The commodities sector is at the heart of the energy transition, impacting both the coming structural decline of fossil fuels and the demand for the new economy critical materials. There is also the delicate matter of future nature-based land-use and food production conflicts facing investors and soft commodity driven deforestation, other potential clouds on their net-zero commitments.

The reality is that many investors are reluctant to talk openly about commodities because of the negative perceptions of the sector. To date, the commodities narrative has been mostly characterised by high emitting energy production from fossil fuel companies and mining companies that are misaligned with a sustainable future & their negative climate lobbying activities, which are still to be effectively curbed by those very same investors.

References to the role of commodities also often brings visions of irresponsible corporations and nations with issues beyond their environmental impact, including poor human rights records and a sometimes-dubious influence on some governments. In some cases, the list of broader ESG issues associated with commodity production reads like a list of investor red flags. If the global commodities sector were a single business, the CEO would be straight on the phone to Saatchi and Saatchi for an urgent rebranding.

Fossil fuels to critical materials–a rebalancing in indices

Investors increasingly recognize that the future of the energy transition and in turn emissions outcomes relies on the rapidly shifting balance in commodities trading from fossil fuels to critical minerals including metals, many of them in key transition sectors. Copper, cobalt, lithium and others are already exploding but their demand is not yet represented in the fossil fuel laden commodities indices that investors overwhelmingly use.

To better reflect this inexorable trend, Dutch giant APG is looking to launch a new forward-looking commodities index that will be constructed based on the future demand for these commodities rather than their historical counterparts, a move that will help shift some of the existing negative perceptions.

As any investor will tell you, exposure to futures indices is not the driver of change that many think they are. Nothing can alter fundamental economics more than early-stage investment, R&D, pro-active policy designed to accelerate commercialization and regulation to advantage the new over the old. Further complicating indices as a lever is that investors’ existing underlying exposure to commodities is often whispered in quiet corridors, blamed on supply chains where their influence is thin or on mining monoliths that no investor can afford not to hold in their portfolio. This has limited the opportunity for open debate.

However, with the development of these new forward-looking indices, investors can acknowledge their positive expectations of the new commodities exposure and then start the difficult discussions necessary to explore the social and environmental downsides. This can be far easier at the commodities level than at the company level, which often degenerates into a complex jurisdictional or commodity divestment discussion that shuts doors rather than opens them.

As the Inevitable Policy Response (IPR) shows in its 2023 Forecast Policy Scenario, most residual emissions by 2050 will be in Emerging Markets and Developing Economies (EDMEs). The transition will reflect a rapid transformation in those economies even though it is too slow to save us from a significant overshoot past 1.5C. Embedded in this inevitable future is the change in the commodities landscape that mirrors the change in the economies that produce the new materials.

To understand how the future will unfold, the history of commodities is worth recalling as the significance of the primary commodity sector in any national economy generally declines as the process of economic development improves in that country. Nations start by digging up their land for resource wealth or utilizing land in some productive way and a tipping point arrives when the benefits of this activity create a secondary manufacturing and service economy which fuel property and other booms to even the global playing field.

For example, the USA’s reliance on the primary sector for GDP contribution was around a quarter at the turn of the 20th century but had shrunk to just 5% by 1960 once Henry Ford and a couple of technology fueled world wars had washed through. History may well repeat itself regarding the new commodities, many of which will be produced in developing nations and some of which will send you scurrying towards an Atlas.

The Coming Commodities Shifts

Understanding how commodity shifts will manifest during the energy transition is vital for investors both at a sector and at a jurisdictional level with complex geo-politics. It is easy to point at investments in certain sovereign states in the most difficult and controversial of commodity producing destinations. China’s desire to influence nations in Africa is well documented and investors need only peek at their Sovereign and Corporate Debt portfolios to see that broader ESG issues are inherent in their investments.

Some commodities are already a major story in themselves with Cobalt in the Democratic Republic of the Congo (DRC) being the most recognised example, the country languishing 136th in The Economists Global Democratic Index out of 167 countries. When, in comparison, Zimbabwe and Burkina Faso are deemed some of the more stable areas to mine commodities in comparison, you have an industry facing difficult challenges.  Rare earth mining is also beset by some prickly ESG issues in some jurisdictions.

