The global financial crisis of 2008 left an indelible mark on financial markets, and scarred the economic system. New regulations, central bank actions and changed investor behaviour profoundly altered market trajectories for the decade that followed.
The outbreak of Covid, together with government and central bank responses, is likely to have a similarly profound effect – after years of disinflationary trends, it may even have sown the seeds for eventual inflation. It has also helped to raise the profile of both sustainability and inequality, providing a timely reminder that both “traditional” and non-traditional climate and ESG risks need to be built into modelling when making strategic decisions about how to deploy capital.
The IMF estimates that global debt stands at $270 trillion, or 350% of global GDP, a figure we have not seen since the end of World War Two. Meanwhile, interest rates around the developing world are at or close to zero, which is spectacularly important for medium-term investment returns. The past decade of QE, austerity and fiscal prudence drove yields lower and Covid pushed them to all-time lows. Indeed, by December 2020, $18 trillion of government debt was negative-yielding.
Why is this important? Because it means government bonds are now especially sensitive to interest rates – and government bonds are the foundation stone on which markets are built. As a result, all else being equal, returns should be lower than in recent years, in both credit and equity markets.
Of course, in reality all else is never equal, but the new pressure on returns is nevertheless a reality.
It may well be inflation, or at least the expectation of inflation, that is the biggest risk to investors. If the keynote of the post-GFC decade was monetary stimulus, we may now be entering a period of traditional Keynesian fiscal stimulus. Money during this crisis has been channelled directly to the consumer as opposed to the banking sector – and money supply has increased markedly. Moreover, fiscal stimulus has fuelled both retail sales and savings rates. The latter could yet be unleashed as additional demand, even as Covid-related bottlenecks remain.
All of this is before the Yellen-inspired $1.9 trillion package and infrastructure bill have flowed through to markets. Some inflation would be welcome in order to erode the large debt burden, but too much inflation would drag bond yields – and, finally, interest rates – with it, making the debt less financeable. The Federal Reserve and others therefore need to engineer the “goldilocks” level of inflation that erodes debt and, as the IMF puts it, “provide a bridge to the recovery”, but does not require too many interest rate rises. Quite the tightrope.
As we think about these long-term themes, we need to view them through the lens of the portfolios we have built for our partner funds. Fundamentally, investment is about understanding the risks that you are exposed to, formulating a view as to the distribution of potential returns, and ensuring that the resulting compensation on offer is appropriate. We have always believed climate change is a long-term theme that investors need to prioritise. However, various recent developments linked to Covid appear to have raised the issue’s profile significantly, among them, new reporting requirements, a change in US government policy, societal changes and evolving investor demands, which have driven capital flows.
What the response to Covid has shown us is that, where there is a political will, significant financing can be found, and governments and corporations can work together towards a common goal. It certainly provides a blueprint for tackling climate change, although the higher debt burden has made it still more of a challenge for governments to fund the incentives and programmes needed to radically move us forward. Consider, for example, the £3 trillion bill attached to getting the UK energy network to Net Zero.1 Given this global need for financing, the recent Biden proposal of a new global tax regime is timely.
Greening the economy will create winners and losers, but the path will not be smooth or linear, as valuations of clean stocks will inevitably run ahead of fundamentals. Investors therefore need to understand the long-term themes, the relationship between technological feasibility and profitability, and the interplay between medium-term valuation considerations and shorter-term investment flows.
This narrative assumes that we achieve Net Zero, but clearly there are significant systemic risks if we do not manage to achieve the Paris targets. As things stands, the governments, corporations and institutions that bind the economic ecosystem are not prepared for a warmer world, and neither are current risk models. Removing a relatively simple piece of the puzzle, such as insurance, can create catastrophic effects, as we saw during the GFC. Some business and property risks could easily become uninsurable, potentially creating a litany of stranded and impaired assets and business ecosystems.
Working with our investment partners, academics and focused groups like the PRI to trace these fault lines can shine a light on where a new series of systemic risks may lie. It is not enough to align our portfolios to Net Zero if we do so in isolation. As for governments, so for companies – the challenges of Covid and climate change alike will only be met through coordination.
1 Source: Energy Technological Institute