Climate change is one of the defining issues of our age. Its physical manifestations are negatively affecting ecosystems, human health, and economic infrastructure. And even if the world is able to keep global temperature increases to 1.5° above pre-industrial levels, much more disruptive outcomes are coming.

Meanwhile, energy systems and patterns of economic activity are being profoundly changed by the growing array of policy initiatives, private-sector commitments and technology advances that aim to constrain greenhouse-gas emissions and limit climate change.

It is vital that investors understand how physical climate change and the energy transition affect the investment returns of the companies and markets in which they invest. We believe that doing so will enable us to build more resilient portfolios and generate better long-term returns for clients. Asset owners and regulators are also increasingly demanding this.

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Research that looks at the relationship between economic transparency and defining investment qualities such as yield spreads, credit ratings and stock price volatility shows sovereign transparency helps improve the value of assets, enables countries to lower their borrowing costs and achieve a better credit rating.

Sovereign transparency helps improve the value of assets, enables countries to lower their borrowing costs and achieve a better credit rating. Speaking at FIS Digital 2021, Marshall Stocker, director of country research, emerging markets at Eaton Vance Management in Boston, explained how the firm’s proprietary index which tracks sovereign transparency in 130 countries has become a valuable investment lens. The discount rate on assets shrinks as transparency improves resulting in assets going up in value, he said.

The index is compiled by rating the availability of a sovereign’s economic data on an annual basis. Key points include if economic data is published in English and how regularly it is updated.

“We find that countries prepare documents in their local language but not in English,” Stocker said, adding that the Eaton Vance index also differs from others in the market given it looks at all available monetary, fiscal and economic data.

Stocker added that economic development and transparency are linked, making transparency crucial for emerging markets. Moreover, the index illustrates that wealthy countries are also the most transparent and he added that contrary to common perceptions, transparency does not create more volatility for investors.

China sits in the the bottom half of countries when it comes to economic transparency. Stocker also told delegates that higher levels of sovereign transparency don’t necessarily increase levels of trust in a government. Elsewhere, he noted that some countries (like Ukraine) have relatively high levels of transparency, but struggle to subsequently enforce rules and laws to deal with the challenges transparency reveals.

Stocker said that asset owners have an important role in engaging sovereign governments on transparency, describing a process whereby Eaton Vance holds sovereign level discussions comparable to investors at a corporate level. The firm shows up at the table with evidence to prove that changes in governance are good for countries.

Majdi Chammas, head of external asset management at AP1, explained how Sweden’s $45 billion buffer fund is integrating transparency into its emerging market passive exposure. The fund uses a corporate scoring process whereby greater transparency increases a company’s weighting in the index. Launched with one of the fund’s emerging market managers, transparency is one of the key pillars in the strategy.

Engagement around transparency is particularly important, says Chammas. Strategy involves engaging with corporates that have a low level of disclosure.

“If the level of disclosure is low, the first thing we do is engage,” he says. In many cases, companies have the data but are often not aware of it. Moreover, although information might not be disclosed by companies or is hard to access, huge amounts of data exists and information can be gleaned from unstructured data and social media. For example, employee discussions can feed into valuable ESG insights.

It led to Chammas reflecting on the challenge of integrating ESG into passive portfolios that own all companies in an index. Through this strategy, AP1 has created a portfolio that has all the hallmarks of passive given its liquidity, systematic characteristics and ability to capture equity premia. He also touched on API’s obligation to be a role model globally, hence the fund opening up and sharing its solutions with other investors.

 

 

Fossil fuel exclusion

Elsewhere, AP1 has begun excluding fossil fuels from its entire exposure.

“We thought it would be tough to exclude such a big part of the portfolio, but we’ve had real success,” Chammas told delegates. Although excluding fossil fuel groups in segregated mandates wasn’t too challenging, the process was more problematic in AP1’s fund exposure and has resulted in the investor launching some new funds and strategies with managers.Recalling the drive behind the strategy change, he said it was based on AP1’s climate and scenario analysis and the financial risk posed from fossil fuel groups.

Chammas concluded that exclusion is only one part of the AP1’s strategy. Engagement and dialogue and an active approach, particularly in China, is just as crucial.

