improving America’s aging roads, bridges, and ports.
With both candidates championing infrastructure spending, investors have been anticipating an infrastructure boom. But this optimism may be overdrawn. Infrastructure’s rising valuations aren’t taking into account the impending political civil war that will take hold of Washington—particularly if Clinton is president and Republicans control the House. Infrastructure stocks will also sink if the economy slows down. The harsh reality is that the economic and political situation may have to get a lot worse before any infrastructure overhaul begins.
It’s no secret that the nation’s infrastructure is in a state of disrepair. The American Society of Civil Engineers gave the United States a D+ for infrastructure in 2013. By 2025, infrastructure’s total economic impact is projected to hit $3.3 trillion and the subsequent funding gap is forecast to rise to $1.4 trillion.
What kinds of infrastructure are we talking about?
- Surface transportation: $1.1 trillion funding gap (54 percent unfunded). Includes roads, bridges, commuter rail, and transit systems. The Fix America’s Surface Transportation (FAST) Act allocated $305 billion to fix these systems through 2020. This 7 percent increase barely keeps up with inflation.
- Electric generation, transmission, and distribution: $177 billion (19 percent). This number doesn’t include the number of security upgrades the U.S. electric system will need to guard against physical and cyberattacks in the coming years.
- Water and wastewater: $105 billion (70 percent). Significant portions of many municipal systems are over 40 years old.
- Airports: $42 billion (27 percent). Most of the nation’s airports were built in the ’50s, ’60s, and ’70s. The federal tax used to pay for airport construction hasn’t been adjusted for inflation in 16 years.
- Inland waterways and marine ports: $15 billion (41 percent). The FAST Act lifted restrictions on U.S. exports of crude oil, which will put more pressure on seaports.
Needless to say, infrastructure is at the forefront of voters’ minds. According to a recent Gallup poll, 75 percent of Americans support federal spending on infrastructure improvements. In many ways, this consensus reflects a long-term generational shift. Over the past several decades, pro-infrastructure G.I.s have given way to values-centric Boomers. While G.I.s spearheaded massive federal projects like the Interstate Highway System (see: “The Long Road to Rebuild America“), Boomers allowed these systems to fall into neglect. (Their elders “paved paradise and put up a parking lot,” after all.) Today, generational attitudes are shifting again. Community-oriented Millennials want walkable living spaces and reliable public transit—they just aren’t in positions of authority to call the shots.
Remarkably, both candidates—Clinton and Trump—have been touting large new infrastructure outlays on the campaign trail. Clinton’s plan calls for $275 billion in infrastructure spending over the next five years, which will be funded by business tax reforms and a $25 billion infrastructure bank. Trump’s infrastructure plan is more ambiguous. He has said that he will double Clinton’s spending plan, which will be funded by private-sector investments.
If these policies pan out, a wide range of public companies stand to gain from increased infrastructural spending. Martin Marietta, Vulcan Materials, and ASTEC Industries—which specialize in construction aggregates, concrete, asphalt, and cement—would benefit from increased spending on surface transportation and airports. Large contracting firms like Jacobs Engineering Group and AECOM could profit if the government doubles down on water/wastewater management, electric power plants, and ports. And who will provide all the construction equipment? Companies like Caterpillar, Deere & Company, and Cummins.
For most of the campaign season, infrastructure stocks have surged in response to this bipartisan enthusiasm. The P/E ratios of Martin Marietta, Vulcan Materials, and ASTEC Industries have been on an upward trajectory since Q3 2015. And the stock prices of these firms, and of the PowerShares Dynamic Building & Construction ETF, have risen to 2007 levels for the first time since the recession. Additionally, a wide range of global infrastructure ETFs have experienced double-digit growth in 2016—compared to the S&P 500’s 5.5 percent. The surge in global infrastructure ETFs is partly driven by the performance of U.S. companies, as well as expectations that foreign companies will benefit from more U.S. infrastructure spending.
But remember: All of these value hikes are predicated on a massive infrastructure initiative starting in 2017. Is such a program a sure thing? Probably not. In fact, the odds of a massive new program being legislated and approved by both parties in early 2017 are small—and are shrinking each day with the increasing polarization among political leaders. Accordingly, the surge in infrastructure stock prices may be unjustified. To some extent, recent stock price movements are already reflecting this growing uncertainty: The prices of many of these firms and ETFs have been edging downward since August. But they have a long way to go. Bottom line: This sector is now a good short.
To be sure, we may get some bipartisan initiatives in the coming years. Some—like the Water Resources Development Act—have already been passed by both houses. Others might have sufficient bipartisan support. Clinton is no stranger to increased military spending. And the GOP’s Better Way campaign emphasizes cyber defense to protect our nation’s power plants and gas pipelines. This slight overlap in cybersecurity may give way to bipartisan infrastructure legislation.
But that’s about it. The new political mood will make it impossible. Post-election Washington will be bitterly divided—with one side determined to obstruct the opposing party’s agenda. Three months ago, a Trump presidency and Republican Congress was an optimistic scenario for infrastructure stocks. But now, we are facing the prospect of President Clinton, who is not terribly liked by her fellow partisans (or her voters) and intensely hated by her opposition. Although the Senate is still up for grabs, House Republicans have already vowed to block her initiatives.
And if the political atmosphere isn’t bad enough, there’s the looming possibility of a recession in 2017. As we have discussed before (see: “The Global Economy Gears Down“), global GDP growth is slowing and some economists are sounding off recession alarms. If this happens, these infrastructure firms will suffer even more. State and local governments will be strapped for cash. And the drop-off in corporate capex will hit these firms on the private sector side as well.
Paradoxically, a full-fledged recession, while punishing these companies in the short run, may actually create a political climate in which large-scale infrastructure packages could once again be enacted. After all, even if political leaders don’t want it, the public will demand it.
In the end, investors should remember that the economy will have to get significantly worse before the political consensus behind infrastructure spending reaches critical mass. The nation’s most expansive infrastructure overhauls occurred in response to the depths of the Great Depression. It’s happened before and it could very well happen again.
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