This article was first published in the second quarter 2017 edition of Personal Finance magazine.
A fragile market can easily be broken or damaged and as investors, we, or the assets managers investing on our behalf, should be aware of the potential shocks and vulnerabilities in the markets when building portfolios, according to Phil Edwards, the European director of strategic research for Mercer, which owns 34 percent of Alexander Forbes.
Edwards says a group of academics in the United States have put together an “Economic Policy Uncertainty Index”, and it is currently at an all-time high, showing that global investors are facing a time of heightened economic and political uncertainty.
He says the Volatility Index (or Vix – also known as the “fear index”) records the expected levels of volatility in financial markets, which are reflected in the prices investors pay for options on securities in those markets.
The uncertainty index is regarded as a measure of investor nervousness and has typically been highly correlated with the Vix – in other words, they reach highs and lows at the same time.
But Edwards says there is currently a large disconnect between the two indices. There are two possible reasons for this, he says: the first is that markets have become conditioned to central banks around the world responding to any period of market stress or economic weakness.
The second is that, following Donald Trump’s election as president of the US, there is an extremely high level of consensus among economic forecasters that the deregulation, tax cuts and fiscal stimulus Trump has promised will be positive for US economic growth and corporate profit growth.
Edwards says the combination of heightened uncertainty about economic policies, as reflected in the uncertainty index, and the complacency reflected in the Vix, results in fragile markets.
The World Economic Forum (WEF) recently produced the 12th edition of its Global Risks Report, which looks at some of the major risks and trends that are likely to shape the world in the future. The report is based on the perspectives of nearly 750 global leaders and experts on the perceived impact and likelihood of 30 global risks, as well as 13 underlying trends that could amplify these risks or alter the interconnections between them over a 10-year timeframe.
Edwards says the framework used in the report to group the risks into five broad categories – economic, environmental, social, geopolitical and technological – is particularly useful for investors.
According to the report, the top risks in terms of likelihood and impact are linked to environmental and climate-change issues.
Although there are some economic risks associated with government policies and price bubbles, Edwards says, these are the risks to which investors and asset managers tend to pay the most attention. It is useful, therefore, to spend some time on the other four risks and consider what they may mean for you, the investor.
The WEF Global Risks report identifies these as extreme weather events, failure of climate-change mitigation and adaptation, and water crises, and notes that this area of risk has emerged as a consistently central feature of its reports, strongly interconnected with many other risks, such as conflict and migration.
Edwards says the North American Space Agency has been tracking the land-ocean temperature index since 1908 and has seen a gradual, if bumpy, upward trend in global temperatures since the 1950s. 2016 was a record-breaking year, in which, for the first time, global temperatures rose more than one degree Celsius above the 1880 to 1999 average. This followed record-breaking years in both 2014 and 2015, he says. Investors are not thinking enough about what impact this trend could have on their portfolios, Edwards says.
In 2015, Mercer was concerned enough to produce a study called “Investing in a time of climate change”, in which the company identified two key risks.
The first is physical risk, where a weak response to climate change leads to more and more damage to infrastructure and coastal property, and real estate investments are affected, Edwards says.
The second is the risk of policy change, stemming from the United Nations Framework Convention on Climate Change, which aims to regulate greenhouse-gas emissions. The agreement was signed by 194 member countries, most of which (the US apart, now that Donald Trump has put some global-warming sceptics in senior government positions) are likely to implement policy changes, Edwards says.
Investors need to ask what impact these policy changes will have on their portfolios, he says. He suggests you consider whether there are assets in your portfolio that have a value today, but may diminish in value in future because, for example, it becomes impossible to dig fossil fuels out of the ground. These assets will become “stranded assets”, Edwards says.
On the opportunity side, there may be assets that could benefit from climate-related policy changes, Edwards says. For example, companies involved in renewable energy may deliver good returns, he says.
The polarisation of societies and growing nationalist sentiment are among the top five trends identified in the WEF Global Risks report, both interconnected with geopolitical risks.
But when it comes to your investments, Edwards says a significant global trend is the ageing of the world’s population as a result of increasing longevity and advances in medical treatment. Taking into account lower fertility across the developed world, the Economist predicts there will be a billion people over the age of 60 within a decade and called its cover story “A billion shades of grey”.
A working population has been supportive for global growth, he says, citing the generation known as the Baby Boomers”, born after World War II, as an example of a young working population boosting the economy, thereby paying what is known as a “demographic dividend”. Yet, in the developing world, there is now a growing ratio of dependants relative to the working population, Edwards says.
Between 2010 and 2015 most of the developing world has seen falling dependency ratios reverse into rising depedency ratios, which could contribute to a slowing of economic growth in the developed world, he says.
In the emerging world too, he says, the dependency ratio is rising, but the overall bias towards a younger, working population will ensure that the demographics remain more favourable in the developing world than in the developed world for some time to come.
Another social trend is the retirement of the Baby Boomers, many of whom have built large pools of savings. Their retirement will result in drawings on this pool of savings, which will remove assets from the financial system and compound low returns in many parts of the world, Edwards says.
While the world has been relatively stable since the Cold War, geopolitical risk is increasing across the world, Edwards says, making it more prone to flare-ups.
There are a number of sources of geopolitical tension, including the conflict in the Middle East, the dictatorship of Kim Jong-un in North Korea, the expansionism of Russian leader Vladmir Putin and, now, the completely different approach to diplomacy in the US of Trump, Edwards says.
A flare-up is also possible over China’s missile launching sites on disputed islands in the South China Sea, he says, and this could bring the three largest economies in the world into conflict: the US, China and Japan, he says. Consider this in the context of the South China Sea carrying a third of all world trade.
According to Edwards, the US-based business magazine Fortune says we are living in the age of “tech unicorns”: privately owned companies with valuations of more than US$1 billion. Two prime examples are Uber and AirBnb, which have disrupted the taxi and holiday accommodation industries.
More than 200 tech unicorns are valued at more than US$600 billion, he says. These businesses have a dramatic impact on the industry in which they operate, overturning the way business is done and producing both risks and opportunities. Many companies are going to be disrupted, but if you can identify the ones that will do the disrupting, you have an opportunity to make attractive returns, Edwards says.
Artificial intelligence (AI) is also on the rise, he says, with computer programs defeating chess champions, poker champions and champions of the UK word-play game Jeopardy. According to a 2013 Oxford University study, half of the jobs in the US will be automated within a decade. The risk factor in this is the need to identify businesses that will be affected by job losses.
Index investors could be particularly at risk, because a large number of industries represented in global indices could be subject to disruption brought about by technological change, Edwards says.
The opportunities lie in identifying those businesses that could benefit from the productivity boost that comes with technology and AI, he says. It will also be important to understand how managers use AI in so-called quantitative strategies.
How should you respond to these risks?
Edwards says the best thing you can do is build a portfolio that is as diversified as possible within the legal framework – for example, regulation 28 of the Pension Funds Act, which governs how you can invest your retirement savings.
He also suggests you make sure your portfolios have dynamic, multi-asset strategies capable of responding quickly to issues that put stress on financial markets. You can also include some hedge-fund strategies designed to make money regardless of the direction of the markets.
Beyond that, you need to have a manager who recognises and responds appropriately to the risks the world presents, because it is clear that the economic order we have invested in in the past is breaking down.
You need a manager, Edwards says, who is prepared to consider investing in businesses that are concerned about sustainability and have carbon policies and environmental, social and governance (ESG) strategies. The manager should also take seriously the risk of cyber attacks on the businesses they consider investing in, as well as on their own portfolios, he says.