Blockchain technology will open up illiquid assets, like real estate, to new investors in what could be the greatest disruption ahead. Franklin Templeton’s Jenny Johnson explains how the asset manager is ensuring it taps the new opportunity.

Prepare for a new tokenised economy where assets are fractionalised, divided up amongst potentially millions of investors into tiny portions of ownership on a blockchain. It will enhance liquidity, price discovery and accessibility to high value, illiquid assets like real estate at a fraction of current transaction costs. For example, it could lead to multiple owners of a single piece of prime real estate via tokens and programmed smart contracts that allow every single investor to safely collect their one-millionth of the rent.

Speaking at FIS Digital Jenny Johnson president of Franklin Templeton explained that it was this belief in a blockchain-led disruption ahead that is driving the firm’s keen focus on how distributed ledger technology will impact asset management and private markets in the future.

Blockchain is already well known for transforming companies’ back-office data reconciliation. Now investors should prepare for further change ahead.

“Real estate is an obvious one. It makes me excited about the opportunities in the industry,” she said.

Franklin Templeton’s investment in the tokenisation space includes incubator investment in a tech-enabled farmland platform that fractionalises ownership, helping farmers sell off portions of their business. Elsewhere, the firm is working on an AI project to value art.

“We are trying to understand the space,” she said. “It is quickly evolving and there are lots of dead ends, but if we are not focused, we will miss out.”

Johnson voiced her determination to bring creativity, innovation and the entrepreneurial spirit to Franklin Templeton as the 4th industrial revolution gathers steam. She warned investors that incumbents rarely fair well during periods of innovation since they have to focus on doing their day-to-day job alongside keeping up with the future. Her strategy is to cultivate small groups of expert teams, carved out of existing teams where their focus on innovation was often seen as distracting.

Johnson urged delegates not to confuse Ethereum, the decentralized blockchain network powered by Ether coins, with Bitcoin which she called “niche”.

She said the programming language on the blockchain will lead to proliferation of other applications in financial services and gaming.

Acquisition

Franklin Templeton recently announced its purchase of private equity investment specialist Lexington Partners for $1.75 billion building its presence in private equity secondary funds and co-investments. The announcement follows on from other recent acquisitions of private credit manager Benefit Street Partners, real estate investor Clarion Partners and hedge fund K2 Advisors. Franklin Templeton’s highest-profile acquisition came in February 2020 when it bought rival Legg Mason for $6.5 billion

Johnson told delegates that the acquisitions fill product gaps at the firm and enable Franklin Templeton to provide asset owners with solutions, not just products.

“We want to partner with thought leadership,” she said.

It’s led the firm to establish an Academy to help train and educate partners and an Institute that draws on expertise across the business. In-house experts offer insights on how investors should position for the evolution of the vaccines, to expertise on water risk. She said that acquisitions have also been shaped to fill specific niche capabilities at the firm. For example, it now aims to offer Separately Managed Accounts to institutional and retail clients that overlay quant data analysis.

Johnson, renown for her championing of diversity, pleaded with asset owners to view diversity in their employees as importantly as they do in the portfolios.

“We don’t put together portfolios that aren’t diverse,” she said. “Different views to solve a problem produce better outcomes.”

Asset owners with long term investment horizons, coupled with legislation, will increasingly hold asset managers accountable. Asset owners are demanding more of their managers and asset managers should be driven by what their clients are looking for, said Johnson, the fourth member of the family over three generations to lead the fund manager since it was founded by her grandfather in 1947.

“My father always used to say, take care of the client and the business will takes care of itself.”

A company’s ability to sell direct-to-consumer, cloud computing and digitisation in payments are key areas for investors to focus. Investors should invest in companies that have a business model aligned to how people want to buy goods and prepare for a separation whereby companies with the technology to adapt streak ahead.

Investors are questioning if index exposure to the tech sector will continue to be a source of future growth. The capital markets used to be a catalyst for growth, but more companies are staying private for longer, forcing investors to explore new approaches.

It means some investors are pondering more venture allocations to get exposure, said fellow panellist David Veal, chief investment officer, Employees Retirement System of Texas.

Alongside exploring technology winners, his eye is on those companies left behind. There is a risk that companies that don’t make the transformation will experience value destruction and should be excluded from portfolios at the risk they will be stranded, he said.

At ERS investment strategy is particularly focused on watching corporate margins in the US compared to overseas allocations. In the US, wage pressures are building and creating headwinds for companies. It makes emerging markets more of a focus, where ERS has had a signification allocation for years.

Both panellists stressed the importance of not just having a US centric view but adopting a global perspective noting that blockchain could revolutionise what is happening.

Still, Veal said the enduring belief that population growth and earnings growth would flow through to investor gains is challenged in emerging markets. He noted geopolitical risk and globalisation trends reversing with implications for multinationals.