However few investors can afford to be without Cobalt in their portfolios whether they like it or not. Nothing short of total auto and battery divestment is required for an investor to look clean if they want to keep the DRC out of portfolios. This reflects how tightly integrated the world’s supply chains have become.

If no investor can look you in the eye and say they are totally clean on myriad ESG issues it further highlights that the real issue is about how to influence the future of commodities as transition shapes new demand, rather than how to avoid them. This is the debate that the APG indices can help promote whilst simultaneously advancing financial returns.

Once agriculture and nature – based commodities join the picture and you accept that the 1.5C overshoot is a coming reality, then investors may be forced into a new approach to commodities. Conflicts between bioenergy and food production are looming in future decades (an emerging issue the just released IPR Land Use & Bioenergy Outlooks both explore) with forestry playing a critical role in carbon removals to redress the temperature outcome towards the end of this century.

The emissions debate for investors is reaching a stage where difficult investment issues like commodities impacts can’t be avoided either in debate or implementation. The most obvious of these is the Net Zero alignment over reliance on Scope 1 and 2 emissions to make any sense. Scope 3 (with upstream supply chains being prevalent) is gradually being recognised as being essential to any logical framework for analysing emissions and pathways for reductions.

Like Scope 3 emissions, commodity exposure is also unavoidable for investors, even those committed to do the right thing on climate, just transition and stewardship. Divestment hasn’t worked as a theory of change and for large investors never could work once Scope 3 emissions were accounted for.

Investors should treat commodities in the same way, realising they are an inherent part of any portfolio and thus it is better to try to manage the inherent ESG issues as best they can whilst supporting the development of the critical minerals that the transition so desperately needs.

Within that framework, a new commodities index would not only be a tool to manage climate-related risks within a commodity futures portfolio but would help drive this new narrative which in turn can influence positive capital allocations towards these commodities.

Given that the Inevitable Policy Response has shown that investment in developing and emerging economies is the key to minimising an overshoot past 1.5C, and that many of these new transition commodities are in developing economies, the intersection of these two themes is a great opportunity for leading investors.

 Julian Poulter is a partner of Energy Transition Advisers (ETA) and head of investor relations at the Inevitable Policy Response (IPR). The views expressed in this article are personal and do not necessarily represent the views of IPR.

 

The €15 billion ($16.1 billion) Ireland Strategic Investment Fund (ISIF) is finding compelling investment opportunities in the energy transition and is successfully drawing in additional investment to finance Ireland’s net zero commitments.

By targeting “climate positive” investments which support Ireland’s transition (outlined in the government’s Climate Action Plan) as a key investment theme, the fund is investing in both sustainable infrastructure and new technologies, and in business models to support the long-term transition. In 2021 ISIF committed €1 billion in climate projects over a five-year period of which it has already invested over €600 million.

The strategy runs in parallel with a divestment programme dating from 2018 when Ireland became one of the first countries in the world to sell out of fossil fuel companies. It  currently has a list of some 200 companies in which it won’t invest as part of that strategy.

When ISIF was established at the end of 2014 from the remnants of the National Pensions Reserve Fund, the sovereign development fund was tasked with attracting €1 million in co-investments across the portfolio for every €1 million invested. Today, typically around €1.6 million in co-investment is ploughed into projects for every €1 million the fund puts in itself, so that since inception ISIF has committed €6.5 billion across 188 investments that have unlocked some €10.2 billion of co-investment commitments.

“It’s positive for our investees and for the wider Irish economy,” says ISIF senior investment director Brian O’Connor, who leads the fund’s investments in indigenous businesses as one of four investment themes that sits alongside climate, housing, and food and agriculture set out in a 2022 framework that shapes the €8.7 billion discretionary portfolio.

The remaining assets (€6.3 billion) lie in directed portfolios held separately and under direction from the Ministry of Finance.  The discretionary portfolio targets returns in excess of the five-year rolling cost of government debt (2.8 per cent) over the long term, and assets are divided into equity (€3.4 billion), fixed income (€1.6 billion), real assets (€1.2 billion), absolute return (€1.4 billion) and cash and equivalent (€1.1 billion).

O’Connor says businesses and projects IDSF invests in must meet a double bottom-line, targeting both returns and supporting economic activity and employment in Ireland.

