The sharp sell-off in United Kingdom government bonds after the Truss government’s mini budget spooked markets, has underscored the fragility in today’s financial markets. The sell-off also highlighted the importance of credibility in financial institutions, said Craig Mitchell, an economist at the UK’s National Employment Savings Trust, NEST, something that is particularly important given the need to anchor inflation expectations.

Speaking at FIS Maastricht, Mitchell noted that despite rising inflation and interest rates, and a cost-of-living crisis, economies may not experience a long and deep recession because corporate and bank balance sheets are healthier than in past crisis.

He warned that persistent inflation is rooted in the labour market.

“Once you get wages rising, it will stay around,” he said. He also noted that once inflation rises above 3-4 per cent (in the UK it is at a 40-year high of 10.1 per cent) it begins to impact financial markets and asset behaviour.

Mitchell noted how NEST is benefiting from its allocation to real assets in an inflationary environment, for example by tapping rising rental income.

The prospect of stagflation, which is difficult to hedge, is complicating strategy said Harold Clijsen, chief executive of PGB, the Netherlands €34.8 billion ($35.2 billion) industry-wide pension fund. He is currently mulling a balancing act whereby the fund keeps open interest rate risk, but diversifies the portfolio into different strategies in the hunt for return.

PGB’s assets are split 60/40 between a return and matching portfolio respectively. Although rising interest rates and inflation are concerning in the return seeking allocation, they have buoyed the matching portfolio where PGB’s coverage ratio is currently 120 per cent.

The internal team run a dynamic risk hedging strategy whereby when interest-rate risk is low, the fund calculates a lower risk budget and reduces its interest rate hedge; when rates move higher it increases the hedge. At the start of the year around 45 per cent of the liabilities’ interest rate risk was hedged, but this has now risen to around 65 per cent on the prospect of further hikes but where decision making also balances the threat of recession – and lower rates.

Clijsen noted that an end to war in Ukraine will have a key impact on inflation.

“Central banks can do something about demand,” he said, in reference to rate hiking policy. “But we need something else to do something about (energy) supply.”

He said high longer-dated yields threaten recession, yet bringing inflation down also remains key. He added that investors can play between regions to make use of different volatility in a more active stance.

Correlation

Edouard Senechal, senior portfolio manager, SWIB, shared his thoughts on the importance that investors get compensated for market risk. Two key components of market risk comprise volatility and the risk of a correlation between asset classes – particularly bonds and equities which are increasingly moving in tandem because of inflation.

Citing research SWIB conducted last year with other investors, Senechal noted that, “during times of inflation there is a higher correlation (between equities and bonds) and during times of lower inflation there is a lower correlation.”

He added that the pattern was true across most markets and the research drew on historical periods like the inflationary 80s and low inflation during the 90s.

“The correlation has been low and negative for the last 20 years when inflation was low,” he said. “If you look at Japan, declining inflation has led to a decline in the correlation in stocks and bonds.”

Higher inflation leads to more restrictive monetary policy from central banks that is challenging for both bonds and equities with an impact on risk premiums, Senechal continued. He said it is difficult to tell if central banks will get on top of inflation and economies will return to the world we had before, or if inflation remains high creating “a much more difficult environment.”

Panellists noted that central banks ability to control inflation is over-rated. “It’s not clear how much central banks can do,” said Senechal.

If central banks are successful, inflation could go back to 2 per cent by 2025.  Enduringly high inflation will be bad for both equities and bonds as well as asset classes that use leverage like private equity. “There are not many asset classes that can do well in terms of high inflation,” said Senechal.

Expensive equities

Panellists noted challenges in pricing. For example, equities remain expensive, suggesting the market hasn’t yet priced in future inflation scenarios. Moreover, the volatility of short term returns makes it difficult to see if a relationship between asset classes is structural.

Panellists reflected on the importance of robust investment strategies in the current environment. Investors have to weigh whether they want to maximize returns and are willing to take on risk – or minimize the returns they want to achieve.

“Macro uncertainties are much larger than they used to be,” concluded Senechal.

