Building income: why Europe’s infrastructure could boom

The German government’s spending plan, which includes €500bn earmarked for upgrading the country’s ailing infrastructure, is a huge opportunity for the country’s infrastructure assets and could stimulate similar programmes in other parts of Europe.

In March, Germany’s parliament approved chancellor Friedrich Merz’s plan to inject €1 trillion into the country’s infrastructure and defence². About half of that is to be used to renew Germany’s infrastructure³.

Chronic underinvestment

Domestic fiscal spending is a theme playing out not just in Germany but across Europe and the rest of the world. This follows a long spell of underinvestment in electrical infrastructure on a global scale which means there is a huge opportunity.

We are getting to point where people recognise the world is going to be short of power and it takes a long time to bring power on. This means we need to reinvest in the electrical grid because we have underinvested for a long period.

Bipartisan support

Infrastructure tends to garner bipartisan support from governments which could bode well for the sector. This is largely because investing in infrastructure can help drive economic growth, creating jobs and boosting productivity – this could be one reason behind the German government’s deal.

With looser fiscal policy, there is a huge opportunity to take some balance sheet and invest in infrastructure. That was seen a couple of years ago with the US with the Infrastructure Act. It could also incentivise private spending and that is where there is opportunity for listed companies.

Regulatory boost

Europe has been regulation-heavy over the past decade which has, arguably, held it back when competing on the global stage. But the Draghi report published in September 2024^[3] and Europe’s ‘Competitive Compass’⁴ are positive moves towards cutting some red tape to help the region become more competitive.

One area where regulation could help is in incentivising private capital to invest in infrastructure. This could be effective if, for example, regulators were to allow a requisite level of returns on capital employed. It is also possible that governments mandate utility companies to spend a guaranteed amount over a certain period to help facilitate growth.

It is unlikely that returns would change significantly but governments could allow growth to be much higher. That could mean utilities that have grown, say, 4-5% over the past 10 years could grow 10-11% over the next five years – and with that comes earnings and dividends growth. So, businesses that are cheap to begin with on a P/E basis could see growth of 2-3x over the next five years.

In the past 11 months, price-to-earnings (P/E) ratios of US utilities have rerated by 17% versus 3% for their European counterparts. European utilities have been trading at a 31% P/E discount relative to US utilities, which is more than twice as large as the long-term average of 15%.
 

Escaping concentration

As well as exhibiting low valuations currently, European infrastructure equities offer investors diversification from concentration in the US market.  Global equities returns have been led by a handful of large US growth stocks – the ‘Magnificent Seven’ – whose performance has been driven by the promise of future growth from artificial intelligence (AI).

The narrowness of the market rally was even more pronounced in the US, where the Magnificent Seven stocks contributed 29% of the S&P 500 Index’s cumulative 242% return over the 10 years through to 31 December 2024. The substantial weighting of these stocks has posed a challenge for investors relying on the S&P 500 for diversification. Specifically, infrastructure stocks have become notably underrepresented within a typical S&P 500 equity allocation.

For investors seeking greater diversification, we believe it is worth considering the infrastructure sector and specifically, European infrastructure where valuations have not been amplified by the expensive AI power boom.

Portfolio positioning

When it comes to portfolio positioning, roughly half the BNY Mellon Global Infrastructure Income strategy is exposed to utilities. Utilities has historically been the largest sector weight in the portfolio, varying between 30% and 50% since the strategy’s inception. At present, exposure is at the upper end of that range, with about a third of that being in European companies.

Other significant exposure is to midstream energy companies, predominantly in the US. These account for about 20% of the portfolio. These companies, which tend to specialise in gas pipelines, are stable businesses because 85-90% of their revenue is based on the volume moving through the pipe and not on commodity price fluctuations. The price of gas could go up or down, but it doesn’t matter as long as gas keeps going through the pipes.

In addition, these pipeline companies have long-term contracts, and their counterparties are regulated US utilities which means they tend to be creditworthy. And while it is long-winded and costly upfront to install gas pipes, once in place, they just need maintaining which is relatively low cost. They throw off lots of cash and therefore tend to be higher dividend yielding.

Looking ahead, we believe gas will remain a crucial part of the energy transition. Other technologies will evolve but we are far away from any of them being really relevant to that change.

The value of investments can fall. Investors may not get back the amount invested.