“We need to recognise we live in a different world to one where globalisation was in full force,” he said.

Investors should remember there is no such thing as a mean reversion in technology – the genie can’t be put back in the bottle. For example, the Amazon-led e-commerce revolution might mature and slow, but it can’t be undone; bricks and mortar won’t suddenly replace online shopping.

“You want to be focused on the future,” said Mark Baribeau, head of global equity at Jennison Associates, who said that a new generation of companies are fighting against the big giants. For example, the next generation of insurgents don’t want to be beholden to the likes of Alibaba or Amazon to sell their goods and are using different systems (like Shopify) to sell direct to consumers.

Direct to consumer movement

One of the most important investor opportunities and key sources of disruption ahead lies in the direct-to-consumer movement. New technology is enabling entrepreneurs starting their own businesses to eliminate the middle person and directly reach out to their customers.

It is evident in the auto industry where the ability to market direct to consumers means manufacturers of new electric cars can sell online, avoiding dealer networks.

“They can keep the margin for themselves,” said Baribeau.

Moreover, innovation in the car industry is now focused on software.

“You don’t need to know how an engine works,” said Baribeau.

This different skill set means new producers’ biggest challenges will be scaling manufacturing to meet demand. Investors should avoid tilting to old incumbents since these companies’ electric vehicle production and sales comes at the expense of not selling traditional cars.

“I would focus on the upstarts,” said Baribeau.

Elsewhere, retailers like LuluLemon and Nike that have physical stores and an online presence have expanded their online sales and gained more control of their inventory. It means they can respond more quickly to changes in consumer tastes and move inventory to where demand is strongest in a new, flexible strategy wholly enabled by technology. Investors should choose companies that have a business model aligned to how people want to buy goods today, and prepare for a separation whereby companies with the technology to adapt streak ahead.

Digital payments

Financial services is another fast-changing industry. China has led the revolution in digital payments via new payment methods like WeChatPay and AliPay, helping transform China into a cashless society and providing end-to-end digital solutions as people use their mobile to transact. The next Fintech boom will occur in the wider Asian region and Latin America where technology will fill the gap traditionally underserved by banks providing convenient, cost-effective solutions that disrupt the market.

Other investor opportunities exist in cloud-based applications poised to replace mobile internet and allowing companies to move to state-of-the-art platforms rather than lumber on under legacy systems. Cloud solutions provide new security and infrastructure management cheaply that is also quickly and easily deployed and upgraded.

“It’s where we see more incremental spending going,” said Baribeau. “And investors just follow the incremental spending.”

The transformation of investment instruments in fixed income has altered traditional 60:40 portfolios. But for some investors, the hunt for yield is a rising cause for concern that could lead to another credit crisis.

The time when investors split their portfolios 60:40 with the debt allocation sunk in government bonds are long over, said David Hunt, president and chief executive of PGIM, the asset management arm of Prudential.

Speaking at FIS Digital 2021, he said that investors now build much more diversified allocations across a wide range of fixed income instruments creating substantially varied and more attractive portfolios.

Hunt called the current climate “punitive” for investors with large cash allocations. It explains why so many now hunt for yield and ensuing huge demand for all kinds of fixed income, and fixed income-like instruments, like structured credit or real estate debt that offer a yield ahead of cash. Investment in all these types of assets has increased as people try to beat a negative return on cash, he said.

However for Richard Williams, chief investment officer of £33 billion ($44 billion) Railpen, who asked a question of the PGIM president, investors’ hunt for yield is a source of concern. He worries that some are becoming complacent about risk in a way that could lead to another credit crisis. Moreover, he noted some investors’ belief that governments will step in in another credit crisis is leading to under-pricing credit risk and a view among some that credit is a less risky asset than it used to be.

“There are a generation of people who haven’t been through a credit cycle,” he warned.

This concern, plus a “hunch” that the market is moving into a higher inflation environment, means Railpen currently holds as little fixed income as possible, alongside reducing credit risk.

Williams told delegates that from a total portfolio level, he was not enthused with credit or fixed income. However, from a liability matching perspective the fund will continue to hold a bit more credit in the future than what it owns today – and will do more in the private markets.

“We try to find assets that prosper regardless of inflation,” he said.

Meanwhile Hunt’s enthusiasm for new investment instruments does not extend to crypto assets. He said that regulation might, over time, reduce the amount of speculation in the crypto space but today his priority is distinguishing between assets that are a store of value and those that are speculative in nature and don’t have a regulatory framework.

“Crypto is in second category,” he said. Sure, regulation and transparency could lead to crypto having predictable features that give it a lack of correlation with asset classes like gold, but it will only have a role in a sophisticated portfolio with this kind of oversight.

