The evolution of the disease and its economic impact is highly uncertain which makes it difficult for policymakers to formulate an appropriate macroeconomic policy response. In order to better understand possible economic outcomes, this paper explores seven different scenarios of how COVID-19 might evolve in the coming year.

The scenarios in this paper demonstrate that even a contained outbreak could significantly impact the global economy in the short run. These scenarios demonstrate the scale of costs that might be avoided by greater investment in public health systems in all economies but particularly in less developed economies where health care systems are less developed and population density is high.

Read the paper here

The ever-changing nature of investing is what makes it interesting.  Our world is constantly changing, evolving — for better and for worse — and the economic forces that underpin returns change with it.  Markets develop and reinvent themselves in response to those shifting forces and to innovation that can bring both new opportunities and new risks.  As investors, we cannot stand still:  we need to adapt to changes in our environment, to capitalise on return opportunities and manage emerging risks.  The 2020s promises no respite; in fact, this decade could see change on an unprecedented scale.  Investors should prepare for a period of business as unusual.

A new kind of unorthodox monetary policy
In an arena where the unorthodox has become orthodox, it is now threatened by yet another new unorthodoxy: central bank policy. The evolution of monetary policy, quantitative easing (QE) and extraordinarily low or negative interest rates appears to be reaching its effective limits in many developed economies. This means policymakers may need to look for new, and possibly untested, levers to pull on in order to stimulate the economy or hit their inflation targets.

One lever that gets a regular mention is fiscal policy. Fiscal deficits appear to have become more acceptable across the political spectrum over recent years, and the once “risky” suggestion of funding fiscal stimulus by increasing the money supply rather than taxes is more likely to be termed “alternative” or “unconventional” in today’s world. The implications for inflation and inflation expectations are profound if this notion becomes mainstream.

Substantially higher inflation is not our base case. Indeed, it may not even be likely at present, but it is a tangible tail risk, one that may well undermine a growth allocation without sufficient protection from inflation-sensitive assets such as real assets. As a result, it would be sensible to think carefully about how your portfolio might perform in a scenario where inflation expectations move from (their current) stubbornly low levels.

A social license to operate
The theme for the second trend is familiar: sustainability. Over the course of the past few years, the momentum behind investing responsibly, particularly where it relates to climate change, has grown exponentially.

There is a growing awareness among consumers of the environmental and social impacts of their buying decisions and, crucially, an appetite to reflect their values in their consumption. We expect this to influence corporate behavior, because firms that cannot demonstrate that their contribution is leaving the world in a better place (or at least no worse) risk losing their social license to operate — a risk that should be assessed in portfolio construction, and which further supports a case for investing in strategies with stronger ESG credentials.

Climate change is changing the climate for investing
According to the Intergovernmental Panel on Climate Change (IPCC), 2030 is an historic milestone for our planet. If we are to prevent warming above 1.5°C, we need to have cut emissions from 2010 levels by 45 per cent by 2030.  The UN has coined the 2020s as the “decade of delivery.”  From an investment perspective, climate change is impossible to ignore.

The risks for investors are clear and present. Even if the physical effects of the climate crisis seem to fall outside of an investor’s time horizon — questionable given some of the weather events we are already experiencing — climate policy has the potential to impact portfolios much sooner, independent of any realised physical impacts.

There is a gap between the stated ambitions of the world’s governing bodies to limit global warming and the pathway for global temperatures expected to occur if governments adhere to current environmental policy. We expect this gap to be closed by more targeted policy, as well as consumer and corporate activity, which represents a risk to less progressive carbon-intensive companies and industries over relatively short time horizons.

What gets measured gets managed, and we recommend all investors undertake some form of carbon-footprint analysis to assess their exposure to climate policy risk, and to then chart a course for alignment with global climate targets.

Investing in the 2020s: It’s a matter of time…
In hindsight, the 2010s were an “easy” investment environment, with rallying equity and bond markets driving strong returns. And with QE suppressing volatility, market risk over this period was much lower than the previous decade. However, for the reasons above, the next decade is likely to prove more challenging — now is not the time to give up on diversification.

To address that challenge, you need to first be clear on your timeframe. If your time horizons are relatively short, perhaps exhibit more caution and focus on market and liquidity risks. Those investors with longer time horizons will need vision to understand the evolution of structural trends and the impact of these on markets.