Scaling local businesses

O’Connor’s team oversees a portfolio of Irish businesses that spans investments in growth equity, private equity and private credit, managed by a range of Irish and international fund managers – the ISIF mandate to invest in the Irish economy allows scope to invest globally if there’s a benefit to support economic activity and employment in Ireland. The team also manages many of ISIF’s co-investments with fund partners and investments are roughly split 65:35 between fund and direct investment, respectively.

The ability to invest with global fund managers if it supports economic activity and employment in Ireland is vital in the fund’s ability to diversify outside Ireland’s small market. “Finding enough opportunity in the Irish economy is a challenge,” O’Connor says.

The fund does its best to invest broadly across many sectors and applies a portfolio approach to achieve a level of diversification across the risk it’s taking and the sectors it’s exposed to as it seeks to get its risk-adjusted returns right.

Investing across the capital structure

Diversity also comes with ISIF’s ability to invest at any point of the capital structure where the team use different instruments to best suit the investee. The fund can be flexible where many other investors can’t be, and is able to offer an alternative to low-risk bank funding or to private equity hunting double-digit returns, often over a three-five-year time horizon. The flexible approach plays an important role supporting an ecosystem of firms at whatever stage they are in their growth journey.

“We can provide debt at one end of the risk spectrum and equity at the other – and anything in between, whether it’s mezzanine finance, hybrid debt/equity instruments, venture capital, growth capital or private equity,” O’ Connor says.

“We aim to ensure the right mix across the capital structure. When co-investing in businesses, ISIF equity gives firms an ability to prioritise longer-term growth knowing that ISIF is not necessarily optimising to a short or medium-term exit timeframe.”

ISIF’s role of catalyst and its ability to attract co-investment capital into the economy is another central pillar. ISIF considers every investment on its ability to promote “economic additionality”, namely, benefits to gross value added (the value producers add to the goods and services they buy), while avoiding “dead weight”, meaning the economic benefits created from an investment would have been achieved in any event; and “displacement”, where the investment would simply substitute existing economic activity.

For example, avoiding dead weight means ISIF won’t invest in sectors that are already served by private-sector investors or by lenders to such an extent that ISIF’s involvement won’t make a difference. Instead, it looks to target important gaps that other investors and lenders aren’t filling.

“We do not alter our investment strategy materially based on market cycles,” O”Connor says.

O’Connor concludes with a nod to how ISIF capital has led to a new generation of international Irish companies.

“Many Irish companies have expanded to international markets in recent years,” he says. “The key is to help these types of companies by continuing to back their ambitions to grow over the medium and longer term and support them with access to funding via the co-investment partnerships.”

 

 

As the Netherland’s overhaul of its €1.45 trillion ($1.6 trillion) pension sector, Europe’s largest, gathers pace the country’s pension funds must shift from defined benefit to defined contribution.

Asset owners are beginning to adjust their hedging policies and asset mix to prepare for a new world that replaces retirement income promises for members with a different system that bases pension payouts on contributions and investment returns, dependent on the vicissitudes of financial markets.

“Pension funds are really busy with the transition from DB to DC. Everyone is preparing for a different asset mix in the new DC system and beginning to incorporate a different approach to interest rate hedging that has always been a very prominent element of risk management in the Netherlands,” explains Xander den Uyl, somewhat of an identity in the Dutch pension landscape. He is now a trustee at €1 billion Pensioenfonds Recreatie, a pension fund for employees in the Netherland’s recreational sector that is at the forefront of a transition that is being closely watched by governments around the world, mindful of the need to reform their own pension systems as aging populations increase.

“Recreatie is really leading the pack in its approach to the reform process and sees a clear future. It’s a nice atmosphere,” reflects den Uyl, who has just taken up the role after a 12-year stint on the board at €9 billion PWRI and who was also a board member at the giant ABP until May 2023, and had been its previous deputy chair.

Rush to hedge

The reforms promise profound implications for Dutch funds’ hedging strategies; the extent to which hedging will remain active and dynamic or shift to shorter duration swaps, and the suitability of LDI strategies in the long-term.

Many Dutch funds have dynamic asset and liability management strategies where a matching and return portfolio, and an interest-rate hedging strategy, all move in line with funding ratios. An investment approach that has been encouraged by strict regulation steering funds to focus on short term stability and guarantees rather than tilt towards risk-taking and long-term returns, but which has also thrived in a low interest rate world.

den Uyl predicts that more funds will seek to hedge interest rate risk in the next few years ahead of the 2028 reform deadline. It could lead to a short-term spike in demand (in 2026 and 2027 particularly) for hedging as funds scramble to de-risk.

