Day Four

Central banks and inflation

As an expert who knows the system of central banks from within, Axel Weber, former Bundesbank President and ex-Chairman of UBS, shared his view of current monetary and fiscal policy.

Although inflation seems to have peaked in the US, he believes that rate hikes by the Fed are not going to end where the market has priced in, and he therefore sees the terminal Fed rate at over 4%. For Europe, especially for Germany, Axel Weber couldn’t rule out a downside scenario with inflation staying high for longer than expected, which would be a strong indication for a future wage price spiral. All in all, central banks are late in hiking and now have to catch up, he noted. If he were in charge of monetary policy, the question as to whether current inflation is transitory or might be permanent would be answered with one simple sentence: “We will make sure that it will be transitory!” In this context, he warned that central banks might also be inclined to prove to markets that an often quoted “Fed Put” does not in fact exist.

Europe has the additional challenge of fragmentation risk, a process that could be set in motion should the ECB and other institutions not find a way to fight the uncontrolled widening of peripheral spreads, that could happen in the process of monetary tightening. However, for Axel Weber, it will be difficult to find a solution that would satisfy markets within the constraints that these institutions operate, and raising expectations too high for such tools could make the problem worse. With government debt now on the balance sheets of central banks getting pushed back into the market, other investors will have to absorb higher levels of these instruments, making upward adjustments in yields necessary.

Finally, when it comes to the future of globalization, a key theme at the event, Axel Weber stated that it staying at current levels would constitute the best-case scenario, but that it’s more likely that we will still see a further reduction in globalization levels.

Eddie Yue, Chief Executive Officer of the Hong Kong Monetary Authority (HKMA) outlined that the key risk for emerging markets is coming from increasing US rates. He outlined how Hong Kong has taken measures over the recent years to prepare for volatile times in financial markets. Besides building up buffers from current account surpluses and improving the liquidity ratios of the banking system, HKMA has strengthened its set of macroprudential tools, preparing for various scenarios and increasing its market surveillance, in particular of the over the counter (OTC) market. All in all, he sees a more differentiated treatment of emerging markets by financial players, with capital flight and market attacks more focused on what the market perceives as the weakest participants. Finally, he stressed the need for portfolio diversification and highlighted good results with Chinese Government Bonds due to their low correlation with US Treasuries, and he also stressed the need to invest in private assets as soon as opportunities occur to, in bear markets.

Jacob Frenkel, former governor of the Bank of Israel, alluded to the fact that a whole generation of wealth managers are too young to have experienced higher inflation, so he took the audience back in time. William McChesney Martin served as Fed chair from 1951 to 1970, the longest serving in that position. He knew that monetary policy had to be anticipatory, so he summarized his conviction with the famous quote "take the punch bowl away before the party gets going". While “data dependency” alone would by definition always mean backward-looking decisions, central bank strategy should be based on “expected data dependency”. Jacob Frenkel added that today the Fed is behind the curve because of a bad strategy that didn’t take into account the real role of central banks as players in the market, as opposed to just being observers. In his opinion, the only way to correct this policy mistake is to accelerate the pace and magnitude of rate hikes even with the risk of overshooting. Echoing Axel Weber, central banks can decide if inflation is permanent or only transitory with their actions.

The approach of Sovereign Funds to Net Zero

In the view of UBS, sustainable investing is a trend that can suffer setbacks, as we’ve witnessed in recent months, but in the long run, it will become even more important. We also believe that energy security and energy transition are two sides of the same coin, Massimiliano Castelli, Head of Strategy and Advice Global Sovereign Markets, summarized this approach.

Havard Halland, Senior Economist at the OECD Development Center, outlined what sovereign funds are doing in the field of climate investing. Recent reports in the media suggest that they aren’t doing enough. 71% of sovereign wealth funds have less than 10% of their holdings in climate-related strategies, and out of 153 funds only 33 incorporate ESG in their risk management, so there’s definitely a lot of room for improvement. So far, only two sovereign wealth funds have committed themselves to a Net Zero target, and many others don’t commit because they can’t implement it. The big question here is how can their investment frameworks gradually be reshaped to be able to invest in a more climate-friendly way? – It’s a big operational challenge!