 

A focus on partnering with specialist, differentiated, active managers with help from “the best board in America” has generated more than 200 basis points a year for The Investment Fund for Foundations. Amanda White looks at the fund’s approach to manager sourcing and the opportunities for alpha in a tough investing environment.

“It’s not a good time to try and be a hero,” Jay Willoughby, chief investment officer of The Investment Fund for Foundations (TIFF) says about the investing environment. “My bottom line on this is stick to your ‘home’ whatever that is, stay home, stay at your benchmark or neutral position.”

TIFF which manages $8 billion for more than 500 foundation and endowment clients in the US, offers five different funds all with a 65:35 allocation.

While generally speaking he says it’s a good time to be sticking to your benchmark, since Willoughby took the CIO helm at TIFF seven years ago the fund has diversified away from fixed income and allocated 20 per cent of the fund into a diversified hedge fund portfolio and 15 per cent in short duration.

“We have argued that fixed income is a lousy investment and that is the one thing we are not staying home on,” he says in an in-person interview in the fund’s Boston office. “And that has outperformed meaningfully over the time frame. It’s been a good decision. That’s the one big SAA bet we make against the benchmark.”

Within equities there are some minor deviations from the benchmark including the US (2 per cent underweight), Europe (4 per cent overweight), developed Asia (4 per cent overweight), and emerging markets (2 per cent overweight, made up mostly of a China allocation).

“They are small but clear positions,” Willoughby says.

TIFF has been an aggressive investor in China with an overweight position of 1000 bps going into 2020 which now sits at about 5 per cent.

More recently, beta has been weak in China but Willoughby says the fund’s managers continue to outperform.

“Longer term it’s too big a market to ignore. There is enormous alpha that can be generated there because 75 per cent of the market is retail traders and investors. If you have a serious research organisation that does real research there’s a lot of alpha to be had,” he says. “Coming into this year our managers have generated 600 bps annually, this year we are still ahead about 300bps.”

The value of active management

As long as inflation continues to dominant the market and the Federal Reserve is focusing on getting it under control, Willoughby believes there is risk in the market and it should be a much better market for active managers

“By having all active managers who are really smart, more will be right than wrong over time,” Willoughby says. “We can stay at our benchmarks and still add a couple of 100 bps of alpha each year, which is what history has shown we can do.”

The fund adds between 200bps to 250bps after fees each year.

“It is very much worth it,” he says.

When choosing managers the fund looks for differentiation and hires specialists, for example a US healthcare specialist manager, with 55 of the 65 managers identified as specialists.

“We hire specialist managers everywhere we can,” Willoughby says. “This means when you look through you have the portfolio you want by geography, sector and factor exposures.”

The team keeps a close eye on the sector positions, particularly any underweight position restricting it to 4 per cent.

“I will not allow more than 4 per cent underweight, so the portfolio has some balance. The overweights are conscious so I am less worried about them.”

The importance of manager selection

The fund’s selection process starts with sourcing. The belief is that if investors are to outperform they need to have differentiated ideas, which means a differentiated approach to sourcing.

Uniquely the fund’s board, chaired by Robert Durden, CIO and CEO of Virginia Investment Management Company, is an important access point for this.

“One of the reasons I came here and what continues to be an advantage is that we have the best board in America, and it continues to be, full stop,” says Willoughby of the board that includes the likes of Rick Slocum, CIO of Harvard’s endowment and Kathryn Koch, CIO of public equity at Goldman Sachs Asset Management.

An example of the board’s impact is when the team started researching China in 2014 and made a number of trips to visit managers. They asked board members for recommendations based on their contacts and that led to a number of good manager leads.

Another way the fund looks for managers is to look at who owns the public companies it considers to be good businesses, and to see who owned them before the company was well known.

All the senior members of the investment team at TIFF have invested directly themselves, so they are good at understanding businesses.

The team has an understanding of what it owns and can challenge managers and know when to add to investments or redeem based on an intimate knowledge of the underlying businesses. It evaluates their return streams and the attribution by various sectors, geographies, top holdings, and market cap which is put into detailed investment memos delivered to the investment committee and board.