Most funds have a relatively high solvency rate because of the rise in interest rates, a position they want to preserve before they transition into the new system, he explains. “Funds are thinking about increasing their hedging position in the short-term because if interest rates go down, their healthy solvency ratio is threatened.”

But from 2028 and beyond, the strategy for long-term hedging will increasingly shift to demand for short-term hedging strategies. The reduction in the duration of their hedging portfolios over time will see more selling of long duration and more buying short duration, he says.

“Less demand for long-duration hedges will have some price effect on rates,” he predicts.

As a regulator, the Netherland’s Central Bank, (DNB) is hesitant to speculate how pension reform will impact asset mixes and hedging strategies, mindful that portfolio composition will only become apparent when pension funds migrate to the new system.

Still, DNB’s Chris Sondervan, a supervisor of specialist financial risk, acknowledges an important change of the new pension system will include an increased emphasis on robust risk preference surveys.

“Pension funds will have a good understanding of their participants’ risk appetite in their investment portfolios and are obliged to have an asset allocation that fits with the corresponding risk appetite,” he says.

Under this new, participant-specific risk umbrella, interest rate risk will be better allocated to reflect respective risk preferences.

“For example, young generations have a long horizon and are, therefore, more likely to hedge against long term interest rate risk, while old generations prefer to hedge short term interest rate risk. The current pension scheme does not take these differences into account, while the new pension scheme allows for tailor made interest rate hedging strategies,” he says.

Changing the asset mix

It’s may not just be hedging strategies that change. Changes to pension funds’ asset mix are also on the horizon. Many funds, particularly with younger beneficiaries, may begin to beef up their allocation to equities and reduce their exposure to fixed income.

“Of course, this will depend on the risk preference of members but there is a feeling that the asset mix amongst Dutch pension funds will become riskier,” says den Uyl, who welcomes a change that will see a shift from “overdone” hedging strategies, often at the expense of returns. Reform heralds the dawn of a healthier system that will see pension funds invest more not just in equity but real estate and alternatives, he adds.

More communication with beneficiaries

Under the reforms, pension funds will choose between two different types of DC schemes, either a “solidarity contract” where the fund decides on the investment mix or a “flexible contract” where the member can choose their own [investment mix].

It means the new regulation will see a sharp uptick in compulsory communication with beneficiaries. “This will be an important part of the work of trustees and boards,” says den Uyl.

There is a possibility heightened communication could have consequences for ESG integration. Although many Dutch funds have integrated sustainability off the back of pressure from their beneficiaries, the success of far-right leader Geert Wilders in recent Dutch elections and who has a hostile stance on attempts to cut carbon emissions, could signpost a population beginning to cool on sustainable investment.

den Uyl believes by focusing on the sustainability message, beneficiaries are unlikely to request changes in sustainable investment, even if the Netherlands political landscape shifts to the right.

“There will be even more communication with members around responsible investment in the new system, but members are pushing for sustainable investment, and I don’t see that changing very much and I don’t see the transition to a new system stopping the focus on sustainable investment.

Although not every political party is committed to reducing the impact of climate change, members understand that a sustainable return requires a sustainable world.”

Still, he does warn that if pension returns start to fall, priorities may shift. “If returns drop, the conversation could change,” he concludes.

 

At $26.4 billion and 28 per cent of Oregon Public Employees Retirement Fund’s total assets under the management, the pension fund’s private equity allocation is at the very top end of its target range.

Not only is the exposure stubbornly high, lacklustre M&A deals and “anaemic” exit activity; a slowdown in fundraising and deployment and market volatility creating benchmarking havoc have also conspired to cause consternation for the Oregon Investment Council (OIC).

“We are still in a phase of markets digesting what has been a wild ride since COVID,” said Michael Langdon, director of private markets at OIC, who charted how unprecedented stimulus in 2020 led to record deal activity; inflation and tightening ensued, and now a disconnect between private equity and volatile public markets continues to thwart performance.