However, over the next five years more sovereign wealth funds are likely to commit to Net Zero, and more importantly, they will declare what the path is to reach these targets.

Sustainable and impact investing: Driving change with engagements

Lucy Thomas, Head of Sustainable Investing, UBS Asset Management says that cumulative net new money inflows into sustainable investment products have been steadily improving in recent years. The key considerations for investors are in the areas of regulation, reputation and risk and return considerations.

With over half of central banks now investing or considering investing according to ESG principles, sustainable investment standards are involving rapidly. Instead of simple exclusion, there is a shift towards thinking in terms of impactful outcomes with customized investment products that have net zero commitments built in that provide system-level active ownership. Instead of ESG exclusions as a risk management tool, the goal of these strategies is to target alpha opportunities. This is achieved with rules-based and active asset allocation strategies, active ownership (stewardship) and transparent disclosures that measure the impact of these strategies. Backward-looking data is a challenge as it’s not standardized yet, so this makes the integration of data science into the investment process necessary.

One of the key factors that influence portfolio outcomes is stewardship, which should focus on outcomes and follows a research-driven approach that demonstrates value add for portfolios. Its goal is to engage corporate management and use proxy voting to influence corporate behavior and accelerate actions. For UBS, it’s important to support Net Zero industry initiatives, and transparency on a portfolio and company level.

Market outlook: A conversation with our Head of Investments

During the conference, there was a very lively debate on whether the world is moving to a “new regime” or whether the recent rise in inflation is still “transitory”. Barry Gill Head of Investments, UBS Asset Management, is of the opinion that we are going through a regime shift due to demographics, global labor dynamics, a political shift towards redistribution and protectionism and government largesse.

Reserve managers sit on significant losses in fixed income due to the impact of rising yields. For Barry Gill, the fixed income investment environment will depend on long-term inflation expectations and if we leave the environment of negative real rates behind us. Search-for-yield has further distorted the investment environment in the past, and we’re now approaching a more normal environment again, but a real repricing of credit hasn’t yet happened.

In equities, it seems that the market focus has somehow shifted from pricing in higher inflation (via multiple compressions) to worrying about the “E” in P/E, so margin compression due to factors like cost-push inflation. This has exposed fragility in certain industries, e.g. retail. Another worry is that central banks might be too aggressive. All in all, the market is still in the early phases of pricing in a recession and lower corporate earnings.

So will we see a continuation of the aggressive “Volcker response”, or see a return of the “Fed put”? For Barry Gill, central bankers might feel that their credibility is on the line, but there might not be enough political support to fight inflation with a deep recession, with elections that are coming up. The full employment mandate might become the primary mandate of the Fed.

The correlation between equity and fixed income has turned positive in 2022, inflicting significant losses to balanced portfolios. For Barry Gill, a positive correlation happens when investors are mainly worried about inflation instead of growth. It’s important to note that a positive correlation has historically been the norm, in particular in emerging markets. The times of natural diversification might be over, except temporary, in times of market stress.

How can you build a resilient portfolio going forward? And what role can alternative asset classes play? Investors currently have relatively simple portfolios, but over time could switch towards more complicated portfolios with idiosyncratic risk-seeking in areas that show inefficiencies that could be exploited. But this might take more risk to generate the same levels of returns. These products could also be more correlated than people think in times of stress. All in all, investors might need to become more sophisticated to manage this transition.

China is an area of focus for most financial institutions. Right now, Chinese bonds are less attractive due to high US yields. But China has its own heterogeneous system that it operates in with its own challenges and opportunities. The dynamics in the property sector are still worrying, but with the capital markets opening up, the story still seems to be intact.

The war in Ukraine has made energy security a priority for many governments. But what are the implications for sustainability? For Barry Gill, there will probably have to be a lot investment into renewables during the upcoming energy transition process, once near-term instabilities around energy security are resolved.