Introducing the AXA IM Investment Institute
It is a great privilege and honour to be appointed as Chair of the newly created AXA Investment Managers Investment Institute. This platform will support our research and thought leadership efforts across macroeconomics, asset classes, sustainability and future trends. Its intention is to help our investment teams generate sustainable long-term performance, help our clients in their own decision making and contribute to the wider understanding of issues and challenges facing the asset management industry. I am excited to be leading this new initiative and to work with world-class investment and research professionals.
There is plenty going on in the world that we need to try and understand and work out what it means for our collective capital. At the macro level, the global economy continues to be impacted by supply issues that have led to shortages of goods and labour as well as by the highest inflation rates seen in a generation. Companies are facing higher costs and pressure on profit margins, as well as having to manage shortages of labour and long supplier delivery times in many product markets. The policy response has been mixed. Central bankers need to tighten monetary policy as controlling inflation is the number one concern. It’s just that they haven’t done it for a while as the period since the global financial crisis has been about fighting the perception of deflation. This is causing angst amongst central bankers themselves – arguing about timing and about the right size of the adjustment in interest rates – and in the financial markets. Meanwhile there is a risk that higher inflation becomes more permanent – not as high as 9% but conceivably 3% to 4%. The role of financial markets is to find prices that reflect expected return and risk. The complexity of factors which are taken into account in order for this process to work are mind-boggling and keep analysts, economists and other commentators busy. Economists talk about “noise” and “signals” when assessing information and there is far more noise than signal, most of the time. Considered research and analysis helps sort between them and this is where I hope our new Institute can really add value.
Orders of uncertainty
Interest rates are always at the heart of financial analysis, and we are in a period where rates are rising. This creates several orders of uncertainty. The first being, how much will they rise? This is important because interest rates are used to discount the future cash-flows that help us value financial assets today. Markets try to price where the terminal rate will be, but this is based on forecasts and probabilities. There is no exact science. The second order of uncertainty is what those future cash-flows will be. It is fairly straightforward when buying a fixed-rate bond instrument because the coupon payments are known. Higher rates mean those future cash-flows are worth less, so bond prices go down. It is more difficult when it comes to equities as future corporate profits are very much determined by what happens to economic growth. That uncertainty also means a bigger risk premium to compensate for the risk of returns falling short. This is why markets continue to be nervous today. Central bankers are vocal about raising rates and this process will extend for some time. High rates mean more cash-flow is spent on servicing existing debt, leaving less to spend on consumption and investment. Some debtors might not be able to keep meeting those payments, a risk that has been highlighted in a research piece by Deutsche Bank1 I have written recently that bond markets are offering some tactical opportunities to increase exposure but there is still the risk of even lower prices as higher interest rates are priced in.
The clearer message from the European Central Bank about its intentions to raise rates has awoken concerns about fiscal sustainability in Europe. Hence the disproportionate decline in Italian government bond prices this week. The market’s memory is of the ECB having policies to support countries with weaker balance sheets in order to minimise the risk of financial fragmentation in the Eurozone. Now that policy is reversing, the conclusion is that risk needs to be higher again. Of course, the ECB has mechanisms to respond (the Draghi put) but in the short-term, sovereign risk in Europe needs to price in weaker growth, higher inflation and higher borrowing costs in a regime where there is no appetite to appease markets with a return to austerity. Currently inflation is higher than interest rates so the real value of debt will be falling, but as rates rise, inflation and growth falls, and debt sustainability becomes a real issue again. Investment returns in Europe will be infected by these risks.
As if rising rates weren’t enough, there are conversations about the end of globalisation, a fractured global geo-political landscape, and a de-stabilised energy market. The Investment Institute’s first major research piece, written by my colleagues David Page and Olivier Eugène, considers the impact of the Russian invasion of Ukraine and the repercussions for the global energy market. A key consideration is the effect on carbon dioxide emissions, which are rising again. For investors following sustainable investment strategies, the energy sector is a major challenge. Crudely, being underweight energy has generated underperformance relative to market benchmarks in 2022. More importantly, net-zero focused strategies need careful consideration of how the energy market can realistically evolve, including the somewhat uncomfortable realisation that traditional oil and gas companies need to play a major role themselves in developing new and cleaner energy sources.
In the spotlight
The Institute will be focused on sustainability. Water scarcity, the need to preserve biodiversity and how our management of emissions reduction interacts with these issues are topics that we will keep coming back to. I was at a conference recently where there was a lot of discussion about forestry as an asset class. It is in demand, which is good because the world needs more trees to help take CO2 out of the atmosphere. Yet a lot of forestry is being bought to provide carbon offsets which means less trees being felled for timber, which means higher timber prices and shortages of construction materials. Furthermore, monocultural cultivation of trees is not great for biodiversity.
Corporate and social responsibility
There will also be more focus on social issues and how they affect the assessment of corporate value. The key is to find companies that are thinking about managing their workforces, not just to reach diversity and inclusion targets, but to unlock value by training, changing workplace arrangements and fostering real employee engagement and alignment with sustainability plans. Indeed, a broader driver of ESG investing will be to identify, when company managers are setting their sustainability plans, how they implement them in such a way that unlocks upside. Only then is there more scope for aligning ESG with better returns. For example, it is one thing to have net zero plans credited under the Science Based Targets initiative. It is another thing to actually implement the plans in a way that improves the bottom line or allows companies to leverage changes in their business model that not only set them on a path to net zero but create new revenue lines.
A brighter future
This year is set to be tough, and the skies are grey. But the future can be better. Technology is evolving continually to support the transition. Labour participation can rise again as the returns to labour become more attractive and if governments recognise that letting the market allocate people to jobs is better than nationalistically driven attempts to “preserve (insert nationality of choice) jobs” by blunt immigration and protectionist trade policies. The most optimism one can have is by thinking what might be if we get the energy transition right. Solar and wind can replace oil, gas and coal. We have the knowhow; we are already doing it. But it needs to be scaled up massively and that will require higher carbon prices and more fiscal spending on infrastructure. But in the end, we will have a cleaner global energy system, a more democratic energy system and, hopefully, a global policy system where control of energy resources is not weaponised for medieval political reasons.
Investors can’t control markets or the returns they get. But let’s take the view that a lot of the current issues facing the global economy are being dealt with. The cost may be weak returns and a recession and the response to that should be to have a defensive tilt to investment portfolios until valuations are obviously much more attractive. We are getting there and in one-or-two-year’s time inflation will be lower, rates will have stopped going up, and corporate assets will provide opportunities to grow earnings strongly again. The AXA IM Investment Institute will try to help navigate these challenging times. Visit the AXA IM Investment Institute here.