The new realities
of investing

Read this article to understand:

• The forces creating new risks and opportunities in global markets
• Why investors should rethink portfolio construction 
• How investors can improve climate risk management
   

Leading institutional investors and asset allocators from the Asia-Pacific region gathered in Singapore in October to hear Aviva Investors’ Chief Executive Officer Mark Versey, Chief Sustainable Investing Officer, Mirza Baig, and Chief Investment Officer, Danny McHugh discuss the key forces shaping investment around the globe. Amy Ross, Head of Financial, Professional and Business Services for Asia Pacific at the British High Commission, Singapore, moderated the panel session.

Question: How are trends, such as the fragmentation of geopolitics and the technological transformation, affecting investment risks and opportunities in global markets?

Mark Versey: We live in a very volatile world. Globally, geopolitics is driving volatility, largely reflecting rising oil prices, with opportunities arising in energy security and defence. In the UK, for example, the government is working with the private sector to mobilise private finance into defence. Supply chains also hold potential, as resilience becomes a key topic. Here the focus is increasingly on building local supply chains. Opportunities can also be found in technology relating to decarbonisation. 

Inflation is a key risk, reflecting increasing energy costs, as well as stresses in government finances, which are elevating bond yields. So, we should factor in higher borrowing costs when assessing many investments. Lending now looks more attractive with opportunities emerging in fixed income and related asset classes. 

Concentration risk has spread from equities to fixed income

Artificial intelligence (AI) is the third mega trend shaping markets. AI is driving substantial capex in the US and is currently powering the US economy. We have monitored concentration risk - exposure to the ‘Magnificent Seven’ - in equities for some time. We are now examining fixed income, where commonly used benchmarks are driving concentration risk.

For example, the Bloomberg Global Aggregate Index comprises global investment grade debt. It, however, weights companies by how much debt they issue. So, the more bonds a company issues, the greater its weighting in the index. In equities, buying the most valuable companies in line with benchmark weightings is a credible strategy. Purchasing the most indebted entities, by contrast, is not a sensible approach. 

However, institutional investors tracking such benchmarks are effectively pursuing this strategy today. So, rethinking the approach to fixed income - given the concentration risk across all portfolios - could provide a more balanced investment approach. Moreover, investment in infrastructure - such as data centres - is also heightening the same concentration risk to a degree that is not fully understood.

We are more optimistic about the prospects for the UK than previously. Devolution, transferring political power to the regions, is creating opportunities in mega projects in areas such as housing, infrastructure, and offices. For certain structures, government funding can absorb first-loss risk, while also increasing accessibility and raising returns to the levels institutions require.

Moreover, regulatory change is driving increased saving for retirement: Aviva is now one of the biggest investors and pension fund providers in the UK. Around a billion pounds flows into our pension funds every month. We invest globally but much of that money is being directed into the UK. We are looking for partners to co-invest with us. 

Question: Against that backdrop, how do you think investors should be approaching portfolio construction to continue to generate attractive returns? 

Danny McHugh: Investors should forget about traditional portfolio construction. Rules such as the correlation between bonds and equities, or the ideas of active versus passive investing, concentration and diversification risk no longer apply. We are in a very different world, with new variables that affect markets with greater frequency than we have ever seen before. Mostly, this reflects headline-grabbing developments in geopolitics. But there are many other less visible influences. 

In response, we are now mapping portfolios from a theme perspective. AI provides a good example. Whether you view AI as a bubble or a super cycle, building a portfolio requires a variety of considerations other than the price of Anthropic, Meta and others. You should also examine systemic risks within the sector. These include debt issuance, the exposure of private markets to AI companies, and circular financing. 

At Aviva Investors, we analyse all asset classes and determine our exposure to key risks so that we can build resilience into portfolios. We explore the most probable scenarios that could affect markets and stress-test portfolios against these events. So, for example, we have evaluated our portfolios against a scenario in which:

• An energy shock causes an inflation spike
• Which results in higher interest rates and bond yields
• Which leads to decreased availability of capital to finance AI
• Resulting in falling bond and equity prices and a liquidity crunch in private markets

In conclusion, the way we construct portfolios has evolved. Firstly, we construct portfolios in a non-traditional way. Secondly, we conduct continual stress testing. And finally, we bring in components – depending on the results of the test - that can act as a buffer against the likes of an inflation spike, a growth slowdown, or a significant depreciation in capital markets.

Question: Climate investing has become considerably more complex in a world increasingly focused on energy security, resilience and new geopolitical realities. How should investors change their approach to meet both their investment and climate targets?

Mirza Baig: The cost of inaction is too great for us to lose focus and momentum. But if we are to proceed with renewed confidence, we should embed certain principles within climate investing: 

Clarity: We should understand the climate backdrop. That requires a clear view of the science behind climate change, so we comprehend the stakes involved. It requires an understanding of the factors driving emissions, the impact of changing weather patterns, and the catastrophic consequences triggered by breaching climate tipping points. We also need clarity on the impact of geopolitics and national policies. So, decarbonisation and climate action has evolved. Net zero might not generate the interest it has in the past, but it is still seen as a critical enabler of a broader set of political goals. These include energy security, independence and even industrial competitiveness. Climate is still a politically backed critical theme. But we need to understand the nuances involved and focus on how the theme develops.

