International | Jan 29 2020
The weather has always been a favourite topic of conversation but it has now assumed an extra, substantial, dimension for investors, Saxo Group asserts.
-Unsustainable economic activity has eroded potential and led to lack of productivity
-Climate disasters tend to act like volatility in the market, which generates even more volatility
-Current yield curve creating an attractive environment for fiscal stimulus to be oriented to green projects
By Eva Brocklehurst
The climate, wherever you are, is getting a lot of coverage lately. The weather has always been a favourite topic of conversation, or to start conversations, but it has now assumed an extra dimension.
Where does this put investors? It appears the cost of the present model used to judge economic prosperity is rising and this scenario requires re-thinking. Saxo Group, in its quarterly outlook, suspects the equilibrium point of economic growth versus the cost has now been passed.
It appears accounting systems and measures of economic growth do not cater properly for the cost of longer-term resource depletion and environmental harm.
Saxo Group's chief economist, Steen Jakobsen, also asserts a lack of price discovery over the past decade has led to unsustainable economic activity, which has not only eroded the long-term potential of economies but also led to a lack of productivity.
Rather than investing in new ways of doing business, existing assets have been sought from "mountains of cheap financing". There will be major political fall-out, Mr Jakobsen believes. This will arise first through the heightened cost of living, as food prices spike, then through increasing inequality.
For investors this comes at a bad time, as in 2019 asset prices rose as major central banks went from quantitative tightening and back to quantitative easing, and governments expanded fiscal deficits. Meanwhile, inflation is expected to continue falling, driven by demographic shifts and a lack of productivity.
Consensus economic forecasts appear to be relying on low inflation and low interest rates, no price discovery and a full acceptance of monopolies in technology with a lack of commitment to reduce inequality.
Mr Jakobsen suspects the lack of focus, lack of accountability and lack of respect for the climate is about to change the dynamics of how politicians are elected, how economic growth is measured and how society prioritises its activities. There are three factors that will change the status quo in 2020, he asserts. These include a change of US President, which would create a new impulse both politically and economically.
Secondly, credit failures, as the excessive value of the market becomes an issue and the loss of control over repo rates by the US Federal Reserve generates event risk for credit. In this the US shale sector is the most exposed. Finally escalating costs of food, water and clean air could signal the enormous under-investment in infrastructure, which increases the risk of a spike in volatility when the next disaster strikes.
Greener Portfolio
So, is it time for a greener portfolio? Saxo Group's head of equity strategy, Peter Gamry, believes so and suspects green stocks could, over time, become some of the world's most valuable companies, even eclipsing the current technology monopolies.
Investors are advised to consider tilting portfolios towards green stocks. The most obvious list of industries which will drive a less carbon-intensive future include solar, wind, fuel cells, electric vehicles, hydro, nuclear, bioplastic, recycling, water, building materials and food.
Some are mature and some are emerging which couples with high risk. Nevertheless, the positive catalysts are clear, such as government support, changing consumer choices, millennials demanding change and technological advancement which lowers costs.
Excepting nuclear and wind turbines, all of these industries trade at valuation premiums to the global equity markets. This reflects investor optimism about future cash flows but also higher risk if expectations are not met.
Mr Gamry considers, relative to the general equity market, hydro, nuclear, recycling and water are less risky industries, as the demand profile is more stable. Those that are more cyclical such as solar, wind, electric vehicles and building materials can be more negatively impacted during a recession.
Unlike the technologies, where returns on capital are "insanely high" and easily scalable, greener industry require vast amounts of capital to operate and, if interest rates rise again, this may have a negative effect on operating conditions and particular on equity valuations. Mr Gamry also suggests being overweight European and emerging market equities, assessing now is not the time to be underweight equities.
Saxo Group's global macro strategist, Kay Van-Petersen, believes climate disasters tend to act like volatility in the market which generates even more volatility. This is driving structural change.
The first, demand, means more and more consumers will want to use their capital to invest in companies which practice sustainability. Companies and entrepreneurs that are proactive in this regard are likely to move ahead.
The second is supply. Governments are coming to the understanding that the tipping point has passed, with the cost of doing nothing about sustainable growth being much greater than the cost of addressing it now.
In 2020, the foundations for a large European monetary and fiscal stimulus package is likely to be implemented. However, head of macro economic analysis, Christopher Dembik does not believe "green" quantitative easing from the European Central Bank, by itself, will de-carbonise the global economy.
Contrary to what happened over the past ten years, central banks cannot be the only operators in this fight and governments will need to step in. Thus, he points out, the current evolution of the yield curve is creating a very attractive fiscal environment to fund green projects.
Australia
Before the severe and tragic bushfires posed headwinds to consumer confidence and economic activity in Australia, Saxo Group expected the Reserve Bank would cut the cash rate in February and once again later in 2020.
The disaster has reinforced expectations for a 25 basis points cut to the cash rate in February, particularly whilst the government leaves the heavy lifting to the central bank. This will mean both the Australian dollar and Australian bond yields are shackled by the domestic outlook.
Australian policy is actually delivering a worsening outcome as coal-fired power generation gets the green light with little regard for the phase-out obligations of the Paris Agreement. However, climate indifference appears to have peaked. Hence, market strategist Eleanor Creagh points out, if the 2020s are to be cleaner and greener, then investors and policymakers must allocate to sustainable business models or face large losses.
Commodities
Global supply chains are being left vulnerable to sudden climate-related drops in yields after several years of ample supply and stable or lower prices. Entering 2020, this has resulted in negative returns from most exchange-traded funds that have broad-based exposure to key agricultural commodities.
Hence, head of commodity strategy, Ole Hansen, envisages the gold price building on 2019 gains, as the technical and fundamental outlook improves. The metal is expected to consolidate above US$1500/oz in the first quarter of 2020 before moving higher to peak at around US$1625/oz.
Brent crude is expected to remain stuck in the US$60/bbl range through the first half of 2020 before moving higher. The price is envisaged at US$75/bbl by the end of the year as inflation picks up in the US dollar weakens. Any short-term weakness, perhaps inspired by speculators, is expected to be limited.
US Dollar
The prospect of the slowing US economy, budget deficits and a US election could weigh on the prospects of the US dollar. The US dollar appears to have defied expectations over 2019, considering the US Fed has outpaced the easing being undertaken by central banks elsewhere.
Saxo Group's head of FX strategy, John Hardy, believes this speaks to the residual strength in the US economy relative to global peers. While many of the US dollar drivers appear well entrenched in 2020, Mr Hardy still envisages a low ceiling to what has effectively been a flat US dollar over the last 18 months.
Another potential headwind emanates from the Fed actions to shore up liquidity in late 2019. "The provision of Fed liquidity and the risk that this eventually results in inflation and more highly negative US real rates look enough to finally turned the US dollar lower," Mr Hardy adds.
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