Raghuram G. Rajan, Professor of Finance, University of Chicago Booth School of Business and former Governor of the Reserve Bank of India, gave delegates at the Fiduciary Investors Symposium, held at the business school, encouragement that the Federal Reserve does have inflation under control.

Rajan argued that central banks are most concerned about inflation getting entrenched in everyday products. From here it can bleed into salaries and is hard to bring down. However, he said the five year, five year-forward rate for inflation, a bellwether of future inflation rates, suggests inflation will come down and that it is contained.

“There is a sense the Fed has it under control,” he said.

Wage agreements will push costs further for companies, creating another reason for companies  to raise prices. However he said the Fed will continue raising rates at the short end and shrink its balance sheet at the long end. The heat will come off the labour market and he predicted the job to unemployment ratio will start to come down. Elsewhere, demand will begin to fall and he said supply chains will not be snagged for ever.

In defence of the Fed, Rajan said that policy makers have acted with aggression. They didn’t act earlier for political reasons. The Fed wasn’t hitting its inflation target, and once inflation started to appear, it didn’t want to kill it: the Fed only acted when inflation was sustained and above its target, he said.

tight labour market

Reflecting on the tight labour market, he noted that during the pandemic participation rates fell. However, people have now come back into the work force in every group in the US except the over 64s. He said companies are facing a skills mismatch whereby the most acute labour shortages are tied to particular sectors and regions, but he said the primary tightening force is the slow down in immigration. Positively, maximum unemployment levels are only inclusive at the end of the cyle: minorities are typically hired at the end of the cycle.

He said wages are starting to increase and inflation is now moving from goods to labour markets in an inflationary process also stoked by war in Ukraine, with the crisis in Ukraine putting supply chains under further pressure and fuelling commodity prices. He noted how war in Ukraine and the lockdown in China will also have a stagflationary impact, slowing growth but also increasing inflation. Still, he noted differences between regions. For example, the labour market is not as tight in Europe; Japan still has very low inflation.

What lies ahead

Rajan said the effect of recent central bank policy is already beginning to emerge. The rise in the dollar has begun to impact exports; he noted the loss of wealth in financial markets, particularly hitting crypto and games stocks.

He said as more is spent on fuel, less will be spent on other goods and services, slowing down consumption.

“As things slow down most people tighten their budget.” However, he doesn’t believe economies are heading for a recession, and said recession is unlikely in the near term.

He reassured that banks are well capitalised across the world. However he flagged that in the shadow financial world, it is less clear which new finance companies have leverage and risky exposure.

Rajan said that the underpinnings of growth have not changed. For sure, falling levels of immigration and deglobalisation will continue to have a negative impact on growth, but he expects the economy to return to pre-pandemic, albeit slow, levels of growth.

He said the Fed has done enough for its policies to start to bite and policy makers will be in a much better position to gage the impact of strategy at the end of the year.

“Monetary policy works with lags before it fully kicks in,” he said. He said if the Fed was still having to go further by the end of the year recession would look more likely.

“If inflation is coming down steadily they may pause, but if inflation is not coming down it will go for a while longer.”

Once inflation is back under control the growth scenario will be no different to what it was before the pandemic.  If inflation doesn’t come under control it will lead to higher nominal interest rates with an impact on portfolios, particularly affecting organisations with highly levered balance sheets. He warned of toxic consequences if high levels of leverage combine with asset declines.

“The increase in leverage in the last few years is something to worry about.”

He said the aging labour force makes immigration increasingly compelling, and a positive force. He also noted how climate change is increasingly feeding into immigration trends. Rajan concluded that climate change is an opportunity for investors and policy consensus is essential to drive investment.

In a panel session at the Fiduciary Investors Symposium at Chicago Booth School of Business, Stephen Kotkin, The John P Birkelund Professor in History and International Affairs, Princeton University, cited the many risks inherent in investing in China.

Kotkin explained that Europe and China’s trade partnership has been damaged by a souring relationship. A trade deal negotiated ahead of Biden assuming the US presidency has floundered and since Russia invaded Ukraine, relations have grown worse still. “Xi is siding with Putin and pushing Europe into the arms of the US,” said Kotkin. In so doing, China has destroyed the wedge it had opened and today Europe and the US are strongly aligned on China policy.

Investing in China holds key challenges for investors. Demography will crimp economic growth and China remains in the middle-income trap. Countries find it hard to rise from middle-income to high-income and success depends on a strong, broad-based education system. China has only developed a high-end education system in its capital cities, leaving hundreds and millions of people without an education. Kotkin said China has begun to invest in its schools at a regional level, but these vocational schools lack qualified teachers.