Stocker concluded that emerging markets do face challenges around access to data and poor policy. But by engaging and trying to improve the situation will lead to change. It involves fundamental understanding of the challenges in each country, he concluded.

Picking up on the themes from their latest Global Real Estate Outlook, the real estate team at M&G Investments discuss the outlook across different sectors and geographies. Which could see rapid growth and which may lag behind? They also explore the potential impact of inflation on the asset class.

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Inflation holds investor opportunities as well as perils. Emerging markets, commodities and linkers do well in a climate of rising prices while central banks are likely to act quickly and aggressively in response rather than early or gradually.

Inflation is set to rise further but the consequences are not all bad, said Patrick Zweifel, chief economist at Pictet Asset Management based in Geneva, Switzerland in the opening session of FIS Digital 2021. Zweifel, who has been at Pictet for two decades and has a particular expertise in emerging markets, said some asset classes perform well in inflationary regimes.

He explained that it is important to distinguish between the two sources of inflation (supply side and demand side) which each feed into different cycles. Lockdowns to contain the virus led to the lower supply of goods and lengthened delivery times leading to a rise in prices. Another phase will depend on how economic policy impacts demand, and the extent to which wages rise leading to higher inflation expectations.

He said that the combination of rising wages and higher inflation leads to sustained inflation overtime which can also make it uncontrollable – a risk he said central banks always seek to avoid. Elsewhere he noted the distinction between inflation caused by spikes in prices in goods and spikes in prices in services. Goods have a much lower share in most inflationary baskets compared to services.

“It is rare to have inflation driven by goods,” he said, noting that services will be the source of most inflation into the future.

Zweifel noted how inflation has risen in the US driven by supply side bottlenecks and pent up demand. This has led to expectations of US inflation hitting 2.5-3 per cent by 2022.

However, he cautioned that a lot of uncertainty about consumption spending could cool inflation as could uncertainty about how much of this spending will be tilted to services. The most extreme scenario pushes core inflation up to 4 per cent by end of next year, he forecast.

Millan Mulraine, chief economist at Canada’s Ontario Teachers Pension Plan flagged the challenge of allocating to inflation protecting assets but also meeting return targets. To which Zweifel counselled on the importance of avoiding risk assets when growth is low and highlighted good inflation hedges like gold and inflation linked-bonds.

Moreover, inflation can occur in a period of strong or low growth. When economic activity is high and inflation is low, risk assets thrive; when economic activity is high and inflation is high – the regime he said “we are currently moving into” – risk assets and commodities perform well. Another scenario comes when economic activity is low but inflation is high. He said that moving through the different cycles can take time, but also warned that markets can move quickly.

Emerging market equities and fixed income, hard and local currency, also offer investor opportunities, performing well in a climate of strong growth and rising inflation. He said it was important to look at emerging markets in the context of their own growth, rather than compare growth to developed markets.

“What matters most is emerging market growth,” he said, explaining that as long as it is solid the fact that it is lower that developed market peers is not important.

Emerging markets are also set to benefit from global trade and rising commodity prices. As for the impact of rising treasury yields, this isn’t damaging to emerging market asset classes either, he said.

As long as emerging markets are seeing their own strong growth it is possible to see traditional asset classes in the emerging market space do well despite rising long-term US yields.

He also noted that the dollar tends to underperform when growth is strong and inflation is high.

“The best performing environment for the US dollar is when everything is bad,” he said, adding that as long as inflation is demand driven, risk assets will continue to perform well.

Next the conversation turned to the role of central banks in controlling inflationary pressure. A concern front of mind for Kylie Willment, chief investment officer, Mercer Asia Pacific who asked for insight into central bank messaging around tapering and interest rate rises in the months ahead.

Zweifel responded that central banks will be unlikely to act early.

“My understanding,” he concluded “is that central banks are most likely to be late and aggressive rathe rather than too early and too gradual.”

The unprecedented level of government debt signals sub-par economic growth ahead, warned Farouki Majeed, chief investment officer, Ohio School Employees Retirement System speaking at FIS Digital alongside Rich Randall, head of global debt at IFM Investors.

Debt beyond a certain point becomes a risk according to Farouki Majeed who applies this same value judgement to assess any asset to the current levels of sovereign debt.