Inflation

The inflation debate needs to move on from whether inflation is transitory or not and should be broken down into a more nuanced approach, said Hunt. Many of the price rises visible around the world are not transitory. For example, energy prices and house prices, fuelled by a long-term lack of building. In contrast, some prices are transitory like lumber or used cars.

However, Hunt argued that long-term and powerful deflationary factors that have kept inflation low are still with us like digitisation, accelerated since COVID. He noted how some industries like manufacturing have seen spikes in productivity thanks to digitisation and new technology coming to the fore. Industries struggling with digitisation, and where technological change hasn’t translated into higher productivity, include financial services and healthcare. However, he argued digitisation will increasingly change financial services, already visible in areas like payments with productivity gains.

The demographic challenge and the number of workers choosing to leave the work force and not coming back is also deflationary. Although he did note that a reduction in the work force could also be inflationary if wages rise.

Hunt also said the risk of a policy mistake by the Fed is high given the many unknowns. He said the Fed typically focuses on the forces at play in the labour market which makes it “overly waited in a dovish stance.”

He added that most expansions are killed by a policy mistake by the Fed.

A demand shock is fuelling inflation and the supply chain crisis. Elsewhere, investors need to prepare for lower returns in US equities and diverse economic performance from different regions as individual country’s pandemic response plays out.

Don’t expect another decade of outperformance from US equity while inflation, fuelled by a demand shock, is set to spike foreign exchange volatility impacting total portfolio returns, warned Rebecca Patterson, director of investment research, Bridgewater Associates speaking at FIS Digital 2021.

Perhaps one of Patterson’s more surprising comments was her argument that today’s supply chain crisis is the consequence of a surge in demand rather than a supply shock – and is here to stay for a while yet. Strong demand in both absolute terms and historically has produced a once-in-a-generation shock that hit companies dependent on just-in-time inventories.

The demand shock is evident in Chinese factories scrambling to meet US demand. They are running at maximum capacity (20 per cent higher than pre-COVID industrial production) so much so they have now usurped local energy supply. The demand shock is clogging up shipping lines and ports and the time needed to meet orders is taking longer. It is also spiking labour costs.

“We are seeing the tightest labour market we’ve seen in the US for generations; firms are saying they can’t fill their positions,” she said.

It will continue as US householders with cash in hand and rising disposable incomes (as wages go up) continue to spend with confidence. It will also support inflation into 2022, something she said many investors were not doing enough to integrate into their portfolios.

“Most don’t have protection for very high inflation; we also think they should focus on how to benefit from rising inflation.”

Countries different responses to COVID will also begin to play out in the investment world. While the US, Europe and the UK embarked on massive fiscal stimulus and held down borrowing costs, other governments (like Mexico) did very little. The different policy reaction is resulting in a dispersion of economic conditions across different countries providing a rich seam of investor opportunities. “We are excited,” she said.

US underperformance

Using the US (where there was a strongest monetary and fiscal response to COVID) to illustrate how this dispersion could impact the investment environment, she flagged challenges ahead for portfolios with large US exposure. The stimulus has continued long after households began to recover their finances after the pandemic. Moreover, there is more to come as Congress readies a huge infrastructure bill that will lead to trillions more stimulus.

She noted that investors tend to extrapolate from the past to help explain the future. But in a new investment climate, last decade’s US corporate winners are most likely to be this decade’s losers. Investors are currently allocating more to US stocks and bonds now than at any time since the mid-1980s, and assets will have to grow beyond what is already priced in to attract more money.

But US companies will increasingly feel the pinch from less favourable tax and regulatory regimes compared to the last decade that have supported earnings. Now, new regulatory proposals are set to weigh on margins like taxes on big tech.

“We think the bar is high for the US to be an outperformer over the next decade,” she said, advising investors to expect better equity returns from outside the US, and ensure geographic diversification.

Currency volatility

The dispersion in global economic performance, and inflation levels, will trigger currency volatility. It could have an impact on total portfolio returns, she warned, urging investors to check their hedging position. In the past, a decision to hedge or not to rarely impacted total portfolio returns. Now, higher inflation and more volatile Central Bank reactions to its spike, could have a big impact on total returns, she said.

She warned that China’s renminbi will also get more volatile. She said China’s central bank is increasingly prepared to have a flexible policy as the RMB becomes a bigger, global currency which will trigger volatility.

Moreover inflation will be fuelled by commodity price spikes, heighted by the lack of capex investment by mining groups in recent years which is destined to keep commodity prices supported for now.

Fixed income

She advised investors to seek out bond-like returns that avoid traditional fixed income and said any bond risk premium will remain scarce ahead.

Responding to a question from Jean David Tremblay-Frenette, director of investment strategy research at AIMCo, on what the future holds for fixed income, she said high bond yields are emerging across different economies but from very low levels.

