The modest signs of progress made in the Cop26 talks in Glasgow show that international agreements to curb emissions are possible, but implementation of the necessary policy changes remains unimpressive.
As the economic story of the 2020s progresses, climate policy will join monetary policy as a prime area of concern for macro traders and asset allocators.
In fact, sudden supply shocks might become much more important in future, relative to the demand shocks that have been dominant in the advanced economies since the 1980s. If so, this will make life much harder for asset allocators.
Supply shocks may be harder for investors to contend with as they typically cause inflation to rise quickly (usually negative for bonds and some equities) while also harming GDP growth (usually negative for most equities).
When demand falls, the impact of lower equity prices on asset portfolios is offset by rising bond prices (ie falling yields).
The two main assets automatically tend to hedge each other, that is move in opposite directions, reducing overall portfolio volatility and encouraging higher average holdings of risk.
Supply shock
Over time, this boosts average returns. The opposite is true when a contractionary supply shock, such as a spike in oil prices, occurs.
Equities still decline, but higher inflation this time increases interest rates and reduces bond prices. Both main asset classes turn negative, forcing sharp risk reductions to preserve wealth. In the era of higher carbon prices, these supply shocks may become increasingly common, disrupting portfolio performance.
In summary, the past decade has experienced consistently high returns for passive holders of 60/40 or risk parity portfolios, driven largely by macroeconomic fundamentals.
However, during the fight against Covid-19, the further acceleration in returns has not been fully justified by fundamentals. Furthermore, the post-pandemic economic cycle is unlikely to share the same favourable characteristics that applied during the recovery from the GFC.
The pandemic has marked a turning point in financial markets. In coming years, asset allocators will need to be much more active when macro shocks occur, and will need to work far harder to preserve absolute returns for their clients.
Gavyn Davies is a former chief economist and international managing director at Goldman Sachs, and former chairman of the BBC. He is now chairman of Fulcrum Asset Management.
