Two recent developments — the accelerating focus on ESG and more aggressive policy interventions — could well change the way we invest in years to come. My perspective is that of a fixed income manager, but I believe these developments will impact all asset classes.
A growing societal and market focus on environmental, social, and governance (ESG) issues has kickstarted a reallocation of capital, which creates new opportunities and risks for fixed income and other investors.
- Higher inflation
In my view, the increased focus on ESG may contribute to higher inflation, at least in the short-to-medium term. Implementing environmental considerations, for instance, while desirable from a societal perspective, may involve short-term cost adjustments. This seems particularly relevant in the context of climate change where, to reach net-zero targets, governments will have to come up with suitable incentives, including potential carbon taxes, while supporting the development of reliable substitutes for fossil fuels. Seeing how reliant we are on fossil-fuel-powered energy for everything we do, this could translate into material cost increases.
Addressing social challenges may also have implications for inflation. Growing concerns over income inequality coincide with policymakers’ renewed focus on keeping inflation in their 2% target range over the long run, which requires getting more money in the hands of consumers. A greater emphasis on ensuring all stakeholders in the production chain receive their appropriate share of profits, particularly at the lower end of the wage scale, may increase inflationary pressures as production costs will rise (cost-push inflation). Moreover, low earners have a higher need/propensity to consume, which will stimulate growth, but also (demand-pull) inflation.
- Higher asset prices
Moral concerns aside, I believe the incentives for companies to adopt ESG principles are increasingly strong. It allows them to respond to heightened consumer and societal expectations and reduces the risk of being on the wrong side of future policy developments. They potentially could also lower their cost of capital. As asset allocators gravitate toward investments that are ESG-aligned — a recent Bloomberg Intelligence report projects that ESG assets may hit US$53 trillion by 20251 — we see those assets attracting a premium relative to similar non-ESG assets.
Aggressive policy intervention
The reaction function of the US Federal Reserve and other major central banks has been compressed over the last 30 years while the breadth of their interventions has expanded significantly. Central banks responded to the global financial crisis with significant quantitative easing and have revived and broadened these programs during the COVID-19 pandemic.
This has been accompanied by fiscal policy action, including direct cash payments, at a scale and speed that is truly astonishing. This sets a blueprint, in my view, for a more short-term-oriented fiscal policy.
Based on the success of the current interventions, I think it is likely that this playbook of rapid monetary policy intervention, coupled with fiscal measures, will be deployed more quickly when the need next arises, with both monetary and fiscal policymakers potentially adding further tools. And the 2020s may well see further crises as economies and markets adjust to a more uncertain environment marked by geopolitical shifts, increased climate action, and digital disruption.
What does this mean for investors?
- Focus on policy alignment — It helps to be on the right side of policy in times of extreme stress. This should favor companies that demonstrate a genuine focus on the environment, stakeholders, and improved governance as these are more likely to weather volatility and avoid regulatory or reputational risk.
- Be ready for inflation — It may be prudent to assess portfolios for their ability to withstand a potentially different inflation regime, which in turn could force a change in the rate regime.
- Act fast — As the policy response lag is compressing, investors need to react faster, and be ready to seek shelter in defensive sectors. Sharper bouts of volatility may also mean that investors reach the upper limit of the risk they can take sooner than anticipated.
- Have more “dry powder” — Pay attention to the opportunity cost between your risk allocation and your liquidity. Ensure you have sufficient risk mitigators in your portfolio while the cost of doing so is still attractive.
- Watch liquidity — The previous crisis has shown that assets that were thought to be defensive and liquid often did not deliver the necessary liquidity when needed.
To what extent both developments will change the investment landscape is hard to tell at this stage. What is certain, in my view, is that investors need to take note and proactively review their investment approach
1Bloomberg Intelligence, 23 February 2021.