Bias to larger funds but smaller funds do best

In its Annual Review of the asset class, the private markets team told the investment council that OPERF’s large program is skewed to allocating to larger funds – yet smaller funds have significantly outperformed. The team have now begun a “manager by manager” analysis to dig down into “why this has happened” although they noted “actual, crystalized IRR” confirming smaller fund outperformance, remains unproven.

The size of the program means OPERF can only access a narrow selection of the manager universe because small managers can’t take large commitments. Of the 5000-odd funds in the asset class composite from 2013-2022, only 352 raised $3 billion plus of committed capital – during the same time period 50 per cent of OPERF fund investments by count and 71 per cent by commitment went to funds with $3 billion or more of total commitments.

Positively, large commitments enable OIC to negotiate more favourable fees.

Cash flow negative

In another challenge, the slowdown in distributions means the private equity allocation has turned cash flow negative for the first time in a decade. In 2023, the portfolio processed capital calls of $2.9 billion and distributions of $2.4 billion leaving net contributions of $518 million.

“2023 was the portfolio’s first negative cash flow year since the GFC,” state board documents.

Moreover, it’s difficult for LPs to model how fast distributions will show up to ease the crunch of negative cash flows. “We control what we commit, but we can’t control how fast managers invest,” the board heard.

The team has also been unable to use the secondary market to pull forward distributions because of challenges around execution. Still, looking ahead, improved pricing in the public market will feed into the secondary market, helping OPERF generate more strategic liquidity.

Pacing and fewer GP relationships

OPEF has a strict private equity pacing commitment of $2.5 billion total annually. But this has also caused challenges to appear in the portfolio because it has led to an underweight in vintages that have performed well. It has created a drag on OPERF’s relative performance due to the strong, early performance from recent vintage years where OPERF is underweight, say board documents.

Around 60 per cent of OPERF’s fund investments in mature vintages are ranked below median as compared to other funds pursuing a similar strategy in the same vintage.  “Fund size continues to have an outsized impact on quartile rankings, particularly with respect to OPERF’s core allocation to North America buyout funds,” say board statements.

The pension fund will keep its pacing range of between $2-3.5 billion while there is a slowdown in distributions.

OPERF is currently “lighter” than it wants with some 30 GPs on its roster rather than a preferred 40. In a catch-22, the team will only add managers as the pacing allows, and given the team will stick with the existing roster unless “the manager gives reason not to reup” it means scant opportunity for new GPs. Since 2015 the program has sharpened manager selection, reducing the number of managers from 70.

The OPERF portfolio has buyout, venture and growth equity. An overweight to buyout and North America has served the fund well. In contrast, the struggle to retain the target weight to venture has been a detractor. In another trend, the investment team expect to tilt more to developed markets in America and Europe because of the challenging geopolitical landscape.

Shifting dynamics

The board heard how the dynamics behind private equity are changing. Since 1981 – when Oregon was one of the first US pension funds to invest in private equity – interest rates have steadily fallen. It means rates have been falling for the entire time the fund has invested in private equity, bolstering the allocation as well as bidding up all risk assets.

The new interest rate environment means that fundamentals and earnings growth will now be the most important contributors to returns in excess of the market. Moreover, if returns are muted on a real basis by inflation, every single basis point is important.

Other market trends include inflated valuations in the tech sector. GPs hunting for capital for their next fund are under pressure from LPs to sell assets but because valuations remain inflated, buyers are cautious. Still, technology is unaffected by cyclical ups and downs. In contrast, PE opportunities in healthcare and services are buffeted more by macro trends, while investors in consumer brands do best focused on the luxury segment and from digitization trends.

The current market is also characterised by an uptick in demand for and availability of leverage from direct lenders.

The board heard concerns about the rising cost of leverage, with the team counselling on the importance of paying close attention to OPERF’s ability to serve the cost of leverage so as not to impact cash flows. Many GPs didn’t hedge interest rate exposure heading into rising rates and worryingly, a fair amount of debt has come due, requiring refinancing across the capital structure.

The $35.9 billion Employees Retirement System of Texas (ERS) has altered its allocation boundaries to permit a 10 per cent maximum allocation to cash.

The pension fund for state employees currently holds just under 8 per cent of its assets in cash in a boosted portfolio that taps the benefits of higher interest rates. It  is also a creative response to diversification challenges given the ongoing elevated levels of correlation between stocks and bonds in the current economic landscape.

