PAVE: Time to Brake (BATS:PAVE)

The Global X US Infrastructure Development ETF (BATS: PAVES) is one of the more interesting thematic ETFs I’ve come across recently.

PAVE seeks to take advantage of opportunities in infrastructure. It became increasingly apparent that United States have a lot of outdated, substandard or dilapidated infrastructure in areas such as bridges and highways, ports, water systems, etc. There’s reason to think federal, state and municipal governments could put more tax dollars to work. in infrastructure spending over the coming years to help address these shortfalls, while helping to promote jobs and provide a boost to local economies.

Specifically, PAVE invests in a variety of industrial, technology, materials and utilities companies that should thrive on increased infrastructure projects. The portfolio is broadly diversified with 100 different holdings in total and no book positions for more than 3.81% of the entire portfolio. Holding companies include construction and engineering companies, raw materials, transportation, construction equipment, and so on.

While many thematic ETFs struggle to gain much market attention or trading activity, PAVE has built a good shareholder base. As of this writing, it has over $7.8 billion in assets under management. Performance has certainly backed this up, with the ETF up 25% over the past 12 months and 134% over the past five years.

Positive tailwinds are now set to fade

And this is where my less favorable medium-term outlook begins to take shape. Industrial stocks in general and infrastructure plays in particular have enjoyed several favorable macroeconomic factors in recent years, leading to outperformance. I expect these to reverse in the coming months, which will likely cause PAVE to give back some of the recent gains.

When thinking about performance, PAVE has two distinct periods. Since 2017, when the fund launched, PAVE has generated about the same total return as the overall S&P 500 — and significantly outperformed the market from 2017 until the start of the pandemic. However, as of early 2020, PAVE has surpassed both The Industrial Select Sector SPDR Fund ETF (XLI) and the S&P 500 quite dramatically:

It is interesting to note that the Industrials ETF has quite a different portfolio mix than the PAVE ETF. As of this writing, XLI and PAVE have just one stock in common among their top 10 holdings, meaning there is real differentiation here. This has allowed PAVE to outperform considerably as investors have been stuck on infrastructure for the past four years.

You could also reasonably argue that some of the top 10 industrial ETF holdings at the time of writing, including Automatic data processing (ADP) and Uber technologies (UBER), are not excessively industrial in nature. Perhaps PAVE’s holding mix will sustainably generate more alpha over time than the broader industrial sector ETF. That could be especially true if the broader theme around revitalizing the nation’s infrastructure keeps pace.

However, my view is that the industry as a whole is entering a difficult time, macroeconomically speaking, and that PAVE holdings in particular are not well prepared for a lower interest rate/slow economy environment.

Risks on the horizon

Infrastructure investment is the clearest beneficiary of government spending in the sector. The Biden administration has been quite helpful to infrastructure companies. Policies such as the Infrastructure Investment and Jobs Act and the Inflation Reduction Act have authorized large amounts of spending on transportation projects, clean water and broadband Internet access, and renewable energy production, among other priorities. Meanwhile, the CHIPS and Science Act provided considerable financial support for semiconductor companies building new foundries and manufacturing facilities in the United States.

With President Biden set to finish his term soon, it is unclear whether the next administration will continue such spending on infrastructure projects. As noted above, infrastructure stocks generally underperformed the S&P 500 during the previous Trump administration.

Meanwhile, Deutsche Bank recently warned that Vice Chairman Harris’ proposals, such as a tax increase on corporate buyback programs and stronger regulation of energy producers, could impact industrial companies. That memo specifically highlighted that companies that generate more revenue in the United States would face a higher tax burden if Harris’ plans were implemented. This could be particularly impactful for companies that generate much of their sales by building and maintaining infrastructure and logistics assets in the United States. The Deutsche Bank analyst noted that companies like it Trane Technologies (TT), PARKER HANNIFIN, (PH) and Emerson Electric ( EMR ) — all top PAVE holdings — could be disadvantaged by these assorted proposals.

I am also concerned about the impact of interest rates on infrastructure stocks. First, higher interest rates tend to have a significant lag before they really impact real economic outcomes. This is because it takes some time for projects to move from the design and scoping phase to getting approvals, financing and actually putting shovels in the ground.

US industrial activity has remained strong in recent quarters despite higher interest rates. However, I suspect that we will really start to see the effects of higher rates in terms of reducing capital expenditure projects in the next year or two as companies cut back on new discretionary spending. Given the significant slowdown in homes, cars, appliances, and so on, it is not difficult to foresee a significant deceleration in industrial spending related to these industries in due course.

There is also a flip side to the interest rate coin. Arguably, investors have recently paid less attention to dividend yields for many stocks, given the abundance of higher-yielding fixed-income options over the past couple of years. Until recently, sectors like telecoms, utilities and consumer staples have underperformed, likely in part because investors didn’t need their dividend streams to generate income.

This, in turn, was a favorable development for more growth-focused funds such as PAVE, which pays a low dividend yield:

In a potentially recessionary macroeconomic environment with declining interest rates on certificates of deposit and government bonds; however, I suspect investors will be less keen to own ETFs that yield just 0.6%.

The final point I would raise is that I suspect that federal government spending may need to be reduced because of the US’s more challenged fiscal position:

Before the pandemic, the federal government ran an annual deficit of 3 percent to 4 percent of GDP. This shifted to a double-digit GDP deficit in 2021 and 2022 as economic activity was disrupted, meanwhile the government authorized massive stimulus programs (including infrastructure spending) to revive the economy.

However, the deficit never returned to previous levels. Despite a strong economy, it was not enough to close the fiscal gap. With the deficit now exceeding 6% annually, spending capacity is significantly tighter. To the extent that the optimistic infrastructure thesis relies on government borrowing to build things, it will be much harder to finance in the future than it was a few years ago.

PAVE’s conclusion

Infrastructure spending has been an excellent investment theme in recent years. There were understandable reasons for stimulus spending to help the economy recover from the pandemic, and infrastructure companies enjoyed a substantial piece of that pie. Meanwhile, developments in the semiconductor and artificial intelligence space have helped fuel large investments in technology manufacturing in the United States, giving the sector an additional boost.

However, I expect the combination of the impact of political and fiscal policy, declining government infrastructure funding and the interest rate environment is likely to limit upside for the sector, and therefore PAVE shares, over the next few years. While PAVE has dramatically outperformed in recent years, it has performed roughly in line with the S&P 500 over the long term. Thus, some reversion to the mean can be expected in the coming months.