As part of a a discussion panel focused on the dangers inherent in historically high levels of sovereign debt to GDP, he told delegates that debt involves borrowing from the future, and that all studies show that countries that have high levels of debt have lower rates of GDP growth.

Reflecting on the best allocations in the current environment, Majeed noted that government bonds were no longer a defensive asset: the downside risk of holding government bonds has increased and the negative correlation with equity reversed.

“We don’t expect government bonds to play the favourable role in diversification we would normally expect,” he said. The pension fund is currently underweight US government bonds relative to its broad benchmark, and overweight investment grade fixed income.

Private debt

One area investors can find opportunity coming out of COVID is private debt. Allocations to this asset class offer highly secured assets like infrastructure or transport assets with predictable cash flows, said Rich Randall, global head of debt at IFM Investors.

IFM, which only invests in corporate debt, has found valuable pickings in the sector in the wake of bank disintermediation since the GFC. Banks have ceded much of their lending in developed markets to the capital markets he said, estimating around $3 trillion of private debt is now in the hands of the capital markets rather than banks.

Moreover, the capital markets are a more efficient provider of that debt, lending to sectors banks haven’t like SMEs. Institutional investors are finding returns while companies are able to tap sources of capital, he said. IFM, a big investor in the US energy space, sees opportunities ahead in brownfield development and renewables.

Although Majeed noted the benefits of private debt, he also highlighted the challenges. For sure, infrastructure debt constitutes a defensive asset, however private assets hold illiquidity risk as opposed to tradeable government bonds.

“You can’t allocate a whole chunk of the portfolio to infrastructure debt,” he said. Even so, in recent years Majeed has increased the allocation to real assets including infrastructure equity and debt, the portfolio is also overweight cash and he has increased the allocation to stressed and distressed credit coming out of the pandemic. The private credit portfolio has a higher distributed yield than infrastructure and fixed income, reflecting a wider strategy to increase the income component of the total return component of the fund, he said.

Corporate washouts

Randall expects more (corporate) washouts to occur as economies recover from COVID. Companies that were hanging on before the pandemic and that got rescued will now face a reckoning. He also flagged the importance of a keen eye on corporate leverage levels, particularly in certain sectors. For example, service-type companies are over-leveraged, and airlines are also highly leveraged. Here he noted fallen angel opportunities as investment grade companies fall into the sub investment grade market.

He also expects opportunities to occur in markets like Australia and Asia where bank disintermediation is less developed. Debt capital provided by non-banks in the US and Europe is developed, but in Asia only around 10 per cent of debt capital is provided by non-bank institutions. He also warned investors to cast a wary eye on manager exaggeration and profile – equity-like returns in the private debt space are unlikely.

“Debt is debt… and if managers are claiming such high returns, a lot will be leveraged at the asset or portfolio level,” he said.

Hedge against inflation

Randall said that the private debt market also offered a degree of hedge against inflation given the majority of loans to infrastructure are floating rate. He also voiced his concerns about changes in political leadership causing the pendulum to swing back and forth between disparate ideologies. The transition of power can have a dramatic effect on how we look at infrastructure, he said citing current unknowns in the political debate in the US around financing social infrastructure.

IFM’s investment is primarily focused in OECD countries, said Randall. Although the firm has done some deals in Latin America, the accompanying volatility didn’t get the risk premium. He also noted a supply and demand imbalance given regional banks’ role in providing capital.

Tackling the sovereign debt mountain will require either selling assets, or raising taxes but panellists concluded that their is a reluctance by political leaders to do either.

Economic growth, the most desired solution, is unlikely. It is tough to get sustained growth rates anymore, said Randall adding that a 5 per cent growth on a sustainable basis is not going to happen.

Inflation is the number one investor concern and whether it is here to stay was the subject of much debate at the Fiduciary Investors Symposium. While its longevity is contested it was agreed that its presence has important implications for the correlation between bonds and equities which creates problems for portfolio design. Investors at PGIM, QMAW, CPP Investments and NEST discuss.

Inflation has become the number one investor worry according to a poll of delegates at FIS Digital 2021 with 51 per cent of respondents naming it above any other risk.

Today’s inflation is a consequence of a powerful surge in growth coming out of the pandemic, bottlenecks in certain goods and changing consumer preferences, said Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income which manages more than $900 billion.