With the possible exception of demographics, structural trends don’t develop in predictable, straight lines. Sentiment spikes and crashes over time, creating opportunities for dynamic investors. In this way, the “long term” is a series of short terms, and investing in structural trends means balancing commitment to a long-term orientation with the need to be opportunistic.

Climate change is no different in this context. We look for clients to employ a process of “de-carbonisation at the right price.”

Change is on the horizon, and where there is change, there is disruption. Be clear on your timeframe, be prepared for business as unusual and position yourself for climate change.

It isn’t a question of whether current economic, political, social and environmental trends will impact portfolios, but rather how and when. It’s a matter of time.

Nick White is global strategic research director at Mercer.

 

Being passively invested shouldn’t mean being passive with regard to responsibilities says the Church of England Pension Board which has developed a new climate transition index with FTSE Russell, LSE and TPI that is the first to incorporate forward-looking climate data.

 

We cannot claim we have not been warned of the need to act. In the UK there have been repeated warnings from the Governor of the Bank of England, and now UN Climate Envoy, Governor Mark Carney, challenging investors to address the risk posed by climate in their investments. At the turn of the year the Governor went further and challenged beneficiaries to ask their pension funds what they are doing to address climate risk. He also questioned the underlying market that is akin to supporting a world with 3.8 degrees of warming.

The Governor’s challenge to the pension industry was further reinforced by Justin Welby, the Archbishop of Canterbury, who stated there was a moral and financial imperative to address the climate emergency. He urged all market participants to use available tools to support the goals of the Paris Climate Agreement, and noting that were they to do, they literally could change the weather. Commenting on the need for collective action Archbishop Welby said “It is possible to act, to take leadership and in doing so challenge a market that is currently aligned to a world of 3.8 degrees of warming.”

One of the barriers to date has been how to bring passive investing into play in support of the goals of the Paris Climate Agreement while meeting our responsibility to deliver returns for our beneficiaries. Starting from the belief that being passively invested shouldn’t mean being passive in our responsibilities, over the past 18 months the Church of England Pensions Board has been working in collaboration with FTSE Russell, the London School of Economics Grantham Research Institute and the Transition Pathway Initiative (TPI) to develop a new climate transition index.

The FTSE TPI Climate Transition Index is the first index of its kind. Its methodology includes tilts and rules that are simply articulated and transparently linked to the Paris Climate Agreement. The index we believe is the first to embed forward looking climate data into the way in which companies are assessed. Key to the operation of the index is that companies with public targets aligned to the more ambitious end of the Paris Agreement (below 2 degrees / net zero goals) have a higher weighting in the new index and indeed can be double weighted. This is in contrast to companies that refuse to disclose information, or with poor records and less ambitious targets that result in much lower weightings or are simply excluded from the index.

Not only are funds that track the index going to be “cleaner” than the relevant market capitalisation based benchmark, but the way the index is constructed complements and provides clear stewardship messages on climate change – businesses that align their current and future carbon paths to the Paris agreement are rewarded while those that don’t are significantly underweighted or simply don’t make the new world of transitioning companies.

The reason the Pensions Board has been able to do this is that three years ago, together with the Environment Agency Pension Fund and the other National Investing Bodies, we launched the Transition Pathway Initiative (TPI), to provide a public database housed at the London School of Economics’ Grantham Institute, that assesses companies on their climate “management quality” and “carbon performance”.

TPI was deliberately designed as an independent, academically robust and non-commercial tool for asset owners that cuts through the mass of information that exists. Three years later the tool has enabled us to not disinvest from carbon intensive sectors but differentiate between which companies are transitioning in line with the Paris agreement and those that are not. TPI is rapidly growing in funds actively supporting it and at time of writing has 64 funds controlling more than $19 trillion in assets.

The Church of England Pensions Board continues to co-chair TPI with the EAPF and working with FTSE Russell (both TPI’s data provider and also index provider), we have sought ways to integrate TPI’s insights into the way we invest. We currently vote against chairs of companies that score poorly in TPI’s assessments and monitor the average TPI scores of each of our asset managers’ portfolios. TPI also provides the assessment framework of company public disclosures for the global climate engagement initiative Climate Action 100+ (CA100+). But the challenge and opportunity of passive investing was to create a methodology that integrates TPI’s insights in a systematic way, and provides extra ‘carrot’ and ‘stick’ that can enhance our engagement and also that of CA100+.