“It’s not like the old days when it [cash] was dead money,” said Daid Veal, speaking at a recent board meeting, adding that alongside allocating more to cash, ERS is profiting from its bias to long-dated fixed income in a barbell approach.

However, despite “good returns” the cash allocation won’t edge higher because a larger allocation would move away from risk-seeking assets and potentially hinder the fund’s ability to hit its 7 per cent return handle. ERS’s exposure to the correlation in stocks and bonds is also capped because of its return-seeking focus with the portfolio split 80:20 to return-seeking/fixed income respectively.

Latest results have ERS beating passive indexes; peer averages, and the policy benchmark with three-year returns of 9.3 per cent. Veal attributed much of that success to the investment team’s implementation and prudent selection of securities and managers, a key focus at the fund that has helped reverse its fortunes since 2014 when ERS was rated in the third quartile compared to peers. Veal joined as CIO in 2021, but worked at ERS between 2009 and 2012.

“Security selection is the beating heart of what we do,” he said. “Asset allocation is on the margin – although we are investing more in our asset allocation teams, security selection will always be our bread and butter.”

Still, despite this commitment to implementation, internal management at the fund is at its lowest level since June 2020, responsible for around 42 per cent of the assets. Veal said he was doing his “darndest” to hang onto staff in a competitive market.  Texas ERS has a 78-person investment team, recently set up in refurbished offices that make collaboration easier.

Next year the fund will RFP/RFQ seven investment consulting roles, spanning all private market consultants, its general consultant and governance consultant. In November 2024 it will bring those recommendations to the board.

New look public equity

ERS’ commitment to implementation and stock selection is particularly visible in public equity where the fund has just completed a reorganization of the program – an actively managed allocation of which about 70 per cent is managed internally. The portfolio’s recovery is a direct consequence of the team travelling to meet managers; understanding how they conduct their business and add value, and finding the best strategies and securities they can.

The new look allocation is structured around a ‘Lone Star’ core fund which has an overweight to AI and other Magic Seven themes, drug manufacturers and aerospace. A key development in the public equity portfolio includes “materially” reducing the number of stocks by half to 1200 in an effort to increase the quality of companies and prepare for possible sub-par returns ahead.

Around 35 per cent of the portfolio is in public equity and when public equity underperforms, it drags down the entire trust. “In my book, investment is not like a base ball home-run, it’s more like tennis and avoiding making mistakes,” said Veal.

Since the restructuring, public equity has gained 9.7 per cent versus MSCI ACWI IMI Index returns of 8.2 per cent, which represents outperformance of 1.4 per cent (annualized net of fees to the end of September 2023).

In private markets the investment team also attributed performance to implementation and tweaking allocations to ensure the best exposures. For example, the fund’s private real estate allocation is different to its public market exposure, underweight office and with a careful approach to leverage.

Uncertain outlook ahead

The investment team predicts a period of uncertainty ahead, unsure whether the favourable economic environment of late will continue or more extreme conditions lie ahead.  A middle path of economic cooling where the economy also “chugs along” in the context of “elevated volatility” is the most likely outcome.

Much of what lies ahead will be determined by US consumer behaviour and consumption patterns. And despite low US unemployment and high nominal wage growth, the investment team said these trends don’t support more purchasing power.

“Folks’ real purchasing power has not improved,” said John MacCaffrey, senior portfolio manager. “They are making more money, but they are still feeling the cost of living.”

Moreover, because many people depleted their savings coming out of the pandemic, consumer spending is also being funded by debt leading to a spike in delinquencies. “Consumer spending is expected to cool at least in the near-term. This will detract from economic growth but it may also bring down prices and decrease inflation,” said MacCaffrey.

The indebtedness of the US government was another conversation point. Veal voiced his concerns on the level of government spending, adding that government finance is crowding out the private sector and skewing supply and demand with consequences for investors.

Moreover, the Federal Reserve and the market seem to be at odds regarding the future direction of interest rates. The market is expecting five cuts next year (helping fuel recent highs in the S&P)  but Fed guidance points to sustained higher interest rates for longer, indicative of sustained inflation. “Markets are fighting the Fed,” said Veal. “It’s a big disconnect. Are markets right, or is the Fed?”

The board also discussed the drag of missing productivity in the labour market. Although AI might supercharge productivity, it is still unclear how the gains in tech-related productivity might manifest. They noted that the last time the workforce got a significant boost in productivity was when women entered the workforce en-masse decades ago.

