The climate emergency, China and Federal Reserve policy pose the most systemic investor risk ahead according to Stephen Kotkin, Professor in History and International Affairs, Princeton University, who said a dramatic misstep from the US Federal Reserve could cause a massive dislocation.

Stephen Kotkin, more known for his expertise in geopolitical risk, says a dramatic misstep from the US Federal Reserve could cause a massive dislocation. He said Fed policy is currently being pushe by the bond market, and policy makers do not seem to have an inflation policy. It’s a key risk from an unfamiliar source, he said.

“If the Fed doesn’t understand how the economy works it is a major risk, particularly given the depth of its involvement in markets. The Fed is the most important global institution, and if it starts to cause havoc it will be bigger than the climate crisis or China,” he says.

Moreover, he questioned if inflation was transitory given one seventh of global goods are currently trapped and undeliverable in the supply chain crisis.

“If inflation is caused by supply chain problems; supply chain problems are not transitory.”

“We are moving to a more significant inflation figure than we had in past,” said Eric Nierenberg, chief strategy officer, at US pension fund Mass PRIM in discussion with the professor. Mass PRIM has shaped a resilient portfolio across a mix of assets and uses a variety of quant tools to build in robustness. As well as long duration treasuries, Mass PRIM has real estate and other assets that weather inflation better than others, he said.

Kotkin said economics and monetary policy are in a state of flux and urged investors to make understanding risk a “much bigger part” of their portfolio construction. He said many institutional investors are already putting risk front and centre rather than “at the end of the process,” but added that risk is both an opportunity and problem to be managed. “There are opportunities in dislocation and opportunities in proper risk management. Investors may find new opportunities they didn’t foresee.”

Kotkin also flagged additional risk in America’s political landscape, calling Biden “incompetent.” The withdrawal from Afghanistan and his failure to pass the infrastructure spending plan or reduce emissions are some examples, said Kotkin – although he credited Biden for rolling out the vaccine. He said Biden was “governing from the left” and that recent Republican gains in Virginia show the political terrain is shifting once again. “For those worried about the Biden presidency being over, there is little time to rescue the situation,” he concluded.

Climate risk

Reflecting on COP26 in Glasgow, Professor Stephen Kotkin is pessimistic that it will achieve much, arguing the world’s current approach to managing climate change is broken and won’t deliver a carbon price or green the grid.

Speaking at FIS Digital 2021, he drew delegates’ attention to how the climate chaos and emergency is only getting worse: energy shortages in countries that have done most to green their economies and a refusal to invest in fossil fuels as energy demand rises, a lack of investment in a grid that can’t manage renewables at scale and Australia and China both expanding coal production despite commitments to net zero – to name a few.

Kotkin said that the more activists’ push, the more insurmountable the challenge of limiting global warming becomes. He also noted how investment in commodities that are vital for the transition like copper and aluminium has stalled on misplaced ESG sentiment.

“We need more copper to stop global warming,” he said.

Kotkin said pervasive greenwashing is a consequence of the lack of carbon price, or a pathway to invest in the Grid.

“Greenwashing requires looking in the mirror,” he told delegates.

He said COP26 was destined to produce unintended consequences and expressed an urgency to try something different. The one ray of hope from the conference is globally accepted sustainability accounting standards that will help push back on green washing.

China

Turning the conversation to China, Kotkin said the re-pricing of China-related risk is now underway. China risk comprises the demographic shortfall and the country’s need to transition to a consumer-driven economy to make a leap to a high-income country. Investors in China also face considerable ESG risk and are struggling to align allocations to China with their ESG goals.

“ESG makes investing in China more difficult,” he said. He also touted the possibility of US / China conflict.

Kotkin said China may overcome its demographic shortfall, step over the middle-income trap and sort its current battles between the Communist Party and the private sector. However, he said it was unknow if China would become a source of stability and growth, or a source of global instability.

He said the US was awakening from a long-held delusion that “China would become like the US politically as it grew economically.”

He said China needed to figure out what it needed to do to transition to the next phase of economic growth, and the US needed to figure out how to manage China’s rise without conflict. He said the role of countries like Australia, Japan and India would be vital in managing China; understanding China is part of the world, but also standing up to bullying.

Kotkin’s view is that China can’t be contained. Instead, policy makers have an essential role in stopping tension turning to conflict.

“People need to rise to the occasion to manage tension,” he said, citing the importance of engagement and showing China red lines but also finding common issues in a relationship balanced on deterrence, engagement and ultimately diplomacy.

 

Sarah Rundell is a staff writer for Top1000funds.com based out of London. She writes on institutional investment across all asset classes, global trade and corporate treasury.
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