The real-world consequence of this index is stark – in a high carbon sector like oil and gas, Exxon and Chevron are not included, but a company such as Shell is included in the index as it has led its peers by setting targets covering all its emissions. While these targets are not yet ambitious enough, and we continue to engage robustly as CA100+ leads with the company, we believe Shell is clearly putting in place a strategy to fundamentally change its business. Nonetheless, Shell will continue to have a reduced weighting until such time that it is assessed by TPI as sufficiently ambitious. Our expectation is that it will achieve this. In other sectors such as electric utilities the index rewards those companies such as Spanish renewables energy giant Iberdrola while removing the transition risk to our funds of being invested in coal-fired power companies that have no plans to transition.

Importantly, the exclusion of companies does not represent disinvestment but differentiation within key energy intensive sectors and therefore a sensible recognition that there is a path for an oil and gas company, steel company, cement company to transition if they set independently verified targets aligned to the Paris agreement.

Our full £600 million ($780 million) allocation that was invested in an index that in effect tracked a 3.8 degree world is now being reallocated to the new index. Adopting this index for our passive allocation means we will now have a 49.1-per-cent lower carbon intensity than the benchmark as well as being invested in companies generating significantly increased green revenue.

The design of the index has been hailed by many including the Bank of England and the UK’s own UN Climate Envoy as industry leading and we hope will pave the way for other investors to join the Pension Board in this approach.

We all need to work towards a net zero world and as investors we can use our financial muscle to actively incentivise companies to transition while creating real world consequences for those that do not at the same time as protecting the interests of those we serve, our beneficiaries. This is part of our answer to Governor Carney when he asks what are we doing and we invite any other pension funds that are passively invested to speak with us or FTSE about this approach. We know we cannot do this by ourselves, but together we can change the weather.

Adam Matthews is co-chair, Transition Pathway Initiative (TPI), and director of ethics and engagement at the Church of England Pensions Board

Over the last five years, Oregon State Treasury which manages the $82 billion Oregon Public Employee Retirement Fund (OPERF) has halved the number of GPs in its private equity portfolio to around 40, increased its average commitment size to $250 million from $100 million, and migrated from mega cap to an upper middle-market bias. The new look portfolio is a consequence of lessons learnt from uneven pacing going into and immediately after the GFC which left the fund overweight poor performing vintages and underweight strong vintages in a legacy that continues to play out.

In an annual deep dive into the 17.5 per cent allocation led by Michael Langdon, senior investment officer, private equity, Oregon’s Investment Council and departing CIO John Skjervem got the low down on performance, current exposure and progress around reform. The mantra is “smooth pacing” with the fund pledging to commit, on average, $3 billion a year (it invested $2.7 billion in 14 commitments in 2019) to high quality conviction names with a focus on accessing new relationships and upsizing the best existing ones.

Easier said than done in today’s active fundraising cycle and the ensuing pressure to invest and chase the market. The Council heard how keeping on track demands discipline, “hard decisions” and “challenging discussions,” especially when faced with new and interesting opportunities with existing GP relationships.

Uneven legacy

In contrast to Oregon’s one-year private equity numbers (strong on an absolute and relative basis) the fund’s long- term results over three, five and 10 years look good on an absolute basis but less robust on a relative basis. The reason lies in uneven pacing in the portfolio around the GFC when it ramped up commitments during a weak time for the asset class and sharply retreated pacing in the immediate years after which coincided with a relative strong performance.

“Decisions made before and after the GFC amplified the impact on the long-term return numbers today,” Tiffany ZhuGe, investment officer, private equity, told the Council.

Between 2005 and 2008 Oregon invested around $14 billion ($3.6 billion annually) into what turned out to be weaker performing vintages which now have a dominant exposure in the portfolios five year and 10 year returns.