He said that although it is unclear how long it will last, the idea that it is here to stay could be ill-founded. Country by country and demographic drivers are disinflationary, he told delegates, arguing that today’s robust economic activity will tail off and the economy could well return to its sluggish 2019 state.

In contrast, Sushil Wadhwani, chief investment officer at London-based investment firm QMAW, urged investors to prepare for uncertainty. He counselled that although “clever people at the Fed” are saying inflation will be transient it is far from clear if it will pass through or hang around. Although he said it is likely to be lower in the next few years compared to current levels, it could still be “uncomfortably high.”

Even transient factors can take a while to unwind – particularly a labour shortage. Structural changes in today’s labour market triggered by the pandemic could take years to pass through and trigger higher inflation for a while yet. Moreover, he said mood music around the minimum wage has changed with many companies suggesting they will increase what they pay. The longer inflation stays high, and the less pre-emptive central banks are in trying to curb it, the greater the risk.

Recalling his own experience as a member of the monetary policy committee at the Bank of England, he said central banks never make decisions on one single, “noisy” data point. Instead, they seek to distil the essence of what is going on. If the data begins to get uncomfortable through 2021, the Fed will likely bring forward tapering and change its signalling on short term interest rates, not currently expected to rise until 2024. However, he caveated that any change in tone or policy is unlikely to happen until a new chair is appointed in 2022 when Powell’s four-year term at the head of the central bank ends.

Tipp said a current challenge for investors is keeping to strategic asset allocations, and navigating the impact of lost diversification between stocks and bonds. He said very little is priced-in regarding rate hikes over the next two years, and noted that inflation in Europe is still well below the ECB’s target 2 per cent which could put rate hikes on hold for years. As for opportunities in emerging markets off the back of inflation, he said hard currency returns in developing markets are challenging to capture.

One popular inflation proofing strategy comes via increased allocations to commodities, said Wadhwani reflecting on QMAW’s 35 per cent exposure to the asset class. However, he steered away from recommendations and said agility is the key to success in the current climate. For example, central bank policy changes would quickly alter the investment landscape.

“In an uncertain environment you need to be agile rather than get fixed on a particular hedge,” he said.

Indeed, QMAW is tactically long commodities because inventories are low and more than half of commodity markets are in backwardation – whereby the future price is lower than the current price because of scarcity. Looking ahead however, he said factors like China prioritising financial stability over growth could quickly change the picture. Moreover, if central banks turn hawkish, it bodes badly for industrial metals.

Mark Fawcett, chief investment officer at the United Kingdom’s NEST is also circumspect if inflation will rise further. Working as head of Japanese equities based in Japan in the 1990s has given him experience with regarding to inflationary signs. He said governments have turned on the fiscal taps to fight the economic impact of the pandemic, but people know it will all have to be paid for. Taxes will rise and this means deflationary forces could hold back the demand side.

He also added that systemic forces will also drive down inflation – taming inflation won’t just be the responsibility of central banks.

For Geoff Rubin, chief investment strategist at the C$475 billion CPP Investments in Canada, the real danger is a policy mistake from central banks.

He said the giant pension fund’s portfolio is not designed for unanchored inflation. Adding that central bank credibility has provided an extraordinary backdrop to investment decisions – and any sense that discipline might be eroding could end badly for the portfolio.

Insurance assets like inflation linked bonds or commodities are good in the short-term but don’t fit easily in a long-term portfolio.

Rubin added that uncertainties around inflation will threaten the negative correlation between bonds and equities that investors have long benefited from, posing a real problem for portfolio design. He also noted that the consequences of inflation would differ for different investors. For example, CCP Investments has a liability structure that is supported by a rise in inflation.

Tipp added that today’s positive correlation between bonds and equites would change if the economy stutters.

“If we drop out, we will see a bond rally,” he said.

At NEST, the (negative) correlation is less pressing: Fawcett said NEST doesn’t hold long-term developed market bonds in its portfolio. It is in these assets, he said, where most of the money printing has happened.

Wadhwani concluded that inflation spikes particularly in certain monetary regimes. For example, the UK could well “wake up and smell the coffee” given the high level of public debt, little appetite to raise taxes and forecast increase in public spending. It could point to a “catalytic” (inflationary) event that might not translate outside the UK.