Investors should look at ways to engineer return seams that feel bond like, investing in companies that have stable, bond-like cash flows that provide a similar return seam to government bonds.

She also stressed the importance of diversification and inflation-proofing linkers and commodity baskets, as well as gold.

Finance day at COP26 bought headline grabbing news – including the establishment of Mark Carney’s GFANZ and new accounting standards – but the PRI’s Fiona Reynolds tells FIS delegates more needs to be done.

A swathe of encouraging commitments from the financial world in response to the climate emergency will help make this year’s COP26 a success, said Fiona Reynolds, CEO of the PRI speaking live from Glasgow at FIS 2021 Digital.

She said that in marked contrast to previous meetings she has attended during her nine-year tenure as CEO, finance’s role in trying to solve climate change is now front and centre, on the main agenda and stage with financial leaders making the headlines.

“The investment sector is playing a major role in transitioning the real economy,” she said.

GFANZ

Headline grabbing news came thick and fast during COP’s finance day kicked off with the announcement from a new financial coalition (and a new acronym) Glasgow Financial Alliance for Net Zero (GFANZ) that it has $130 trillion to spend on tackling climate change.

“From humble beginnings they released their first progress report yesterday,” said Reynolds of the organisation, led by Mark Carney, the former Bank of England governor, now a UN special envoy on climate and finance.

“There is now $130 trillion in private capital committed to transforming the economy.”

It wasn’t long before the eye-watering number raised concerns that GFANZ, which comprises 450 banks, insurers and asset managers from around the world of which investment managers account for $57 trillion of the pledged assets, banks $63 trillion and asset owners $10 trillion, may not be able to deliver all it promises.

Critics voiced concerns that not all GFANZ signatories will set out credible, near-term decarbonisation plans, and said that it doesn’t represent a new pool of money.

Moreover, banks have signed up to the pledge while continuing to finance fossil fuels.

“None of the GFANZ initiatives require their members to commit to phasing out from fossil fuel finance. The initiative will fortunately be reviewing its guidelines every year – we’ll be keeping our eyes peeled for the entry criteria moving upwards,” wrote advocacy group ShareAction in a twitter post. Comments echoed by Reynolds who said all GFANZ members’ net zero disclosures would be scrutinised annually.

Nigel Topping, high level champion for climate action at COP26, who spoke at FIS Sustainability 2020 on how asset owners should do more to hold their managers to account on climate change, argues that GFANZ’ voluntary commitments will not solve the problem without policy action.

“Financial services firms will play a critical role in the transition to a net zero economy, including mobilising the trillions in investment needed, but greater policy action is needed. Specific policy requests of today’s GFANZ call to action include: the end of fossil fuels subsidies; carbon pricing; and a comprehensive reform of financial regulations to support the net zero transition,” he wrote on LinkedIn.

Accounting standards

Perhaps one of the most exciting developments came with the starting gun sounding on new sustainability accounting rules, destined to put sustainability reporting on the same footing as financial reporting. A breakthrough Professor Stephen Kotkin hailed as possibly the most significant initiative to come out of the conference.

IFRS Foundation trustee chair Erkki Liikanen announced the formation of the International Sustainability Standards Board (ISSB) which, integrating existing, key reporting criteria, aims to develop a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.

“The development of a consistent standard on climate, and eventually all ESG issues, marks a hugely significant step for investors. Vitally, the ISSB has committed to develop standards which align with the requirements of specific jurisdictions – namely the EU’s Corporate Sustainability Reporting Directive, the US and Asia-Pacific,” said Reynolds.

Other standout announcements include UK Chancellor Rishi Sunak reaffirming plans announced in October to require British listed companies to publish net zero emissions road maps by 2023 that set out how they plan to decarbonise by 2050. A task force made up of industry representatives, academics, regulators and civil society groups will be established to develop a “gold standard” against which companies must detail their transition plans. “Hopefully others will follow,” said Reynolds.

Elsewhere Reynolds, who hands over the PRI leadership to former Cbus CEO David Atkins in December (and joins Conexus Financial, publisher of Top1000funds.com as CEO) noted that the financial community’s role in protecting biodiversity has been another conference theme.

“Firms need to focus on other areas like deforestation,” she said, referencing how a group of 30 investors announced plans to coalesce around an initiative to eliminate commodity-driven deforestation by 2025.

“It’s a small group, but it will grow.”

Reflecting on other initiatives away from finance day, Reynolds said the announcement that more than 40 countries have pledged to quit coal was marred by the absence of key coal consumers China, US and India.

“It’s good, but not good enough,” she said.

Reynolds said that most asset owners that are PRI signatories won’t invest in new coal projects and Asset Owner Alliance members (PRI signatories that have committed to net zero) have committed to get out of coal by 2030.

“Only a small percentage of world energy comes from renewables. We need investors to invest in solutions,” she concluded.

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.