Kotkin said investment no longer has the ability to shift the Chinese economy to a consumption driven economic model supported by local consumer demand. “The high investment model has hit a wall,” he said. Moreover, China will not solve its problem via governance.

The communist party has clamped down on the private sector. Liberalization threatens the communist system, beginning a process that questions the monopoly of the party. Although the party could reform economically and allow the private sector to flourish, independent sources of wealth and power threaten the Communist system.

He noted how the government is trying to encourage private sector growth at a low level, supporting small entrepreneurs. Kotkin referred to economic growth in China as an output not an input: the party says what it will achieve – and if it doesn’t achieve it, the regime lies.

Kotkin added that it is difficult for ESG investors to invest in China. Chinese policy towards the Uyghur population in the north-western region of Xinjiang, Tibet, Taiwan and Hong Kong doesn’t sit easily with ESG investment. Regarding Taiwan, Kotkin said that the status quo is tipping away from China given the majority of Taiwanese no longer identify as Chinese in a shift accelerated by the younger generation. He noted that China’s strategy is to integrate Taiwan economically to gain political integration. China’s strategy will focus on economic coercion, and the regime is watching how the west is applying economic pressure on Russia.

He noted that the Chinese regime will “not wait for ever” as Taiwan moves further away from China in its identity and politics.

Kotkin said that even if some of these assumptions are incorrect, investor returns in China do not equate to the risk. “Are you satisfied that the risk premium is good enough?” he asked delegates.

He noted how investors and companies are starting to move in multiple directions. Some investors see China as a one-way bet; a story of high returns and growth while financial firms are tempted by the level of savings in China. However, he noted how an increasing number of firms are diversifying their supply chain away from China. Some companies, like Apple, are particularly vulnerable to China. “If China stops working, Apple goes up in smoke,” he said.

FIS delegates reflected that they have more confidence in private-sector investment in China than public sector investment. Elsewhere, others argued that owning Chinese government bonds could be an effective and lower risk strategy to gain exposure to Chinese growth – but would require living with the ESG risk. “You could buy bonds if you can keep quiet,” said Kotkin.

Elsewhere delegates discussed the idea that China will ultimately emerge from the middle-income trap. In this way, buy-and-hold strategies could work in an approach structured to benefit over the long term. In this approach, investors should remain humble, remembering the Fed has also got it wrong. In another approach delegates talked of the importance of engaging. For example, the PRI has worked with Chinese companies involved in BRI construction.

Ukraine

Turning the conversation to Ukraine, Kotkin articulated the challenges that lie in the way of a Ukrainian victory.  Russia has a stranglehold on the economy, leaving Ukraine with no government revenue to meet its payroll commitments while the current aid packages will soon run out. “The stranglehold on the Ukrainian economy will be expensive for western taxpayers,” he said.

Russian troops will have to be evicted, yet evicting Russian troops involves going on the offensive, requiring new skills in the army. He said it could become apparent in July and August if the Ukrainians are able to go on the counter offensive.

Moreover, Western unity is fragile. For example, Hungary has not agreed to the recent oil embargo; Turkey has thrown a spanner in the works of Finland and Sweden’s plans to join NATO. Lastly, Kotkin noted that sanctions have consolidated the Putin regime. Still, the most effective sanction is technology export controls, slowly strangling Russia’s ability to access software vital for its military industrial complex.

 

 

The private credit market is starting a new sixth cycle, said Victor Khosla, founder, SVP Global, which manages around $18 billion across the asset class. Khosla said key factors that suggest the market is in the early stages of another cycle include high yield spreads widening over treasuries and the fall in equity markets.

It has led to the emergence of opportunities in selective areas, with the expectation that more will start to appear in the next three to six months. The size of the opportunities will depend on whether the economy enters a full-blown recession or not: if this cycle bites, and Khosla believes there is a fair chance it will, he expects an 18–24-month recovery.

In a reflection of the growth in the number of deals coming across the desks of SVP’s 65-person team, he said experts are now working on around 55 deals, up from 13 in January 2022.

Recent deals reflect specific characteristics of the current economic climate. For example, earlier this year SVP bought Associated Materials, a building products company and a market leader in vinyl windows, vinyl cladding, and metal siding and trim. Hit by higher raw material costs, the business failed to respond in time by raising its own prices; cash flows fell, and the owners got anxious. “We stepped in to buy the business,” said Khosla. Now SVP Global is working with the company to drive change, building a new source of value creation. “We can see the early fruits,” he said. Describing the acquisition as an attractive control investment, he expects similar opportunities ahead given the economic environment.

