Canada’s infrastructure sectors, including pipelines and real estate, are outperforming the broader market so far in 2021. Anthony Okolie speaks to James Hunter, Global Infrastructure Analyst, TD Asset Management, about whether there’s still more upside as the economy continues to reopen.
- Yeah, for sure. And I should start by saying it's been a fantastic year for stocks. The total return on the TSX-- 18%-- and there haven't been any meaningful drawdowns along the way. Some volatility, for sure, but nothing like what we saw last year. Now, in the first chart that I brought, you can see that the pipelines and the real estate sectors have done really well with returns in the high 20s. That's well above the market-- which is the green line-- and yellow utilities are up about 7%.
And as you say, we typically think of dividends as an important source of total returns in the infrastructure space. So it's interesting to think that, with an average yield of about 4%, they're only contributing about one fifth of the returns this year. And that's because there's been a good recovery in the valuations as these stocks move ahead of cash flows and earnings, which will improve as the economy reopens.
- OK, so first, let's talk about pipelines. There's been some M&A activity this year. Has this been a catalyst for the sector?
- Yeah, we started the year with a bang as a bidding war broke out for Inter Pipeline and that certainly renewed interest for oil and gas infrastructure, reminding us that if hard assets get too cheap, they can and they will be acquired by other public companies. I do think there's a couple other things to keep in mind. One is Enbridge's line three replacement project. It was really important to see the Minnesota Court of Appeals reaffirm their permits back in June, and that should come into service in the fourth quarter. So that's been a catalyst for the stock and the sector.
The other is the Keystone XL project that was canceled and that's a tough loss for TC Energy. But remember that it probably would have been a multi-year highly contested build. Probably would have been delayed along the way and that could have become an overhang for the stock. So now that that's been put to bed, investors can refocus on collecting their growing stream of dividend income.
- OK, so let's talk about another hot sector. The real estate sector has been hot this year, third best year to date, in fact. Why is it doing so well?
- Yeah, well think of all the business activity that didn't happen last year. So shopping in retail malls, working in offices, people moving in and out of apartment buildings, that hurts the cash flows of the REITs, which are very reliant on the financial health of their tenants. And so while we've been experiencing the slow and steady reopening here in Ontario, the stocks have really gotten ahead of that because they're anticipating better rent growth and occupancy in the coming quarters. They've also been responding to this environment of an extended duration of low interest rates, and that's really producing some really good performance.
- OK. Lastly, utilities. Why have they struggled to keep up with the rest of the market?
- It's mostly because utility earnings, they don't respond much to economic conditions. They're so highly regulated and contracted. And remember also that they're essential services. Think of natural gas for heating the home or electricity. And so that's great for a recession like last year, it's not so good for an economic boom this year. The other factor would be renewable power producers. These are about one third of the sector in Canada, and renewables are seeing an influx of new competition from energy companies and capital from institutional investors. And this is driving down the rate of return that they can earn on their new projects. So the stocks have slowed in recognition of that competition.
- OK. So putting it all together, what's your outlook for the infrastructure sectors?
- I brought along a second chart that I think you'll find interesting. And here you can see the green line, which is the market cap of the infrastructure sectors put together. And market values haven't recovered to the pre-pandemic levels, where they topped out around $450 billion. And yet the yellow line, which is bond yields, has moved lower. And so I do think there's going to be support for cash-flowing infrastructure assets in this low rate world.
My outlook by sector does vary. Pipelines are a decent recovery play. We just have to watch them carefully because dividend growth is slowing and the asset mix is carbon-heavy. Utilities we're cautious on because their earnings just can't keep pace in a recovery, but we are bullish on the real estate sector. That's because so many of the REITs really benefit from renewed economic activity and I think their valuations can move higher as rent growth accelerates. Plus the dividend yield of 3%, it's attractive and it's sustainable. So my outlook for real estate stocks is quite positive.
- James, thank you very much for your time.
- Thanks, Anthony.