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    April – Resilience, Hedges and Sustainability Trialogues

    April – Resilience, Hedges and Sustainability Trialogues
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Witnessing the fortitude of the Ukrainian people over the past month has inspired me to look into the nature of resilience. While the ability to withstand and overcome adversity is fluid and difficult to measure, the scientific community has established remarkable findings on how resiliency works and evolves over time.

    Research from Harvard University views our resilience mechanism as akin to a cognitive ‘scale’ on which we continuously weigh the positive and negative external shocks to which we are subject. This internal indicator is tilted a certain way, thereby influencing us to consider the world through an optimistic or pessimistic lens. Our degree of resilience, represented by the place of the fulcrum on the chart below, is set at a certain level at birth and can evolve in either direction throughout life. As a result, some people have the ability to maintain a positive outlook on the world and keep moving forward amid substantial adversity, while others give up and fall into despair, even within a more favourable environment

     

    Chart 1 (1200x627px).svg

     

    Interestingly, research has found that one of the most significant indicators of a person’s resilience lies in their degree of confidence in their capability to alter the course of their life. Developed by American psychologist Julian Rotter in 1954, the ‘locus of control’ theory distinguishes individuals who believe most of their life results from their own actions, from those who consider that their trajectory is primarily the result of random external factors. The former group is said to have an internal locus of control, while the latter has an external one. People with an internal locus of control have been found to be on average more resilient in the face of extreme challenges. Insurance companies, for example, have observed that communities with a prevailing internal locus of control tend to be less affected by natural disasters such as tornados.

    This is a powerful finding, as it suggests that irrespective of the level of control you may actually have on a given situation, the belief in your ability to influence it makes you better off from a resiliency standpoint. In sum, you get resilience credits for trying.

    Irrespective of the level of control you may actually have on a given situation, the belief in your ability to influence it makes you better off from a resiliency standpoint

    British poet William Ernest Henley had come to the same conclusion through his art decades before science caught up. Back in 1875, affected by a severe case of tuberculosis, he wrote the following verses on resilience in a poem called ‘Invictus’ while recovering in hospital:

    “It matters not how strait the gate,
    How charged with punishments the scroll,
    I am the master of my fate,
    I am the captain of my soul.”

    Anecdotally, another champion of resilience, Nelson Mandela, often recited the Invictus poem to fellow inmates during his 27-year imprisonment.

    Returning to Ukrainian resilience, the domestic tax authorities have certainly displayed a high internal locus of control in their attempt to influence the outcome of the war. Besieged by a country that is almost 30 times larger than theirs, they could have easily concluded that revising the tax code wouldn’t matter. Yet, on 1 March they issued a statement amid bombardments specifying that any seized Russian combat equipment need not be declared.

     

    Central bankers – in control?

    Shifting to monetary policy, having an internal locus of control – or the ability to credibly pretend to have one – seems to be a prerequisite of a successful central banking career. Federal Reserve Chair Jerome Powell has been doing a good job of appearing self-assured in his ability to tame inflation through accelerated rate hikes. We would refer readers to his remarks for the National Association for Business Economics on 21 March: “The ultimate responsibility for price stability rests with the Federal Reserve. Price stability is essential if we are going to have another sustained period of strong labor market conditions. I believe that the policy approach that I have laid out is well suited to achieving this outcome.” We are somewhat more sceptical on the Fed’s ability to contain price pressures that depend to a large extent on supply-side shocks. While we foresee inflation gradually decreasing, we believe it will remain at around 5% by year end, significantly higher than the Fed’s target.

    While we foresee inflation gradually decreasing, we believe it will remain at around 5% by year end, significantly higher than the Fed’s target

    In contrast, on the other side of the Atlantic, European Central Bank (ECB) President Christine Lagarde is starting to show signs of an external locus of control, as the ECB keeps its policy on hold despite historically high inflation prints. Consumer prices in the euro area surged by 5.9% in February, with energy prices spiking by more than 30% relative to the previous month. Confronted with these alarming figures, Christine Lagarde intends to maintain a highly accommodative policy to support economies particularly exposed to Ukraine-related disruptions. We expect central banks in developed economies to grow increasingly out of sync in the coming months, with the Fed and Bank of England pursuing a hiking process they have already kicked off, while the ECB lags behind.