European opportunity

Khosla believes Europe may hold the most compelling opportunities in private credit in the coming months. Many European economies were weak before the pandemic and the European banking system is still laden with debt. He cited estimates of over €1 trillion of bad debt sitting on European bank balance sheets by the end of 2022 – much less than the debt on the balance sheets of US banks. “We expect Europe to hurt more in this cycle,” he said.

Although Khosla said opportunities are unlikely to focus on specific sectors, he noted that industrialised businesses subject to inflation in raw materials (like Associated Materials) might suffer more than others and run into problems with liquidity. “Some business can pass through price rises, but many can’t.” He noted how some power generation businesses are struggling and said that real estate is also going through a correction that will take a few years to play out.

SVP is distinct from rival investors specialising in private credit because around 30 per cent of its capital is invested in control deals whereby the manager takes a majority equity control of the business, directly getting involved in fixing and improving the company. This element of control makes SVP’s investments less cycle dependent and more evergreen. Indeed, some of SVP’s best historic returns haven’t come as part of a private credit cycle. When SVP Global is a majority equity owner it is also easier to push through ESG criteria, he said.

Late Exit

Another key characteristic of today’s market is difficult exits: challenging market conditions are delaying exits and monetization. Khosla said that SVP owns businesses today that are ready to exit, and if markets were stable, these businesses would be sold. “We are not selling; we are pulling back.” Khosla concluded that SVP has made progress hiring a more diverse workforce, recruiting more women and minorities. “The way we recruit has changed,” he said.

 

 

A push towards standardised data and more appropriate incentives is bringing more private sector capital into play on the path towards net zero emissions by 2050.

The world is approaching an inflection point on climate investing, says the Asia-Pacific chair of one of the world’s largest asset managers, with developments on standardised data and appropriate incentives that are speeding the pace towards net-zero emissions.

Ben Meng, chair of APAC at asset management giant Franklin Templeton, which has around $1.5 trillion of assets under management, pointed to the International Atomic Energy Agency’s estimate that it will take energy investment of $5 trillion every year to achieve 2030 climate goals on the path to net zero.

Given the high level of public indebtedness, the majority of this estimated capital will have to come from the private sector, but fortunately there have been strong developments in the areas of information and incentives that are bringing the private sector to the table, Meng said.

Speaking at Top1000funds.com’s Fiduciary Investors Symposium held between May 23-25 at the Chicago Booth School of Business, in a panel discussion on climate strategy and net zero portfolios chaired by Conexus chief executive Fiona Reynolds, Meng said strong climate risk data will be needed, and welcomed the International Chamber of Commerce’s proposal to make climate risk disclosure mandatory.

“Climate data needs to be regulated, just as financial data has to be–you know, comprehensive, reliable, timely, auditable,” Meng said. “With investment grade information, Wall Street, or the private sector is fully capable of developing the analytics so that the investor can do a risk and return trade-off analysis.”

Investors also need incentives, Meng said, and the removal of disincentives. The United States should get rid of unnecessary fossil fuel subsidies and put a price on carbon, he said.

“Put a price on carbon, let it be taxed, or carbon pricing as the private sector prefers, so any investment I make in reducing carbon emissions, I can turn that into the carbon pricing market to capitalise on that,” Meng said.

With mounting action on these two fronts of information and incentives, and with Europe considering a border carbon adjustment tax which could have ripple effects globally, Meng said he believes the world is approaching an “inflection point” on climate investing.

Also on the panel was Ariel Babcock, head of research at Focusing Capital on the Long Term, a global not-for-profit research organisation backed by members including asset owners, asset managers and multinational companies. FCLT does evidence-based work to help better focus capital on longer-term investment horizons.

Babcock said climate came onto her organisation’s agenda in recent years after hearing from a growing number of members that they were under increasing pressure to make net zero commitments and rapidly decarbonise their portfolios with divest and exclude policies.

“From our perspective, that approach was very short term in nature,” Babcock said. “It produces paper decarbonisation that hasn’t actually changed the real world or done anything different for the planet.”

Organisations focussed on decarbonisation often struggle with collecting all the data required, she said. Even for those who get a full picture of their current carbon footprint, they aren’t always sure where to go from there.

The process begins with clarifying investment beliefs, then thinking about risk appetite, then selecting appropriate benchmarks and making sure your evaluations process and incentives are aligned with those benchmarks, Babcock said. Finally investors can think about how they might incorporate some of those beliefs and risk assumptions into their investment mandate and contracts with external advisors.

Hard questions investors may need to ask are: What is the competitive advantage gained from investing in new technologies? Are you getting appropriately compensated for the risk you are taking on, or are there some uncompensated risks? Will near term emissions go up in the portfolio as you acquire new assets and put plans in place to clean them up? Transparency on these matters is crucial, he said.

