Chris IggoChair of the AXA IM Investment Institute and CIO of AXA IM Core
June 24, 2022
Why geopolitics must not derail the energy transition - or investors’ resolve
Energy security, the robustness of global supply chains and climate change have become inextricably linked in recent years. Geopolitical and environmental tensions have contributed to the need for companies to focus on shortened supply chains and reduced carbon footprints, and for governments to incorporate sustainability into fiscal investment and policy frameworks.
8 minutes
Original Content: AXA IM
The escalation of trade tensions between the US and China in 2018 was followed by the COVID-19 global shock to output. The path of globalisation was brought into question as a result. More recently, the war in Ukraine has highlighted issues around energy and food security – and how potential geopolitical alignments can disrupt the global trading system. Uncertainty around near to medium-term inflation and economic growth has resulted.
Arguably, investors should consider resetting expectations which may be based on a pre-2018 world of low inflation, low interest rates, globalised manufacturing and markets, and depressed risk premiums in financial markets.
What drives our approach to responsible investing is to think about ‘people and the planet’ and we use the United Nation’s Sustainable Development Goals as a reference framework. Our investment decisions are being increasingly guided by the impact they have on areas such as combating inequality, reducing poverty, supporting peace and strong institutions, as well as on climate change, the provision of clean energy and the health of our oceans.
Security challenges
Recent global events should make us recognise there are material risks of adverse outcomes in many of these areas. Peace and security in Eastern Europe have been challenged by the Ukraine crisis and progress towards reducing CO2 emissions has been pushed back by the political and economic need to replace Russian energy sources. In the short term this looks like it means more fossil fuel utilisation and a reduced probability of limiting the rise in global atmospheric temperature to below 1.5oC by 2050.
The rise in energy prices will reduce real incomes, especially for the poorest, while the rise in global interest rates that is accompanying higher inflation rates could impact on economic growth and employment for many. There is also the risk of a political push-back to the net-zero agenda as populist voices focus on the cost-of-living crisis and push for renewed investment in fossil-fuel capacity.
The main channels through which the Ukraine crisis has impacted the global economy are energy supply and prices, potential disruption to trade in other commodities, and overall business, consumer, and investor confidence.
Supply and distribution
Combining the crisis with the ongoing impact of COVID-19, seen most recently in terms of lockdowns in China during the early Spring, it is clear more thought needs to be given to the security of supply, in terms of inputs to the manufacturing process but also in terms of distribution. Labour shortages at transport hubs have become more commonplace, disrupting exports and imports and onward distribution to consumer markets. Shortages of materials have hindered construction, while lead times for many durable goods have become extended. For those countries dependent on Russian supplies of oil and gas there is an acute vulnerability, to further price increases, but also to reduced access to supply. At the extreme end there is the risk is of an acute economic and social crisis.
There are both short and longer-term issues at stake. In the short term the focus is on how higher energy prices will impact on the path of inflation in developed and emerging economies and generate a permanent shift higher in inflation expectations. This is a clear and present danger given the path inflation has taken since 2020 and considering that inflationary pressures have not been limited to just energy.
Mis-priced inflation, yields and rates
Core inflation is higher and wage growth has responded both to higher costs and to tight labour markets. For fixed income investors this creates the biggest challenge for many years. Higher inflation means negative real returns from bonds both in terms of income (yields are lower than inflation) and in terms of capital adjustment as interest rates are increased. Moreover, inflation eats into the real value of a nominal bond portfolio.
The consensus outlook says that inflation pressures will ease over the next year, and that current forward pricing of interest rates should be compatible with what central banks do with policy interest rates. In short, most of the monetary tightening is anticipated to happen within the next 12 to 18 months, and thereafter both inflation and interest rates should come down.
There are potential alternative outcomes for bond investors. One key risk is that inflation is mis-priced and will remain higher over the medium-term than is currently expected. Forward inflation markets do suggest higher average inflation rates than those we saw pre-pandemic, but they are only marginally above existing central bank target ranges.
If the world must adapt to new supply chains, reshoring and higher costs of transportation, then inflation could generally run higher. That would bring higher equilibrium rates too, potentially pushing bond yields above what is currently priced in forward markets. Inflation uncertainty should lead to higher interest rate term premiums. Given existing household, corporate and government debt levels, higher financing costs could bring credit problems and more dispersion among credit-based assets.
Further investment implications
At this stage we do not know how the Ukraine crisis will play out. Coming on top of already elevated energy prices, the impact on real incomes is clear to see across developed and emerging economies. In some places this is being partially absorbed by fiscal support but that has a cost. Economic growth forecasts have been revised down and that should, all things being equal, push risk premiums in credit and equity markets higher. Equity markets have derated to some extent over the last year – as is typical at the start of a monetary tightening cycle – but consensus expectations are that earnings will continue to grow.