Willoughby says it’s the team’s ability to ask deeper and more penetrating questions of their managers, and so get better answers, that contributes to TIFF being a better partner.

The average manager holding period is more than five years and some have been engaged for 30 years.

The fund values curiosity, imagination, integrity, independent views and repeatable competitive advantage and for Willoughby it boils down to two key things: a sustainable advantage and alignment of interest.

“We want our managers to have some sort of sustainable competitive advantage and to be able to articulate that. If they don’t have one then we are usually a pass, but if we wanted to hire them it would be because we thought they could do what everyone else does but better,” Willoughby says.

Alignment of interest is important, Willoughby says, not just because it usually means the fees are fair but because of what it says about the portfolio managers.

“Alignment of interest also means there are investors there who love what they do and would probably do it anyway without the money. They want to be the best at what they love to do and do it forever. We are often an early or seed investor because of that. We are not afraid of the track record thing, we think that’s an edge.”

Key elements of ESG integration at Pensioenfonds Metaal & Techniek (PMT), the $112 billion Dutch fund for metal and technical workers, centre around an ongoing engagement program with the oil and gas industry, data gathering, divestment, and working with other investors to coalesce around climate action.

The pension fund has created bespoke equity and bond indexes across all its developed and emerging market liquid allocations, most recently introducing additional screens barring ESG laggards from the indexes and raising the threshold to entry.

All investments are assessed to see if they can be part of the climate solution and PMT is targeting allocating €10 billion to impact investment by 2030. All the while diligently reporting progress back to members, said Hartwig Liersch, PMT’s chief investment officer, speaking at FIS Maastricht.

Data quality

One of the biggest challenges in PMT’s ambitious strategy is data access and quality. Movement and progress on corporate transition plans requires data to assess if corporates are  on a sustainable path and will reach their objectives, explains Liersch.

It’s important to see if companies are transitioning on a path of 2 or 1.5 degrees, and extracting data on corporates’ Scope emissions is challenging. Liersch noted how the war in Ukraine has influenced companies net zero pathways.

“Plans are different to what they thought,” he said.

At NOK 786 billion ($78 billion) Kommunal Landspensjonskasse (KLP), Norway’s fund for local government employees and healthcare workers, strategy is shaped around engagement and working with other investors. The passive investor is systematically shifting from high to low emitting companies and sectors and monitors and cajoles 7000 companies across 50 countries tracking MSCI and Barclays’ equity and bond indices, of which it currently excludes over 200.

In a second approach, fellow panellist Arild Skedsmo, senior analyst, responsible investments, KLP, explained how KLP is also expecting its emissions to fall in line with the real economy.

It’s a strategy KLP supports by trying to influence companies to make ambitious climate commitments and put credible plans into action. Success depends on KLP working with other investors, said Skedsmo.

“We have limited leverage. We need society to work together.”

Alongside influencing corporate behaviour alongside other investors KLP works with regulators and governments to wield influence. Challenges include mobilising this collective force to convince company boards to act; persuading corporates that climate change is also an opportunity, and that investors expect them to make long term transition plans is difficult, he said.

Skedsmo echoed previous comments about the importance of data. However, he noted that it isn’t always necessary to ask for complete data sets. KLP is invested in thousands of companies and tapping top-down portfolio analysis is not always necessary. Focusing on how a company is doing within its sector, using monitoring tools and working with other investors, stakeholders and civil society is sometimes more beneficial – supported by KLP’s own bottom-up analysis of emissions within sectors.

Sovereign engagement

For sovereign bond investors looking to integrate ESG, engagement includes working with governments. Climate change is a threat to sovereigns, said Jens Waechter, senior global macro and research analyst, Franklin Templeton Investments.

“Mitigation is financially beneficial.”

Franklin Templeton invests in global sovereign bonds and corporate bonds in developed and emerging markets. Engaging on ESG issues includes talking “behind closed doors” with governments and addressing challenges within the wider context of ESG analysis.

“As a private investment group, it’s tricky to walk up to an elected government and tell them what they should do,” he said.

ESG analysis comprises three steps, he continued. The investor gathers forecasts on the transition progress of investee countries over the next three to four years. He noted that countries don’t need to be rich to transition.