“Commitments made 12-15 years ago still represent 20 per cent of the portfolio,” ZhuGe said. Post GFC, in the years 2009 to 2014, Oregon’s commitment pacing declined to $1.4 billion annually, committing on average 60 per cent less capital per year during a period when private equity made healthy excess returns over public equity. The portfolio has been overweight in vintages that return less than 7 per cent per annum and underweight in vintages where returns are over 14 per cent per annum, she detailed.

Fees

Oregon’s reform process has also centred around fees in a recognition that fee mitigation is a crucial seam to performance.

“You are not going to get relative outperformance by just being in the asset class,” Tom Martin, managing director at TorreyCove Capital Partners, Oregon’s private equity consultant told the Council.

Fee mitigation is driven first and foremost by “quality primary programs” through which Oregon scales the benefits of its brand and ability to deploy dollars at scale, gains early mover advantages and “unique fee mitigating structures.”

Oregon’s co-investment program is also driving fee compression, introducing “customised structures and pricing” alongside primary relationships.

“It may not be a management fee saving from the primary commitment, it might be the blended rate you derive through co-investment deals you do alongside that GP,” he said.

The Council heard how the re-designed co-investment program implemented last year has already helped reduce fees, and has been “successful so far” in terms of activity and reception from GPs. Its impact will really kick-in in the years to come, predicted Martin. “It’s providing a cost savings to the tune of what will become several hundred million dollars a year over time. As this compounds, it will generate a material benefit to the program.”

Manager reduction

The reform process has also slashed the number of GPs.

Although Oregon added three new names to the portfolio last year, between six to eight names exited in a “big year of churn.”

Until recently Oregon had “outsized” manager relationships plus mandates with around 80 substantially smaller relationships. Today around five managers account for 30 per cent of the portfolio and the GP roster has been cut in half to around 40-45.

The fund now has an “informal goal” to ensure no single GP represents more than 5 per cent of the portfolio. It has also beefed up its manager due diligence and monitoring processes. This includes updating and compiling multiple data sets which track over 800 GPs, gathering information on different geographies, strategies and fund size allowing the pension fund to source ideas and manage its GP pipeline.

Pivot

Elsewhere, Oregon has added more value-oriented strategies to counter the tilt to growth and made strides to reduce its exposure to North America (targeting around 60-65 per cent) in favour of an increase to Europe (targeting 20-25 per cent) and Asia (targeting 12-16 per cent), with the team expressing a “high degree” of confidence in returns coming out of Europe.

The fund also continues to reposition the portfolio away from the larger end of the market to mid-market. Here the challenge is “deployment at scale” at this competitive point, requiring proactive outreach and relationship management, as well as selling Oregon’s brand.

Looking back at 2019 the team noted a “modest decline” in M&A transaction volumes and leverage finance, and record fundraising levels in terms of total capital raised, average fund size and the length of time required to raise a fund.

Oregon processed $3.1 billion of capital calls and received back $3.4 billion in distributions, leading to a net positive cash flow to the fund of $350 million, a decline compared to previous years. Something the team attributed to a slowdown in transaction volumes, fewer exits impacting on the number of distributions, and the use of subscription lines which defer capital calls and slow activity.

In another trend the team observed how public and private companies that share the same sector are increasingly “decoupling.” For example, in financial services listed banks and insurance companies battle interest rate volatility and high levels of regulation. In contrast, privately held fintech groups are smaller and more nimble; able to disrupt and disintermediate.

ESG

The Council also heard how ESG is increasingly integrated into private equity in an “evolution” that isn’t appreciated, or easily visible, beyond a closed group of LPs.

Integration has moved on from LPs simply requesting GPs have a written ESG policy to LPs increasingly demanding GPs move beyond marketing to real risk mitigation. Now Oregon is starting to see ESG risk factors applied to companies’ cost of capital whereby companies with an ESG profile become more valuable.

“Nothing gets private equity managers more excited than good old-fashioned value creation,” the Council heard.

I chat with Asif on his career journey, how the world changed after the GFC and what he sees for the future of machine learning assisting with rigorous testing of a hypothesis.

Career, systems, how the world changed after GFC, data sets that are interesting, AI and machine learning, neural networks, testing a hypothesis and data.

Nothing on this podcast is to be considered investment advice or a recommendation. No investment decision or activity should be undertaken without first seeking qualified and professional advice.