The key risk to equity performance is an earnings shock from corporates or through more severe cuts to economic growth forecasts. A US recession in the next two years, driven mostly by the Federal Reserve’s response to higher inflation, is a clear risk. Higher inflation probably requires policy to target demand. The rise in energy prices does create risks of second-round inflation effects. Higher rates will be part of trying to break the inflation cycle and that creates growth risks. The outlook for bonds and equities will diverge at some point as a result.
The longer-term themes of security and sustainability will persist beyond the current monetary tightening cycle. This is not the place to speculate on global geopolitical outcomes but the arguments for countries and companies to have more security in terms of energy is clear to see.
This of course means we need to accelerate the transition to alternative energy for both political-economy and environmental reasons. Technology driven reductions in the cost of alternative energy set against the elevated cost of hydrocarbons make clear the economic logic of this. But, of course, the constraint is capacity and achieving critical mass will need a lot more investment.
The investment potential
The sunny uplands of the energy transition are appealing: De-centralised energy production; massively reduced reliance on hydrocarbons; cheaper energy not subject to the same level of geopolitical influence. Geographically well-positioned regions could become major sources of cheap renewable solar and wind power, feeding into other intermediate energy sources like hydrogen.
The potential for economic transformation is clear. Once the writing on the wall is clearer for those nations traditionally supported by hydrocarbons, there will be an acceleration of the transition in order to maintain economic competitiveness. Would Russia be able to behave in such a way if the energy transition was already more advanced? The impact on the global economy would be much less, for sure.
We have long championed the investment opportunities provided by the energy transition. It is even more important today, in the wake of recently updated analyses on climate change, to push the carbon reduction investment theme. Companies developing technologies which contribute to decarbonisation and energy efficiency should benefit. Investors are finding a growing universe of green assets in which to invest.
Countries able to accelerate the shift away from reliance on hydrocarbons will experience lower energy price inflation going forward which is clearly beneficial to households and the corporate sector. Unfortunately, the most recent period has shown up those that have underinvested in the energy infrastructure. And that brings us back to the inflation risks. Whether through raising carbon prices or limited capacity in the traditional power sector, the transition is likely to see higher energy prices before the global economy feels the benefit of a more sustainable energy sector over the medium-term.
Geopolitics vs. investing for the long term
Geopolitical security is also likely to be a concern going forward. Being reliant on materials, commodities, goods and skills which reside in or originate from unfriendly political states is more of a concern for companies. The US/China trade war and Brexit, in different ways, provide examples of those risks. As part of assessing ESG risks, understanding supply chains and their vulnerability for the business as well as their impact on people and planet will be even more important in determining attractive investments.
Geopolitical events can lay bare weaknesses in the global economy. Often energy has been the conduit for economic disruption, but trade and people displacement are also typical. The minimisation of physical risks to companies supports the ongoing deployment of digital solutions and automation in the value chain. The Ukraine crisis has arguably strengthened the western political alliance and the value in liberal social democratic economies. It has also brought into focus weaknesses. Delivering more secure and equitable health, energy, food and physical protection are likely to be key priorities for society over the next decade.
For investors the need to go even further in understanding business models, the risks they are subject to, and the broader impact they have is even greater today. Investment opportunities in companies which are on track to meet their net zero carbon emissions targets, which can manage their supply chains so they are at less risk from shocks and which can focus on providing equitable, flexible and well-rewarded employment is the nirvana for responsible investors. At the same time avoiding exposure to assets in countries falling short of international benchmarks in terms of human rights, diplomacy and environmental standards should be a guiding lesson of recent events.
Five key takeaways
- The Ukraine crisis, the fiscal and monetary response to the pandemic, and the lingering effects of 2018’s US-China trade dispute should prompt pension funds to revisit their assumptions about the global economy. Inflation may prove sustained, even as interest rates move higher
- Inflation is being driven notably by the impact on energy prices from the war in Ukraine. Elevated price levels will reduce real incomes and could well dent business and consumer confidence, as well as growth expectations
- This creates a problem for fixed income investors as yields sit below inflation levels and as rising prices eat into the real value of a nominal bond portfolio. Equities face an elevated risk from potential slower growth, with recession risk in the US now higher as the Fed battles its inflation dilemma
- The energy transition looks ever more appealing, if harder to achieve in light of events in Ukraine. We cannot speculate about global geopolitical outcomes but the arguments for countries and companies to have more security in terms of energy is clear to see
- Capacity remains a constraint for the energy transition. Countries able to accelerate the shift away from hydrocarbons will likely experience lower energy price inflation in the future. Companies active in technologies which contribute to decarbonisation should benefit