Although wealthy countries have the resources to transition, progress in emerging markets particularly catches his eye.

“When you see countries with limited means take small steps they deserve as much capital as those countries that are capital rich.” He noted that it is financially more rewarding to invest in countries moving in the right direction.

He noted that investments aren’t possible via tactical allocations, but require an investment case, analysing to what extent sovereigns and companies are improving or backtracking.

Franklin Templeton aims to use robust data sources that draw on a methodology that doesn’t change all the time. Waechter noted how in many cases, plans corporates make around net zero are aligned with sovereign progress.

Assessing Singapore’s commitment to net zero by 2060 involves understanding what the policies are and the State’s capex plans in a way that will offer insight on corporate net zero progress too.

“This is macro data, and it is very important to get it – we can’t create it ourselves,” he said.

He also noted the importance of finding a general trend rather than seeking to unearth every detail, focusing on which key indicators to follow.

 

Europe must prepare for recession and negative economic growth, warned Clemens Kool, Professor of Macroeconomics and International Monetary Economics at Maastricht University, speaking at FIS Maastricht.

The spike in energy prices has had the biggest impact on European inflation, said Professor Kool who is also chair of the academic board at Studio Europa Maastricht. Central banks have been pushing to exclude variable items like energy from the inflation basket, yet energy and food are the most important signals of inflation.

“Energy prices are volatile and an important component of the total basket,” he said.

Moreover, energy has an impact on the supply and demand side of the economy. Energy impacts the input prices for key goods and is an increasingly large part of demand in the consumption basket.

“Energy is influential as a driver of other prices,” he said, adding that inflation comes from too much demand chasing too little supply – at which point fiscal and monetary policy attempts to break demand.

Wage spiral

When demand and supply interact, it can cause a wage price spiral.

Prices are currently rising so fast in Europe it is triggering a wage price spiral. People in work are experiencing a cost-of-living crisis and demanding pay rises. Firms must go along with it because of the scarcity of labour, in a vicious circle that translates back into prices and a new round of wage increases.

Anchor

Central banks have a vital role anchoring inflation expectations. Policy promises to maintain inflation close to 2 per cent helps anchor inflation expectations. But if central banks fail to convince people they are serious about anchoring inflation, the spiral continues leaving central banks with more difficult choices, he said.

Kool said that Europe has not tipped into recession yet. Mostly thanks to robust private demand and the lingering impact of expansionary monetary and fiscal policy as economies continue to come out of the pandemic.

The more inflation expectations edge higher, the harder it gets for policy makers. It is key to ensure expectations of inflation stay as low as possible and is particularly “crucial” for financial and labour markets. Expectations play such a big role, once high inflation is embedded in peoples mind it is difficult to dislodge.

Positively, he predicted that prices will gradually shift lower as energy demand drops off. However, tightness in energy supply will continue for as long as it takes Europe to find alternative sources of energy either nuclear or green, sustainable energy.

Kool said the ECB is reluctant to change its inflation benchmark. However, he noted that the Federal Reserve has a more flexible approach – raising the target is more likely in the US than Europe. He said statistically, inflation looks like it will remain high because it mostly derives from the energy squeeze.

Expansionary policy

A key challenge is the fact monetary policy in Europe is still expansionary. High inflation in the 1980s was also characterised by high interest rates. In contrast, although interest rates are rising today, they are still close to zero. Liquidity remains in the market because QE is still pervasive. It leaves central banks with a challenging balancing act – raising interest rates and taking out liquidity. For the ECB this will involve difficult policy decisions that suit northern and southern Europe.

“The ECB has to think about tensions between northern and southern Europe; raise rates and the gap increases,” he warned.

Kool said it remains unclear whether liquidity in the system will be reduced – the ECB can still buy government bonds – sentiment in the bond market [that they will] remains optimistic. The most likely outcome ahead is stagflation. He questioned whether Europe is poised to enter a long period of low or no growth but said that recession is likely.

“How long or deep is difficult to say. My crystal ball is no clearer than yours.”