Discipline: We should ensure that we apply the same investment rigour to assets associated with the low-carbon transition as elsewhere. For various reasons, investors have been prepared to make a ‘leap of faith’ in this area compared to other assets. For example, cement and steel, which account for around 15 per cent of global emissions, have attracted great interest in terms of decarbonisation.  From an investment perspective, we are supportive of recycled cement. It can be produced at the same cost and to the same quality as virgin cement, while providing benefits to the environment. Green steel also brings environmental advantages. But it is up to 30 per cent more expensive to produce than traditional steel, a premium the market is unwilling to pay.  So, without government guarantees, the area is not viable for non-discretionary capital.

Sophistication: While simplicity is appealing, investment effectiveness remains key. Globally, climate investment has tended to focus on exclusion and carbon intensity portfolio targets. While simple to explain, that approach presents various challenges. It is disconnected from real world decarbonisation and hurts companies most in need of capital. Adhering to reduction targets also entails the rapid building of portfolio-level risks. That’s because investors are forced to sell companies and even industries. Consequently, I believe we need a more progressive, forward-looking net zero approach. Transitioning companies should be rewarded rather than punished. Critically, this requires a portfolio glide path that is more benchmark aware to ensure we do not inadvertently swap climate with other risks.

Question: How will the UK’s current policy and regulatory agenda unlock long-term capital and drive outcomes both for the UK and investors?

Mark Versey: I co-chair the Net Zero Council with the Secretary of State for Energy Security and Net Zero. It is focused on encouraging UK manufacturing to decarbonise and electrify. Over the past four years, £100 billion of investment has flowed into renewable energy. There is a huge government drive to work with business and finance and encourage manufacturing to adopt the measures required to reach environmental targets. Mayors, who now have new powers to overcome planning restrictions, are driving house building in the UK.

Critically, the goal is also to power the economy. We work closely with the government-financed National Wealth Fund, which aims to ‘crowd in’ private capital. It does that by providing financing alongside private capital. It also shields private investors against risks, such as advances in technology or changes in demand. 

As an example, we have invested in electric charging points across the UK. We also collaborate with the recently established National Housing Bank, which seeks to encourage investment in housing to meet the government’s target of building 1.5 million new homes. The demographic change seen across all developed economies, including increasing life expectancy and older people being unwilling to downsize, is driving an acute shortage of housing. 

The sector, along with retirement income, are the two biggest UK investment opportunities that we have identified.  

Question: How does Aviva Investors help investors access these opportunities?

Danny McHugh: Private markets, as an example, are an excellent diversifier to their public counterparts and provide a strong, long-term hedge against inflation. Consequently, we have a significant allocation to private markets across our portfolios.  Our biggest pension portfolio, for example, has more than 10 per cent invested in the asset class. We believe it should also be important to most global investors. We have been investing in private markets, particularly real assets via both equities and debt, for decades. New sectors are emerging and we are now investing heavily in single family housing rentals and intend to hold these assets for the longer term. 

The return potential from these types of investment is attractive, both on a global and risk-adjusted return basis. Given our proximity to these asset classes and our long track record and knowledge of investing in them, we are ideally placed to identify interesting opportunities for investors in the UK and continental Europe.

Question: Where do you see the strongest potential for delivering differentiated returns over the next few years?

Danny McHugh: Overall, we remain positive on the outlook for equities, with an overweight in the US and emerging markets. We have an overweight in government bonds, particularly favouring UK gilts over US treasuries. We also like emerging market debt on a selective basis. It has a strong carry proposition and generates good income. In private markets, we remain overweight real assets, reflecting their inflation-protection characteristics and strong growth prospects.

Question: If investors could make one change today to improve how they manage climate risk, what should it be?

Mirza Baig: Climate investing has experienced some distinct phases: The initial focus on mitigation, e.g., decarbonisation, has evolved with adaptation and resilience subsequently added as extra layers. Going forward, I expect the world to accept that the goal of limiting the long-term rise in global average surface temperature to 1.5°C will not be achieved. So, the only way to stabilise the ecosystem is through negative emissions capacity, whether that be via natured-based or technological solutions. But the later you gain exposure to this area, the less effective and more expensive it becomes. I would encourage all investors, particularly given the outlook for the price of carbon credits over the medium to long term, to carefully explore how carbon credits could and should fit within a balanced long-term portfolio.

Question: What should investors seek from partners to ensure their portfolios are best placed to meet the challenges and opportunities presented by this changing world?

Mark Versey: The way we invest in fixed income needs to evolve, by changing benchmarks and mandates. Look for a partner who can do this and can bring private credit and asset backed finance in particular to fixed income. They should also be able to apply a sustainability lens that is forward thinking and does not exclude investments but rather seeks to encourage the energy transition.