November – neuroplasticity, TINA and COP26

investment insights

November – neuroplasticity, TINA and COP26

Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

Stéphane Monier

Chief Investment Officer
Lombard Odier Private Bank

In a month where we are firing test rockets at asteroids and worrying about water buffaloes harbouring Covid-19, the term ‘neuroplasticity’ takes on a particular relevance.

Neuroplasticity is a medical term that describes the brain's ability to adapt to its environment. While common to nearly all mammals, neuroplasticity is distinctively malleable in humans. This process, which gives us the ability to navigate a world in constant flux, has helped us prevail over other species since the first Homo sapiens appeared around 300,000 years ago.

Our brains can change and evolve thanks to some 86 billion neurons, whose performance largely depends on the quality of their interconnectivity. From birth to the age of three, the number of synapses connecting each of these neurons grows from 2,500 to 15,000. From then on, our cognitive abilities evolve on a use-it-or-lose-it basis, as the brain constantly reconfigures itself to optimise responses to new challenges.

Generally, young brains tend to be more plastic than older ones. However, scientists have found that mental activities stimulate new connections between nerve cells, thus building up a hedge against cognitive loss. More specifically, studies show that some of the most effective levers in maintaining a healthy brain consist of embracing new experiences and expanding one’s social interactions.

In light of the above, I hope that this new monthly commentary, which I intend to make community building though your comments, will help preserve my brain from the inevitable march of time.

Central bankers must have maintained remarkable neuroplasticity in recent years, as they are thrust into the limelight and take us ever further into experimental monetary policy territory

Central bankers must have maintained remarkable neuroplasticity in recent years, as they are thrust into the limelight and take us ever further into experimental monetary policy territory. Having launched a swift response to pandemic-related financial turmoil in March 2020, Fed Chairman Jerome Powell, for instance, is now maintaining vastly accommodative policy despite rising inflation prints. This has led US real yields to fall to unprecedented lows this month.

The resulting anaemic returns in public fixed income markets continue to fuel TINA (There Is No Alternative) purchases among investors, who are taking increasingly more risk to meet their return targets, thereby bringing equity indices to record highs.

A couple of years ago, this macro section would typically have been dedicated to discussing the dynamics of key economic indicators such as growth, inflation, employment, household consumption or housing starts. While these remain key inputs to our analysis, a significant role for our macro team today has become trying to anticipate central bankers’ actions.

In doing so, we uncover asymmetric risks for Powell, ECB President Christine Lagarde and their peers. Indeed, letting inflation run above target for some time represents much more benign a mistake than upsetting financial markets and potentially the recovery. From this angle, it is easier to understand Bank of England Governor Andrew Bailey’s decision to keep rates unchanged this month, despite October inflation reaching a decade high of 4.2%. No one wants to be responsible for derailing growth.

We uncover asymmetric risks for Jerome Powell, Christine Lagarde and their peers

At Lombard Odier, our base case is that central banks will continue to err on the side of caution, removing extraordinary support progressively and flexibly. Rate rises, when they come, will probably be gradual and well telegraphed to markets. In other words, the music may not be as loud, but it will continue to play for some time.

This section discusses our monthly asset allocation changes and the rationale behind them. For this first edition, allow me to briefly summarise our positioning by asset class by ascending order of risk:

High but slowing growth, along with gradual fiscal and monetary tightening, mean that volatility should rise in 2022. We thus recommend building a cash buffer to seize opportunities in the increasing chance that they may arise.

Within liquid fixed income, we struggle to find any value, particularly in developed economies, be it in the sovereign or corporate space. Investors keen to maintain a bond anchor may look to emerging markets for a substitute, and particularly to Chinese debt, which we believe pays an acceptable yield premium over US Treasuries, for instance.

You may have deduced from the previous two paragraphs that the bulk of our current portfolio exposure sits within equities. Indeed, the continued economic recovery and expected ongoing support from fiscal and monetary policies lead us to maintain our pro-risk exposure. In terms of styles, we favour cyclical and value stocks, which we tend to find in larger numbers in Europe and the UK, as well as small caps.

The continued economic recovery and expected ongoing support from fiscal and monetary policies lead us to maintain our pro-risk exposure

Finally, yet importantly, we encourage investors that can afford to forego liquidity to consider increasing their exposure to private assets. In particular, real estate and infrastructure are two sectors that we believe may significantly benefit from the stimulus packages being voted across developed economies.

As COP26 concluded this month, allow me to close this first Rethink the Month commentary with sustainability, which is central to both our corporate philosophy and investment strategy.

Going back to plasticity, while the human brain can go through numerous mutations, the human body has strict limits, beyond which it cannot function. Scientists tell us there are nine “planetary boundaries” that define the safe operating space for humanity. We must limit global warming to 1.5°C to keep within this liveable range. As investors, we take our responsibility to create differentiated sustainable investment solutions seriously. At COP26 we also signed up to leading initiatives, including the Glasgow Financial Alliance for Net Zero (institutions with USD130 trillion under management, which are decarbonising portfolios) and the Forest Investor Club (to eliminate deforestation risk from them).

We estimate that close to 80% of the global economy is now covered by net-zero targets. Yet we also calculate that today, only a quarter of large cap firms are aligned with 2°C, and only 6% with 1.5°C. Viewed this way, there is a substantial ‘credibility gap’ between future intentions and current actions. For example, last October, global airlines committed to reaching net-zero emissions by 2050. However, according to their industry-wide roadmap, 65% of emissions reductions are supposed to come from sustainable fuels, where current supply would fall short of demand by a factor of around…4,500x.

Meeting the Paris Agreement target of 1.5°C is a critically difficult challenge for the human species. It is time to put our unique collective neuroplasticity to work: the world faces no challenge more urgent.

Wichtige Hinweise.

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