“The things we were also hearing that were tripping people up in starting to implement and move towards a decarbonisation objective was sort of making sure that there were very clear lines and very clear communication,” Babcock said. “Being really transparent up front with your stakeholders about the fact of that, right from the beginning, is really important.”

Aaron Bennett, chief investment officer at Canada’s University Pension Plan – a new asset owner which is not even one year old, with about C$12 billion of assets – said while better and more standardised data will be crucial, investors in the meantime can gain an advantage if they have the ability to extract insights from messy and non-standardised data, he said.

Engagement with managers is also critical, and needs to be done in a structured and clear way, he said.

“Really work with them to understand what it is you will and you won’t do, the kind of reporting you’re looking for and the kind of reporting you don’t care about,” Bennett said. “Because I have been on the asset management side, and I know that the requests can sometimes seem endless from clients, and I really appreciated that element that said ‘that’s fine, we appreciate your reporting on all this, these are the three data points that matter.”

Investors who don’t plan to divest need to have a plan to transition, he said, and be transparent about it to members.

“And that gets you away from the conversation that says well, I just need you to sell all your oil and gas companies right now and everything will be fine,” he said.

“Horrible” sentiment towards technology stocks is dragging down the value of some of the “best business models on the planet,” experts say.

The biggest technology wipeout since the tech bubble in 2000 is producing some “amazing opportunities” to choose quality technology stocks that are being dragged down in value, according to John Donnelly, managing director at New York based asset manager Jennison Associates which has around $214 billion of assets under management.

Sentiment is “absolutely horrible” right now towards technology stocks, Donnelly said, speaking at Conexus Financial’s Fiduciary Investors Symposium held between May 23-25 at the Chicago Booth School of Business, in a panel discussion looking at technology and its role as an enabler and a disruptor.

But with hundreds of billions in value wiped from the NASDAQ this year, Donnelly said there are particularly good opportunities for investors in software. Cloud computing is “less than 30 per cent penetrated by any measure” and there is strong, ongoing growth in giants like Amazon Web Services, Microsoft Azure and Google Cloud Platform, he said.

Despite falling in market capitalisation, the world’s top 25 software companies have strong revenue, high customer retention rates and the ability to grow with their existing customer bases “without adding one dollar of sales and marketing,” Donnelly (pictured) said.

 “These are still the best business models on the planet,” Donnelly said. “That didn’t change just because we had a liquidity induced bubble.”

E-commerce is a tougher area, he said, with a plunge in low-end consumer spending after strong sales during the pandemic. Consumers are returning to physical stores now that lockdowns have been removed, and there is a shift from buying goods to experiences as consumers are fatigued on buying goods, and these trends are working against e-commerce, he said.

“So the growth in e-commerce is going to be more linear and you don’t have that accelerating S-curve type growth where you hit the adoption point in the curve,” Donnelly said.

Subscription businesses like Netflix are also “more penetrated than people think” leading to weaker growth in subscribers, he said.

Donnelly also pointed to enormous promise in blockchain and the applications that will be built on top of it, although we don’t yet know what the winners will look like, he said.

“There’s too much young talent going into the space for this to not be real,” Donnelly said. “There will be a killer use case that evolves, and comes out of nowhere. We don’t know exactly what it is today. And when that happens, there will be a lot built on top of it and then the use cases will start expanding.”

technology as a disruptor

Also speaking on the panel was Brandon Gill New, director and co-head, multi-strategy investing and digital assets, at $25 billion Canadian Pension Plan OPTrust

OPTrust has a digital assets sleeve with a team of three, which Gill New described as a “risk mitigation strategy” in anticipation of digital assets being a “very disruptive asset class to capital markets” and an important asset class for the fund to better understand.

“It’s not about just Bitcoin, it’s about all of the technology behind it that is actually quite innovative,” Gill New said. “There is a serious amount of momentum behind it and it is a bit of a revolution that’s bubbling up and we want to make sure that we understand that really well, and we’re mitigating any risks in our portfolio certainly around that.”

The tokenisation of private assets is set to dislocate and disrupt real estate markets and other private markets, she said, with tokenised real estate holdings no longer requiring a single cashed-up buyer.

 “You can actually chop that up into little pieces and actually, you know, invest in real estate in a very liquid way and that’s obviously something that our real estate team needs to understand,” Gill New said.

The disintermediation of asset exchanges and the displacement of brokers is also a significant trend the fund’s private equity and private markets team needs to understand, she said.

