Virtus Duff & Phelps Global Infrastructure Fund

4Q22

Market review

Equity markets rebounded from October lows to finish the quarter with gains. Global developed markets (as measured by the MSCI World Index (net)) rose 9.77% on a total return basis. Equity gains were supported by hopes that inflation may be peaking across Europe and the U.S., which would ultimately bring an end to interest rate increases. Optimism for a future economic boost arising from Beijing’s loosening of pandemic restrictions in December also provided support to equity markets. Global listed infrastructure stocks (as measured by the FTSE Developed Core Infrastructure 50/50 Index (net)) rose 9.25% in the quarter, modestly trailing the broader market.

Transportation stocks reversed course this quarter and traded higher as the market rallied. Labor contracts for the U.S. freight railroads were resolved with an assist from the government, clearing the way for improvements in staffing and service levels. European airports experienced strong passenger growth with some seeing traffic return to pre-pandemic levels. Toll road traffic was solid, with lower fuel prices removing some headwinds for vehicle usage.

Utility stocks also bounced back in the quarter. European utilities rose as investor concerns about a potential energy crisis were assuaged. In response to high energy prices, European governments opted for price caps and windfall taxes to protect consumers rather than more heavy-handed regulation. U.S. utilities traded higher as early outlooks for 2023 were generally positive and investors perceived lower earnings risk with utilities relative to other sectors.

The energy infrastructure sector traded higher despite near-term weakness in commodity prices. Energy demand was lower as warm weather across the northern hemisphere dampened heating needs while commercial and industrial users in Europe curbed their activity to conserve resources. We see these conditions as transitory. Global inventories remain low and spare production capacity is very limited, which will likely tighten commodities markets and support higher prices in the future.

Communications was the worst-performing sector in the quarter and for the year. While fundamental business conditions for wireless towers remain quite positive, higher interest rates took a toll on the tower stocks. Despite the recent decline in stock prices, U.S. and European tower companies enjoy robust conditions for future demand.

Portfolio review

Underperformance was due in part to stock selection, which was negative across all sectors except transportation. Sector allocation also detracted from performance, as overweight positions in communications and energy, combined with an underweight position in transportation, had a negative impact. An underweight position in the utility sector had a negligible influence on performance.

Two transportation stocks were the top contributors for the quarter. Australian toll road operator Transurban Group performed well as the company reported solid traffic volumes and revenues; in addition, management cited improving visibility on greenfield project deliveries. Spanish airport operator Aena SME SA rose as passenger volumes recovered toward pre-pandemic levels. Management also provided a positive outlook for passenger traffic and retail sales growth in future years. Currency appreciation provided a further boost, with Transurban and Aena aided by the strength of the Australian dollar and the euro, respectively.

The largest detractors to performance were Cheniere Energy and Dominion Energy. Cheniere Energy is the leading producer and exporter of liquefied natural gas (LNG) in the United States. After a very strong third quarter and solid year-to-date performance, Cheniere’s stock pulled back during the fourth quarter. Global LNG prices moderated due to high European gas inventories and a slow start to the heating season in Europe. We are encouraged about the long-term fundamentals for LNG demand and remain positive on the name. Dominion Energy, a Virginia-based utility, traded lower after announcing a business review and potential restructuring. The announcement surprised investors and raised concerns that the outcome of the business review could be dilutive to earnings. While this is a risk, based on our revised estimates, we think the share price reaction is overdone and continue to hold the stock.

Investment outlook

The year ahead will present challenges as industries adjust to higher interest rates and commodity prices as well as continued political uncertainties. We are optimistic that listed infrastructure companies will display the resiliency of their business models as they weather these headwinds. We believe secular trends support continued progress within each sector. Asset renewal, energy security, decarbonization, and data growth are driving durable, long-term investment cycles that will continue for years to come despite negative short-term economic developments.

Wireless tower activity in the U.S. should remain robust in 2023 and beyond as carriers shift from the initial stages of 5G buildout and blanket coverage to focus on more targeted network densification. In Europe, we expect healthy organic activity to continue as the tower companies benefit from 5G expansion as well as inflation-linked escalators embedded in their contracts. We believe the 5G buildout and predictable cash flows provided by long-term contracts will make the tower companies more resilient to the macroeconomic challenges that may be ahead in 2023.

Utilities benefit from the transition to renewable energy and renewal of assets and we expect these positive tailwinds to last for years to come. Higher interest rates and commodity prices provide near-term challenges that must be overcome, but we believe these obstacles are a speed bump rather than a dead end. In fact, the Inflation Reduction Act of 2022 provides strong financial support for the energy transition in the United States and should help offset short-term headwinds.

For European utilities, the war in Ukraine and the loss of Russian natural gas remain the greatest hurdles. Higher natural gas prices have led to consumer affordability issues and potential political intervention. To date, European governments have managed affordability with power price “caps” and windfall taxes on energy companies. While we find valuations of European utilities attractive, our enthusiasm is tempered by potential fallout from even higher energy prices if weather conditions are extreme over the coming months. Ultimately, we believe that Europe will secure adequate energy resources for 2023 and an acceleration of renewable energy deployment will be part of the solution.

Toll road volumes have shown resiliency with many roads already exceeding pre-pandemic traffic levels. Toll roads are stable businesses with inflation-linked tolling regimes and efficient cost structures. Therefore, we foresee another steady year of operations ahead.

North American railroads are beginning to emerge from the service issues induced by the global supply chain disruption. In 2023, we expect strong pricing gains, which can act as a powerful hedge to inflation headwinds. Furthermore, rising global political tensions have disrupted the supply of essential commodities. We see railroads’ established networks as part of the solution, shipping commodities to meet elevated demand.

Airport traffic saw a sharp recovery in 2022. Pent-up demand for leisure travel has fueled “revenge travel” and businesses are eager to reconnect with customers in person. However, we see signs of a potential slowdown in 2023. Higher prices for jet fuel and airline tickets may weigh on leisure travel, while business travel is likely to face continued competition from video conferencing and corporate ESG objectives.

Midstream energy was the best-performing infrastructure sector in 2022 and we remain constructive on the outlook for 2023. The midstream sector continues to be well-positioned to weather high inflation and commodity price volatility. Midstream balance sheets are significantly stronger and dividend payouts are at sustainable levels. Most companies are at or near targeted leverage metrics and have pivoted to shareholder-friendly capital allocation policies. The sector is more insulated than it has been in prior downturns, which gives us a higher degree of comfort amid an uncertain macro backdrop.

The coming months will undoubtedly present unforeseen challenges, but we expect to find opportunities as well. Based on our current views of macroeconomic trends, industry drivers, and geopolitical risks, we believe our strategy is appropriately positioned. Our objective is to invest in companies with experienced management teams and predictable business models that are positioned for success despite the uncertain economic environment. As always, we will continue to closely monitor global developments through our research and management meetings, incorporating changes to portfolio positioning as warranted.