Elsewhere, the team flagged that the government’s anti-trust agenda could also pose a threat to the ability of companies to earn profits.

The World Economic Forum’s annual meeting in Davos served as a pivotal forum for leaders to deliberate on the challenges confronting today’s business community. Artificial intelligence was the talk of the town – you would be hard-pressed to walk down Davos’s promenade without seeing “AI” emblazoned on a half dozen storefronts or events.

Beyond main street, the impact of geopolitics was a focal point for corporate and investors alike. In a world grappling with war in Ukraine and the Middle East, US-China tensions, and polarised domestic politics in many countries, business leaders find themselves at the crossroads of global complexities and investment decision-making.

Which begs the question: how are investors assessing and addressing geopolitical uncertainty in their strategies?

The cross-border risk premium has gone up

In discussions with institutional investors from around the world throughout the week, including in FCLTGlobal’s own CEO roundtable event, the overarching trend is one of viewing geopolitics through the lens of risks, commercial, reputational, and organizational. In that sense, the risk premium associated with cross-border investments has witnessed a significant uptick, forcing leading investors and corporates to acknowledge and incorporate geopolitical factors into their decision-making processes. Geopolitical effects are now an inescapable consideration for any new capital allocation decision, with risk management taking precedence over risk avoidance.

Insights from an EY survey of 100 global CEOs highlighted the pervasive influence of geopolitics on decision-making. A staggering 99 per cent of respondents acknowledged this influence, with 40 per cent reporting delayed investments and 37 per cent having to halt planned investments due to geopolitical concerns. This survey underscores the widespread impact and urgency of addressing geopolitical challenges in the investment landscape.

Engaging with governments emerged as a key strategy to assuage geopolitical concerns. While this has been a longstanding practice for corporates, it is a relatively novel pursuit for the investor community. The importance of bridging the gap between geopolitics and global investment through active dialogue was emphasized by participants, recognizing it as a critical component of risk management.

Not all crises are created equal

Each crisis must be assessed based on its strategic importance to the organization or portfolio, demanding the ability to distinguish short-term noise from long-term trends. With conflict in Ukraine, Gaza, and now flare ups on the border of Iran and Pakistan just this past week, sifting through which events require action and which don’t will be a critical skill for investors.

For the last several decades, investment behavior vis a vis geopolitical events has been far more reactionary than anticipatory. This approach was appropriate as geopolitical shocks were mostly temporary fluctuations. Now, there will be structural change to the industry as alliances and alignments are constantly changing shape.

It almost goes without saying that the evolving US-China relationship, which I heard described as a “fall thaw,” is firmly a trend rather than noise; this dynamic has universal implications for the investment community. Fundamental disagreements persist, and while tensions may ease of in the year ahead, the consensus is that cross-border investments will decrease over time. This transition to a multipolar world, coupled with rising protectionism, supply chain realignment, national security investment laws, and increased regulatory scrutiny, adds layers of complexity that necessitate strategic adjustments.

All geopolitics is local

More than 60 countries will hold elections in 2024, and the significance of domestic politics in shaping future policies cannot be overstated. Investors are increasingly recognizing that their home government policies can either exacerbate or mitigate the complexity of operating internationally.

The trends of nationalism and a desire for more autonomy underscore the evolving landscape. In response to these shifts, corporates are strategically reinforcing regional supply chains and adopting a “building local for local” approach, cultivating local supply to cater to local customer bases. The challenges extend beyond politics, with disparate sanctions regimes and climate policies presenting obstacles to scaling decisions across multiple jurisdictions. The inconsistency in governmental approaches to climate, specifically, has emerged as a major variable, with some nations prioritizing ambitious green initiatives, creating investment opportunities in renewables and sustainability. This policy divergence forces investors to navigate varied regulatory frameworks, incentives, and penalties.

As the world witnesses increasing tensions in key regions, the traditional notion of geopolitical events as strictly buying opportunities no longer holds. Such considerations are now inseparable from capital allocation decisions, prioritizing risk management and rendering risk avoidance nearly impossible. As new developments unfold, the ability to distinguish signal from noise will be more critical now than ever before.

Sarah Keohane Williamson is chief executive of FCLTGlobal.