What will the world look like in 2100? It sounds an awfully long way away – but then again, our credit portfolios hold bonds that mature after that date. I ask the question in light of COP26 and the challenges societies face in limiting temperature rises over the long term.
The objective of keeping the rise by 2050 to 1.5% above pre-industrial levels looks unlikely given that China is still focusing on a 2060 Net Zero goal, India is targeting 2070, and Russia is yet to set a formal goal. However, there have been some wins: a greater focus on restoring the world’s forests; more technical and financial support for developing countries; commitments to cut methane; wider recognition of the end for coal-fired power generation and signs that the world’s two economic superpowers are more prepared to co-operate on climate issues.
The transition to a lower carbon economy may be helped by two great trends: innovation and demography. The price of renewable energy is falling dramatically, whether it be solar or wind (both on and offshore); the rate of technological improvement suggests this will continue. Coupled with progress on energy storage and the outlook looks encouraging. Yes, there will be price shocks when the sun does not shine or the wind does not blow hard enough – but they will get less relevant over time.
The other trend is demography and this is where outcomes are more problematic. The developing world is seeing a massive demographic shift. Where some saw lockdown as likely to rekindle birth rates the opposite has been the case. Shrinking populations in energy hungry societies will be good from a climate perspective and perhaps we are seeing an end to a focus on economic growth as an ultimate goal. But there is another side to the coin. At the present time a fertility rate of 2.1 is required to stabilise the UK population; on current trends this will fall to towards 1.4 by 2023. Later household formations are central here – reflecting housing and childcare costs, greater female employment opportunities, urbanisation, and more State support in old age. Fears about what the future climate holds has lent further impetus.
The UK is not alone, or even at the forefront. Countries like Spain and Italy could see their populations halve over a century to 2100. The key problem is how governments will finance themselves, as we are on a treadmill where growth supports higher living standards, greater government spending and expectations of ever rising prosperity. As growth stalls due to demographic pressures the cost of the carbon transition and healthcare will fall on a shrinking base of taxpayers. I think we need a Minister for Demography that sets out the long-term challenges we face as a society. Let’s face it, Covid will look like a blip compared to the demographic trends we face.
Cash and government bonds
UK Q3 GDP growth at 1.3% was weaker than expected and below the Bank of England’s (BoE) forecast of 1.5%. This reduces the chance of a December rate rise – which in any case would be non-sensical given the November outcome. Hospitality, arts / recreation, and health were the biggest positive contributors to growth but supply chain issues were a drag with construction output falling. Worryingly, consumer spending and fixed investment were both quite a bit weaker than expected, as was net trade. I still feel that the optimism for a strong bounce back in 2022 is too high, being overly dependent on precautionary savings being run down by consumers. More optimistically, business surveys look consistent with relatively robust activity in Q4.
Government bonds remained volatile with US inflation data adding further uncertainty to the path of short rates. The Consumer Price Index (CPI) reading, at 6.2%, was well ahead of expectations and saw five-year treasury yields hit 1.25%. This rippled through global yield curves, pushing 20-year US rates back towards 2%. However, this needs to be set in context: back in March of this year the 20-year yield was nearer 2.4%. It seems to me that the reaction to the CPI data was relatively modest. Indeed, one question I am wrestling with is why long dated real yields are so low in an environment where global supply will be high in the medium term, with decreasing / no support from further quantitative easing (QE). Is it that long-term trends suggest deflation rather than inflation? Implied inflation suggests not and we saw another increase on the back of the CPI print but demographics indicate much slower global growth in the long term.
Investment grade credit spreads continue to drift wider, with the more market sensitive sectors like banks being most impacted. However, this is more about noise than a discernible trend at present. In big picture terms spreads remain towards their lows of the year. Indeed, risk assets in general have coped well with the volatility in government bonds and I can’t get bearish with reals yields where they are.
High yield reflected these trends but attention remains focused on emerging market (EM) debt. Looking at returns this year in high yield funds it is clear which ones have significant exposure to EM, and China in particular. I remain of the view that these areas will be fruitful sources of added value in the long term but it also highlights the need to control risk and seek portfolio diversification.
COP26 is about how to come up with solutions for climate warming – the focus is strategic and how big shifts can be attained. For politicians in democracies this does not come easily, with horizons set by election dates. Reading about one UK Cabinet Minister apparently lambasting banks for not offering bigger mortgages made me despondent. I really do think we need a Minister for Demographics to get away from short-term thinking.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.