     

    Asset allocation implications

    Turning now to asset allocation, we take our fiduciary duty to build resilient portfolios for our clients very seriously. While the strength of the post-pandemic rebound offers some economic buffer in most developed economies, we note that geopolitical factors may cause potentially severe financial turbulence. Against this backdrop, our goal is to maintain upside potential while strengthening our hedges against any adverse development.

    Our focus remains on building resilient portfolios… our goal is to maintain upside potential while strengthening our hedges against any adverse development

    To this end, we have de-risked portfolios through cutting our equity exposure, specifically in Europe, where corporates are the most vulnerable to the Ukraine crisis, both in terms of procurement and sales. We have also reduced our exposure to convertible bonds and applied increasing differentiation in our emerging market debt holdings. On the one hand, we have reduced our overweight to Chinese debt amid a growth deceleration and disruptive Covid outbreaks. Flows into the asset class following China’s inclusion in global bond indices have slowed, and the recent tightening of spreads with US Treasuries makes Chinese debt comparatively less attractive, as illustrated below. We retain a small overweight for its portfolio diversification properties.

     

    Chart 2 (1200x627px) (1).svg

     

    On the other side of the emerging market spectrum, we are constructive on Brazilian debt, considering the country’s commodity exposure, and a monetary policy cycle close to peaking at double-digit interest rates and low comparative exposure to geopolitical risk. That said, we have partially hedged the currency exposure to shield portfolios against possible future movements in the Brazilian real.

    We have used the proceeds of divestments to build a cash buffer, as well as building a hedge against war escalation through a basket of commodities such as oil and gold. On the fixed income front, we have added to our US Treasuries’ exposure on the back of more attractive yields. In light of high market uncertainties, we seek instruments that would do well in most growth regimes. For example, we believe industrial metals should deliver in most scenarios: while accelerated demand from the likes of China would create upside in case of a prompt crisis resolution, disrupted supply would likely support prices in case of further entrenchments between Russia and the West.

    We have used the proceeds of divestments to build a cash buffer, as well as building a hedge against war escalation through a basket of commodities such as oil and gold

    In the currency space, we have reduced our exposure to the euro on the back of the ECB policy normalisation lag versus peers and Europe’s higher exposure to the Ukrainian conflict. In contrast, we are overweight the US dollar (USD) and Swiss franc (CHF) considering their safe haven status, and constructive on the renminbi (RMB) in anticipation of an increased representation of the Chinese currency in international trade (it currently stands at 3% versus around 40% for the US dollar).

    In addition to these tactical adjustments, we continue to strategically build our capabilities to identify and partner with sustainability innovators. The recent spike in fossil fuel prices, combined with rapidly advancing clean energy technology, makes the transition all the more compelling. As illustrated on the chart below, the long term cost of building new wind and solar infrastructure is now inferior to continuing to operate old gas plants in most European countries.

     

    Chart 3 (1200x627px).svg

     

    Staying on the topic of resilience, a sobering British study published earlier this month reveals that deforestation and climate change have made nearly three quarters of the Amazon rainforest subject to significant “resilience loss, which makes it more vulnerable to extreme events such as droughts or fires. This is particularly concerning as the phenomenon has a ratcheting effect: the more the climate changes, the drier the forest becomes, making it less and less capable of regeneration. Today the Amazon is dangerously close to a point of no return, past which it would be doomed to morph into a savannah and cease to be the carbon sink it currently represents for the planet. In addition to its effects on the climate, this would be an incalculable loss for our planet, as the Amazon is home to more than 10% of the world’s biodiversity.

    Nearly three quarters of the Amazon rainforest is subject to significant "resilience loss", which makes it more vulnerable to extreme events such as droughts or fires

    Against this backdrop, we are certainly trying to adopt an ‘internal locus of control’ approach in contributing to the climate transition. This month, our team took part in the Geneva Trialogue 2022, an event hosted by the United Nations, University of Geneva and Open Geneva. It aimed to bring together international organisations, academics and the private sector to elaborate concrete and rapidly implementable solutions to climate-related challenges. This year’s theme was ‘open innovation for education’, focusing on the means to scale education to tackle the UN’s Sustainable Development Goals (SDGs). For the financial sector, we discussed the best ways to attract young talent with technical backgrounds to consider careers in sustainable investing. This was another good opportunity to brainstorm innovative ideas and meet passionate students, some of whom are now interning with us and making great contributions to our team.

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