The operating environment for asset managers has become profoundly different from the last two decades, with inflation, geoeconomics fragmentation and climate change emerging as key drivers of financial markets, says Monetary Authority of Singapore (MAS) managing director Ravi Menon at the IMAS-Bloomberg Investment Conference 2023.
He notes that the short-term driver of risks and returns is the trajectory of interest rates, which in turn depends on the inflation outlook and monetary policy response from major central banks. “The good news is that inflation seems to have peaked and come off a bit. The bad news is that it is still quite high,” he adds.
Global headline inflation averaged 5.6% in 4Q2022, compared to 6% in 3Q2022 — this has occurred in line with the sharp fall in food, energy and logistical costs. Nonetheless, inflation remains well above the average of 2.5% seen in the decade before Covid-19, from 2010 to 2019. However, expectations by some market participants that central banks may start easing are “excessively optimistic”, says Menon.
“Forward guidance by the advanced economies’ central banks indicates further tightening to core inflation. Both the Fed and the ECB [European Central Bank] have reiterated their commitment to achieve their inflation targets of 2%. The key challenge facing most central banks, including MAS, is to secure a return to low inflation without incurring too large a cost to economic growth and in some cases to financial stability.
“Thus far, the disinflation process has taken place in an orderly fashion, without much dislocation to the functioning of the global economy or financial markets. But continuing to get this balance right will be a challenge, especially if inflation gets stuck at too high a level,” he adds.
That said, how fast core inflation can return to the central banks’ target bands is contingent not just on monetary policy, Menon notes. The speed of disinflation is subject to three near-term uncertainties — labour market dynamics, China’s reopening and the surge in food and energy prices.
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Against this backdrop, investors will need to consider building greater resilience in their portfolios, says Menon. “All said and done, inflation will eventually come down and interest rates normalise, though both are likely to be slightly higher than what we have been used to,” he adds.
Effects to receding globalisation
Over the medium term, the key driver of returns and risks in the financial markets will be the effects of geoeconomic fragmentation. Rising tensions between the US and China have led to higher trade barriers, tighter cross-border investment restrictions and greater domestic production of critical goods deemed to be of strategic national importance.
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On the trade front, slightly more than 60% of the trade between the US and China is subject to tariffs, notes Menon. The investment flows between the two economic giants have slowed amid tighter regulations by the US to safeguard national security and supply chains, while both countries have stepped up domestic industrial policies.
China has committed US$1.4 trillion ($1.9 trillion) over the next five years to augment domestic technology and digital infrastructure. Meanwhile, the US has passed the US$280 billion Chips Act to boost the semiconductor research and production capabilities in the US for the next 10 years.
Aside from reducing trade and investment, these measures have also reshaped broader shifts in global trade patterns and supply chains — most evidently in the electronics industry. The US’ share in China’s electronic exports fell by four percentage points between 2017 and 2021, while regional economies such as Taiwan, Vietnam and Thailand gained market share.
Looking ahead, increased domestic capacity for electronics production in both China and the US will likely lead to a substitution of imports, says Menon. The US has proposed a Chip 4 Alliance with Taiwan, South Korea and Japan for semiconductor production, which could potentially divert trade flows away from countries that are not part of the arrangement.
“The result of the geoeconomics fragmentation is most likely slower economic growth. Several studies show that the long-term effects of receding globalisation are costly,” says Menon.
Citing an International Monetary Fund study, a scenario of limited trade fragmentation could reduce global GDP by 1.2%. Meanwhile, a World Trade Organization study found that under a more adverse scenario of a full technological decoupling from 2020 to 2040, the loss in GDP will be 8% to 12% in individual countries.
“Fragmentation in the real economy will also have an impact on capital flows and financial markets. Geoeconomics fragmentation elevates financial market risk and disruption as capital flows become more regionalised and less global. Consequently, this reduces market liquidity and returns, and increases market volatility.
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“The impact of disruptions of cross-border capital flows again falls disproportionately on the less developed countries. No country will emerge unscathed amid rising geoeconomics fragmentation, with emerging market economies set to bear the brunt of reduced trade and capital mobility,” warns Menon.
Building climate resilience
Climate change is possibly one of the most significant financial risks for investors over the long term, says Menon. This risk can materialise in two ways — first is the physical risks from climate change itself, which includes physical damage to properties and assets, disruption to supply chains, production stoppages and reduced agricultural yields which will reduce growth and push prices higher.
This is followed by transition risk, which comes from government policies, technological advances and shifts in demand patterns aimed at mitigating climate change and promoting sustainability. An example is the introduction of carbon pricing, which will change the earnings profiles of businesses, favouring firms within industries with cleaner technologies and lower carbon emissions, relative to more carbon-intensive firms and industries.
The effects of climate change on the global economy and asset markets are hard to predict, says Menon. There are inherent uncertainties in modelling climate outcomes and assessing its impact on the global economy. This is due to the limited historical data, potential non-linearities and tipping points in climate systems as well as the long horizons over which climate change materialises.
Hence, asset managers will need to build climate resilience into their portfolios, Menon highlights. They need to consider how climate change could affect the businesses that their portfolio is invested in; which firms within the portfolio have not made credible efforts to decarbonise their operations; as well as the investments that run the risk of being stranded assets in a net-zero world.
There have been significant policy moves on the sustainability front that will attract very keen invested interest in the years to come, notes Menon. In the US, the introduction of the Inflation Reduction Act will direct nearly US$400 billion in federal funding to incentivise low-carbon investments in areas such as clean energy generation and storage; electrical vehicle manufacturing; and carbon capture. In Europe, meanwhile, the REPowerEU act will mobilise up to EUR300 billion ($572.9 billion) of investment in areas such as renewable energy storage and energy efficiency to achieve the 2030 target of a renewable share of 45% in energy production.
There are also significant opportunities for sustainable investing in Asia. According to McKinsey’s estimates, net zero by 2050 would require about US$9.2 trillion of investment per year, out of which about a third would be in the Asia Pacific.
“Southeast Asia has high potential for climate action. Estimates from Bain & Co show that five sectors — renewable energy, electric vehicles, forest conservation, built environment and sustainable farming — account for 60% of Southeast Asia’s carbon abatement potential. For example, renewables such as solar and wind will reach an annual US$30 billion opportunity by 2030 while electric mobility will get an annual $50 billion opportunity by the same period,” says Menon.
To meet these needs, blended financing should be catalysed, he adds. Catalytic or concessional capital from multilateral banks, public and philanthropic sources is also needed to improve project bankability and crowd-in private sector capital.
“We need to also strengthen the financial ecosystem to deploy blended finance at scale. This involves looking beyond the financing of individual projects and moving to a portfolio approach where concentration risks can be reduced through a diversified pool of assets,” Menon concludes.