Ali El-Annan, head of technology at SWIB which has around $165 billion in assets, described how the asset manager had created a data science team which produces various analytics and automates aspects of the fund’s asset allocation process.

“You’ll hear me use the word ‘automated’ a few times, [about] different things in our asset allocation process, and what that does is, it reduces operational risk,” El-Annan said. “It frees up our investment staff to focus on things more investment related.”

 

Investors should shape strategies that protect against the downside, said Jeff Gardner, senior portfolio strategist, Bridgewater Associates.  Speaking at the Fiduciary Investors Symposium at the Chicago Booth School of Business, he said that investors should prioritise protecting against losses in the current environment: increasing returns can be additive to long-term wealth, but missing the big losses is just as important to driving long-term wealth creation. Strategies using put options that protect against downside outcomes can help raise the consistency of returns and lower volatility.

In an environment where it isn’t clear which, if any, asset will be protected, reducing downside outcomes is a powerful tool. Even if two different assets have the same return over a long period of time, the asset with less risk will give more wealth because it avoids the losing periods.

Put options protect against drawdowns, but often at a cost that outweighs the long-term benefits. He suggested a strategy that offers downside protection but also positive returns when equity markets are performing. He said put options can protect investors in the peak to trough of equity falls, offsetting declines, adding that options premium is at its highest after the decline in markets making protection expensive.

The strategy offers investors a diversifying solution in a market environment where few assets look truly diversifying.  Every asset has a bias and performs better – or worse – in a particular environment. Biases amount to inconsistent returns and have led to classic strategies like holding diversifying assets or creating overlays that hedge exposures – for example hedging liability risk by overlaying with duration.

The challenge today, however, is that there is little option to diversify. Traditional assets can provide some level of diversification, but it is possible that all assets suffer at the same time and bonds may not provide traditional diversification.

“Everything can go down and there is very little that can protect you,” he said. Gardner warned, however, that moving away from structural diversification to tactical strategies comes with timing risk.

Looking back

Gardner set the scene by outlining the causes of the current economic climate. The decline in inflation and historically low interest rates over many years has driven financial returns – returns that have also been fuelled by globalisation. In another trend, returns over the last decade have gone to capital and not benefitted labour.

“Political pressure is changing this,” said Gardner. He also noted how assets in underlying portfolios have outperformed their underlying economies.

Central bank stimulus in response to the pandemic has been highly inflationary and equivalent levels of stimulus have only ever been seen in war time.

“We combated the Covid war with a war time policy: this cycle is now playing out” he said. He noted that US household wealth increased during Covid, creating a nominal demand which supply couldn’t match, making the economy vulnerable to shocks – like war in Ukraine and Covid’s resurgence in China. The large stimulus to cushion the impact of Covid on less fortunate households was important, yet he added that the Fed could have pulled back on the stimulus earlier.

Gardner said policy makers are in a tough spot, caught between trying to support growth and bring inflation down yet unable to accomplish both simultaneously. It leaves investors focused on mitigating risks – and holding onto how well assets have done recently.

The future

Reflecting on what the Fed might do next, he noted that a small tightening – enough to bring inflation down – is priced in by markets. However, equity markets have not priced in any adjustment to earnings: the drop in equity markets is so far due to rate rises.

Gardner said that European economies, hit by the loss of Russian energy, are most likely to experience stagflation and shared concerns of a food crisis in northern Africa that could kick off further unknowns. He noted the bifurcation in equity markets, where the US has outperformed Asian and European indices, could signal opportunities in Japan and China and urged investors to hold more real assets. He noted how investors have been unwilling to hold real assets because they have dragged on portfolios, and have historically under allocated to real assets compared to financial assets. He advised investors to focus on the cash flows in their investments, warning that cash flows in real estate may not offer inflation protection.

Western economies are balancing tightening with weak growth, but other economies, like Japan, don’t have the same inflation problem. He added that emerging markets also look cheap. Elsewhere delegates noted that gold has not reacted to market turmoil, despite rate cuts and the dollar strengthening.

“Gold is underperforming and it’s interesting it hasn’t had a bump [up] from crypto selling off,” said Gardner.

Looking ahead, Gardner said China’s Covid challenge (where low vaccination rates among the elderly and less effective vaccines prevail) has been priced into supply chains. He said that moving from a zero Covid strategy in China carries risks, and shifting to effective vaccines is not a short-term fix. Still, China is now focused on finding the right policy mix to support growth, and has the tools to ease interest rates and allow the currency to weaken.

He said that Bridgewater has predicted more downside than has yet occurred, missing the forces that led to the continued extension, and the willingness of the Fed to keep stimulating the economy. However given today’s inflation levels he concluded:“It does finally look like a turning point.”