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8 min read 16 Mar 22
The Investment Office Insights article is a quarterly thought leadership piece which covers 2-3 topical items that the Investment Office think are worthy of comment and analysis. Each quarter, you will get a chance to hear from various teams within the Investment Office, depending on what is topical at that particular time.
In the first ever Investment Office Insights report, the Investment Office discusses recent inflation data and the effect that this has had on different markets, along with a summary of COP26 and why they think it was important.
Economic growth: As interest rates are positively correlated to economic growth, the Omicron variant of COVID-19 drove a reduction in longer term US interest rates (bond yields) in the last quarter of 2021, as the fallout from potential lockdowns led to investors marking down expectations of future growth. More recently, a consensus among the scientific community has emerged that the severity of Omicron is lower than the Delta variant experienced early in 2021. Following on from this, markets concluded that the levels of restrictions were unlikely to be as onerous as Spring 2021 and consequently the new year has seen a re-rating of bonds to reflect a higher likelihood of monetary policy normalisation through 2022 and beyond. For example, the US ten-year government bond yield increased by 34 basis points to 1.84% by the 18th January.
Inflation: Central banks use monetary policy to achieve a target level of inflation. When inflation rises, expectations of higher interest rates to combat inflation feed into bond yields. Coming into the new year, commentators’ estimates on US inflation coming in at 7% for the year to December grabbed the attention of bond investors and, combined with the relief of the lower Omicron severity, drove bond yields higher.
Profit growth: A consequence of the pandemic and its lockdowns has been the huge benefit to the online economy, as economic agents rapidly adjusted and in many cases, brought forward plans to conduct business virtually. The ensuing rapid profit growth was concentrated in the technology sector, at the same time as future growth expectations began to embed a quicker transition to hybrid ways of working than might have been expected five to ten years ago. The supernormal component of their earnings – those attributable to peak-pandemic – are unlikely to persist, and the ‘return to normal trade’ has typically meant a rotation out of these sectors. We saw the peak of the Nasdaq US tech index as the Omicron cases peaked, and a drop in the index following the positive medical reports on the lower severity of the virus.
Interest rates: A large part of the technology sector consists of companies that are in the growth phase of their lifespan. This means that a large part of the current valuation is made up of forecasted future profits that occur far out in time (sometimes once the companies become profitable, if they aren’t already). Stock valuation works by discounting future profits back to the current day using an interest rate, known as a discount rate We show a stylised example below of a growth stock with back-end loaded earnings and another stock with a more even earnings projection. As can be seen, an increase in the discount rate* has more of an effect on the longer term cash flows, and the downward pressure on growth stocks (which on average have more of their value in the future compared to slower growth sectors) is therefore larger. This helps explain why Tech, despite its healthy earnings growth, has underperformed the wider market.
*Note in this simple/stylised example, we use a single discount rate, whereas in reality different discount rates would be used for different maturity cash flows.
Outcomes: COP26 brought together 120 world leaders and over 40,000 delegates to Glasgow, representing all 197 signatories of the UN Framework Convention on Climate Change alongside industry heavyweights, in an intense fortnight of negotiations. In many respects, COP26 was a frank acknowledgement of the challenges associated with actually meeting the ambitious targets embedded in the Paris Agreement to limit the rise in global temperatures to “well below 2°C , preferably to 1.5°C, compared to pre-industrial levels”.
COP26 proved to be a success despite the challenges ahead to achieve the Paris Climate target of 1.5°C. All 197 signatories agreed to the Glasgow Climate Pact, committing to further accelerating decarbonisation plans and specifically to strengthen their emissions-reduction targets for 2030 by November this year.
Commitments on financing were a key takeaway, with developed nations pledging to provide necessary funding for adaptation and mitigation to developing countries. However the provision of $100bn annually was an overdue reassertion of a missed promise following the Paris summit. Developed countries expressed confidence the target will hit by 2023, but in light of national interests taking priority throughout the pandemic recovery, this will face tough scrutiny. China pledged to reach net zero by 2060 and India by 2070. Whilst this is 10 and 20 years later than other countries who have committed to the same goal, it nevertheless represents progress in making commitments against which progress can be tracked over time. The push for more detailed roadmaps to net-zero continues and until such plans are converted into national legislation it is difficult to estimate how far or close we are from reaching it.
Despite estimates suggesting the pledges from Glasgow will be enough to limit peak warming this century to 1.8°C, last-minute amendments made to the Climate Pact struck a substantial blow to keeping the “dream of 1.5°C alive”. China, India, and other developing nations insisted wording to be changed from the “phase out of coal and fossil fuel subsidies” to the “phase down of unabated coal and inefficient fossil fuel subsidies”.
Implications: Realignment of trillions of dollars is required by central banks and financial institutions to facilitate global net zero ambitions. Bloomberg’s New Energy Foundation estimates that reaching net zero by 2050 will require a whopping $92-$170tr of global investment – leagues ahead of the sums currently pledged. Funding requirements mark an opportunity for investors to further their involvement with climate investment at both a local and international level. Furthermore, Rishi Sunak has announced that all financial institutions and listed companies should publish net zero transition plans by 2023. Whilst not mandatory, investors are likely to see a shift towards better transparency surrounding firms’ climate ambitions.
Financial institutions controlling over $130tr have agreed to realign towards the net zero emissions goal, backing cleaner energy sources whilst directing finance away from fossil fuels. Going forward, investors should expect to see continued improvement of reporting under the ESG microscope, with industry laggards facing mounting regulatory and client pressures. From a markets perspective, the rising cost of capital for companies seen to be lagging in their transition to a low carbon future may present headwinds at index and regional levels for those equity markets with larger weightings to those behind the curve. This may also have implications for investment styles – we have already mentioned that Technology stocks are more exposed to the interest rate cycle than other sectors; and many of the innovative companies leading the green revolution are likely to be growth stocks of similar ilk. There may be a period of transition where optically, Growth investment becomes more synonymous with ESG, while stocks considered cheap on simple metrics (ostensibly Value) may feature more impaired industries such as fossil fuels. This underlines the importance of ESG integration into the stock selection process in order to account for such structural change.
As resources and expertise improve, momentum surrounding ESG investment will continue to gain traction, and exciting opportunities spanning the spectrum from risk-managed to solution-focussed will emerge exponentially.
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