It was in 2020, a few months after the start of the Covid-19 crisis that Klaus Schwab, executive chair of the World Economic Forum, called for The Great Reset – a clarion call for the world to act ‘jointly and swiftly’ to revamp all aspects of our societies and economies.

Saying the tool to do this is stakeholder capitalism – and fundamental to this is a much-needed transition to a ‘fairer, more sustainable post-COVID world where companies have a responsibility, and a rare opportunity, to rethink organisational and workplace structures and to invest in their workforces’.

Over the last decade or so, conversations around the future of work have been largely linked to job automation. However, the pandemic has rapidly widened this conversation to also include where we work, how we work and the ways in which workplaces and the workforce is organised.

It has also had a big impact on employee-employer dynamics – effectively the give and the get – with more employees demanding improved flexibilities and employers struggling to catch up.

With productivity and organisational culture on the line, leadership engagement on the topic has mushroomed. The focus has often been on emblematic issues such as hybrid working, shortened work weeks and the redesign of workspaces to create more magnetic offices. However, there are some wider themes which we have observed through our work with investment organisations:

1. The hybrid work journey remains messy

It is clear that the future of work is hybrid. In a CFA Institute’s survey on the future of work, 81 per cent of investment professionals stated that they would like to spend more time working remotely, with employers having to rapidly adapt to meet this demand through more flexible working policies.

However, hybrid design needs strong execution, with value being currently derived through considering social interactions, space utilisation and time optimisation and future value being developed through the presence of networks, relationships, shared norms and trust. There is a real opportunity here to think about what hybrid working actually means, with better policies involving a degree of co-creation with employees and where work is adapted based on location, synchronicity and connectivity needs.

Part of the hybrid challenge isn’t just about getting employees into the office – it’s also about making the most of their time. Microsoft’s latest Work Trend Index notes that despite the fact that 44 per cent of hybrid employees and 43 per cent of remote attendees don’t feel included in meetings, just 27 per cent of organisations have established new hybrid meeting etiquette to ensure that everyone feels included and engaged. Leaders need to make the office worth the commute and employees now have different expectations as to what the office experience should deliver. Social capital and the value that it adds through collaboration, belonging, trust and goodwill should be seen alongside human, intellectual and financial capital in organisations as a key enabler of value creation. Innovation is also powered by social capital. So the challenge for leaders is to reconfigure their workspaces to prioritise social engagement and set aside time for in-person activities where interaction is facilitated.

2. While talent is everywhere it is unnecessarily scarce

We are in the midst of The Great Reshuffle – a term broadly used to describe the mass movement of workers seeking roles that better meet their work/life requirements and/or are better aligned with their values.

US academic, Anthony Klotz – who coined the forerunner term The Great Resignation – notes that individuals are now seeking opportunities that allow them ‘to fit work into their lives, instead of having lives that squeeze into their work’.

Talent is dispersed globally and there is an opportunity here for leaders to become more creative in using global talent and to think about how it can be used to create a more agile and distributed workforce. The shift to a more networked structure requires moving from traditional approaches where employees are boxed into projects based on their current job role to a more holistic, flexible approach which matches employees’ varied skillsets to relevant projects. This requires the collection of more data on employee experiences, a better understanding of a workforce’s skills and embracing technological innovations that allow teams to work in more global and continuous real-time ways.

With in-person time being reduced, we also find that the T-shaped qualities of people and teams becomes more valuable in the new world of work. T-shaped individuals and teams seek to connect dots better through building inner ties and developing outer networks. There is a real opportunity here for leadership to transform existing teams into superteams – by combining diverse and talented individuals within a strong culture and having excellent governance – to deliver exceptional outcomes.

3. The rise of the human-centric organisation

The COVID-19 crisis has been a defining leadership and transformation moment, where leaders have been called to reset their future of work agendas and lead the way to better and more human-centric workplaces and workforces.

We are now in the era of human-focused company culture where workers are re-evaluating what matters most to them. This has prompted employers to focus on the wellbeing and personal satisfaction of employees though increasingly flexible work arrangements, investing in wellness programs and boosting diversity, equity and inclusion efforts.

