The ever-changing nature of investing is what makes it interesting. Our world is constantly changing, evolving — for better and for worse — and the economic forces that underpin returns change with it. Markets develop and reinvent themselves in response to those shifting forces and to innovation that can bring both new opportunities and new risks. As investors, we cannot stand still: we need to adapt to changes in our environment, to capitalise on return opportunities and manage emerging risks. The 2020s promises no respite; in fact, this decade could see change on an unprecedented scale. Investors should prepare for a period of business as unusual.
A new kind of unorthodox monetary policy
In an arena where the unorthodox has become orthodox, it is now threatened by yet another new unorthodoxy: central bank policy. The evolution of monetary policy, quantitative easing (QE) and extraordinarily low or negative interest rates appears to be reaching its effective limits in many developed economies. This means policymakers may need to look for new, and possibly untested, levers to pull on in order to stimulate the economy or hit their inflation targets.
One lever that gets a regular mention is fiscal policy. Fiscal deficits appear to have become more acceptable across the political spectrum over recent years, and the once “risky” suggestion of funding fiscal stimulus by increasing the money supply rather than taxes is more likely to be termed “alternative” or “unconventional” in today’s world. The implications for inflation and inflation expectations are profound if this notion becomes mainstream.
Substantially higher inflation is not our base case. Indeed, it may not even be likely at present, but it is a tangible tail risk, one that may well undermine a growth allocation without sufficient protection from inflation-sensitive assets such as real assets. As a result, it would be sensible to think carefully about how your portfolio might perform in a scenario where inflation expectations move from (their current) stubbornly low levels.
A social license to operate
The theme for the second trend is familiar: sustainability. Over the course of the past few years, the momentum behind investing responsibly, particularly where it relates to climate change, has grown exponentially.
There is a growing awareness among consumers of the environmental and social impacts of their buying decisions and, crucially, an appetite to reflect their values in their consumption. We expect this to influence corporate behavior, because firms that cannot demonstrate that their contribution is leaving the world in a better place (or at least no worse) risk losing their social license to operate — a risk that should be assessed in portfolio construction, and which further supports a case for investing in strategies with stronger ESG credentials.
Climate change is changing the climate for investing
According to the Intergovernmental Panel on Climate Change (IPCC), 2030 is an historic milestone for our planet. If we are to prevent warming above 1.5°C, we need to have cut emissions from 2010 levels by 45 per cent by 2030. The UN has coined the 2020s as the “decade of delivery.” From an investment perspective, climate change is impossible to ignore.
The risks for investors are clear and present. Even if the physical effects of the climate crisis seem to fall outside of an investor’s time horizon — questionable given some of the weather events we are already experiencing — climate policy has the potential to impact portfolios much sooner, independent of any realised physical impacts.
There is a gap between the stated ambitions of the world’s governing bodies to limit global warming and the pathway for global temperatures expected to occur if governments adhere to current environmental policy. We expect this gap to be closed by more targeted policy, as well as consumer and corporate activity, which represents a risk to less progressive carbon-intensive companies and industries over relatively short time horizons.
What gets measured gets managed, and we recommend all investors undertake some form of carbon-footprint analysis to assess their exposure to climate policy risk, and to then chart a course for alignment with global climate targets.
Investing in the 2020s: It’s a matter of time…
In hindsight, the 2010s were an “easy” investment environment, with rallying equity and bond markets driving strong returns. And with QE suppressing volatility, market risk over this period was much lower than the previous decade. However, for the reasons above, the next decade is likely to prove more challenging — now is not the time to give up on diversification.
To address that challenge, you need to first be clear on your timeframe. If your time horizons are relatively short, perhaps exhibit more caution and focus on market and liquidity risks. Those investors with longer time horizons will need vision to understand the evolution of structural trends and the impact of these on markets.
With the possible exception of demographics, structural trends don’t develop in predictable, straight lines. Sentiment spikes and crashes over time, creating opportunities for dynamic investors. In this way, the “long term” is a series of short terms, and investing in structural trends means balancing commitment to a long-term orientation with the need to be opportunistic.
Climate change is no different in this context. We look for clients to employ a process of “de-carbonisation at the right price.”
Change is on the horizon, and where there is change, there is disruption. Be clear on your timeframe, be prepared for business as unusual and position yourself for climate change.
It isn’t a question of whether current economic, political, social and environmental trends will impact portfolios, but rather how and when. It’s a matter of time.
Nick White is global strategic research director at Mercer.