LinkedIn’s 2022 Global Talent Trends survey notes a 147 per cent increase in the share of job posts that mentioned wellbeing since 2019 and a 73 per cent increase in companies’ posts about wellbeing. According to the survey, employees that feel cared for at work are 3.2x more likely to be happy at work and 3.7x more likely to recommend others to work for the company. The same survey notes that work-life balance trumps even bank balance for job seekers.

Productivity is multi-faceted. Work has long shifted from simply a function of time, activity and effectiveness and viewed solely through the lens of the value delivered to the organisation. Instead, the employee value proposition has become more central and includes work flexibility, work/life integration, personal growth, employee experience and wellbeing. There is an increasing appetite for a new leadership model to deal with these challenges that is less hierarchical, more networked, more versatile and is driven by more soft power. This new model needs to encourage empowerment, joined-upness and humanism with positive stakeholder outcomes at its core and which champions connections and collaboration while focusing on behaviours.

It’s a juggling act.

Successful work design in this new world will require finding a fairer balance between employee and organisation, where employees crave flexibility and meaning and employers require productivity, impact and a culture that aligns with its purpose.

A key ingredient of success will be an emphasis on how work is done. This is the sweet spot where organisation and employee can meet around belonging and teamwork at the same time as values and expected behaviours. Finding this balance will require some juggling and enlightened leaders will need to think deeply about these wider themes.

Marisa Hall is the co-head of the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.

The historical undervaluing of water as a resource, combined with climate change, is impacting communities around the world and posing a systemic risk to investor portfolios.

Water deserves the same attention from investors as climate and the growing water crisis poses a systemic risk to portfolios around the world, argued Brooke Barton, a key figure behind the Valuing Water Finance Initiative which has gained the backing of dozens of the world’s largest institutional investors.

Humanity has underestimated the degree to which climate will be a threat multiplier to freshwater resources, said Brook Barton, vice president, innovation and education at the Boston-based non-profit sustainability advocacy organisation Ceres.

Climate change is driving the hydraulics cycle, or water cycle, into overdrive and increasing the intensity and frequency of droughts and floods, she said, speaking at Conexus Financial’s Sustainability in Practice forum held at Harvard University.

This has disproportionate impacts, with 2.1 billion people currently lacking access to fresh water on a reliable basis. Recent examples in the United States include the flooding of a water treatment plant in Jackson, Mississippi which has led to an ongoing public health crisis.

“We have now weeks of residents either without water or on boil water notice in a predominantly black city,” Barton said.

Barton said one of the more compelling and simple statistics that illustrates the importance of water is that the average human can only live without it for three days.

“Water and water risks that we are seeing across the world run really fundamentally to the survival of the human species in the near term,” Barton said. Despite this, “we have countless examples of mismanagement and a general tendency to undervalue this resource,” she said.

Companies are finding it increasingly challenging to grapple with water issues in various geographies where there is either too much, too little, or it is too dirty for industries dependent on extremely clean and safe water, she said.

Conflicts are emerging between the rights of companies to water, versus the rights of people and farmers, she said, pointing to Coca Cola’s groundwater pumping in India, Barrick Gold’s closure order and sanctions in Chile, and the impacts on shipping in Europe due to low river levels.

However investors still tend to view water risk as an idiosyncratic risk specific to certain locales, geographies and sectors, rather than a more systemic risk to portfolios, she said.

In response, comprehensive data sets are emerging on corporate disclosure, driven by the CDP. And Ceres in conjunction with the Center for Water Security at the University of Saskatchewan has released the first comprehensive scientific review of corporate water impacts on freshwater.

Ceres is coordinating the Valuing Water Finance Initiative, partly modelled on Climate Action 100+, where institutional investors are committing to engage with the world’s 72 largest corporate water users to convey six expectations around water risk management and stewardship.

These expectations align with the United Nations’ 2030 Sustainable Development Goal for Water, and actions laid out in the Ceres Roadmap 2030.

The initiative was launched with 64 signatories representing US$9.8 trillion in assets under management.

An associated framework for assessing corporate progress against these expectations will soon lead to benchmarking, Barton said.