How are today’s transitions shaping tomorrow's investment portfolios?

A number of transitions are already impacting global markets and economies. Ostrum Asset Management’s chief economist, Philippe Waechter, combines with Xavier-André Audoli, Head of Insurance Multi Assets, to compare views on how these trends are impacting the landscape for investors.

Which trends and transitions do you think are likely to re-shape the investment landscape over the next ten years?

Philippe Waechter (PW): If we think about where we are today, we are looking at the unwinding of globalisation. In the former environment, economic decisions were based mainly economic optimisations – the best way of developing my job or my business is to invest in Vietnam, Malaysia, or South Africa. This is no longer the case. The world is becoming less global, more local. We all want autonomy. We want to have an industrial policy that says I want to be able to build my own electric vehicles, my own batteries. I don't want to depend too much on China. We all want to depend on ourselves, not on others. This is a consequence of Covid-19 and the shortages in semiconductors we had after the pandemic.

And this has changed the global picture, having a deep impact on states and companies' strategies. One interesting indicator is the foreign direct investment in China. It has dropped dramatically since the beginning of 2023. Nobody wants to be in China except Germany. In the US, the Inflation Reduction Act has encouraged the view of wanting every manufactured product needed in the US to be produced in the US. So, everyone has to be more autonomous in the way they are doing business.

Xavier-Andre Audoli (XA): I agree. The consequences of deglobalisation are already there with rising inflation and higher interest rates than the previous decade. When it comes to asset allocation, deglobalization means decorrelation between countries and geographical areas. A more geographically diversified portfolio is a source of opportunities for our clients.

On the flipside, deglobalization implies more risks – especially through geopolitical change, trade wars, protectionism, and probably more extreme events. We need to hedge our portfolios against these deglobalisation-related risks in the coming decade. And we’re not talking only about allocation, we are also talking about how to manage drawdown risk in this new environment.

Ageing populations are expected to have several significant impacts on global economies. What are your thoughts about the demographic transition?

PW: Demographics are impacting everything. In China, and in Europe, the population is ageing rapidly, and this will have a strong impact on all our futures. United Nations projections to 2100 show that in the three blocks, Eastern Asia (including China and South Korea), European Union and the US, the population of the first two will decline when the US population will continue to grow. It will have an impact on bargaining power of each of them and therefore on the geopolitical equilibrium.

In Europe we will have to arbitrage between pension to retirees and income from the active population. This is a very tough choice and the only way to limit this arbitrage is to open the door of migration, to allow people from elsewhere to come to work, to produce, to create revenues. And this revenue must be able to support retirees and other non-active participants in the economy.

It will be a nightmare somewhere and we don't know how to handle it because there are considerable political constraints, from the AfD in Germany to Le Rassemblement national in France. If we are not able to increase revenues through migration or large increase of productivity, ageing population will lead to accept unpalatable truths like a lower standard of living. It's complicated. In Europe, we have to reinvent our model, to rethink our way of living, a kind of revolution. But revolutions are done by young people, not by retirees.

XA: We collaborate very closely with our clients and partners on how to finance all the life steps, especially retirement. This is a key topic for insurance companies and public and private pension funds. A longer retirement period may enable us to take more risk, assuming that in the long-term risk becomes a potential source of benefits. It means we may have to rethink our portfolios. The European and American models may converge to include a riskier portfolio with more equity, due to the longer investment horizon.

How do climate change and artificial intelligence have an impact on investments?

XA: Climate change will not dramatically change our allocation. Strengthening climate-friendly investments is not a question of allocation between fixed income, equities, and other buckets, it's a question of sector and security selection inside buckets. For instance, we ban oil and gas from the portfolio and add green and sustainable bonds to the fixed income bucket, without changing the allocation between the various buckets. What’s clear, however, is that climate events will grow dramatically in the next 10 years, especially in Europe.

Artificial intelligence is a not-so-new topic that doesn’t necessarily feature in asset allocation for the time being. My belief, based on current available technology, is that if all asset allocators used AI in the process of defining their strategic asset allocation over the next ten years, everybody would do globally the same allocation. So, there is a risk of over-standardisation, where everybody will be long the same asset class or short the same asset class, and it becomes a self-fulfilling prophecy.

If ever an extreme event happened, such as a black swan, which AI has no view on, it would be catastrophic because it would increase all the impacts of the extreme event. Hence, if everyone decides to use AI, hedging tools will be particularly important in the next decade.

Alongside this risk, there are of course opportunities. For instance, AI could complement the team’s input and enable us to cover every asset class around the world. That means more diversification in terms of geographical area and type of risk. So, with AI, as with most things, it’s about considering all the risks while keeping the door of opportunity open.

PW: In the last 30 years we have had three types of revolution. The microcomputer. The mobile phone. The internet. With each revolution, we thought that the problems of productivity would be solved. It has not been the case. The macro productivity in Europe is not growing up. And even in the US, even if it is better than the in Europe, it's not as strong as hoped. So, I don't know what will happen with AI, but I'm not sure that it will be all that positive on the economic side.

More broadly, beyond AI, can we rely on technology to help us tackle climate change?

PW: When you look at the IPCC report, we'll have to be able to capture carbon and store it if we want to converge to a carbon neutrality in 2050. But the current technology can’t do it. There’s a huge new carbon absorbing plant which opened up in Iceland earlier this year. It can absorb something like 40,000 tons of carbon from the air annually, which is the equivalent of removing over 7,000 cars from the road. It sounds impressive, but it's still nowhere near enough.

It’s a bit like asking a computer in the 1950s to calculate two plus two, and the computer takes up a small office block. It takes time to go from that size of computer to a mobile phone and the point is that we don’t have time. We have to reduce our consumption and our capacity to limit the carbon emission in 10 years from now, not in 20 or 30 years. Yet the technology in 10 years is not expected to be able to capture what is needed.

Nevertheless, we have to innovate in the carbon capture process. We will probably be above 1.5°C in 2050. This means that we will have to capture carbon to limit the temperature in 2100. We have to reduce our carbon emission now but we have to innovate to capture carbon in the future. That’s what we need to do. It will cost a lot in investment meaning that we will have to make an arbitrage between expenses.

And the last point is on geo-engineering. Putting something in the sky to reflect the sun. I hope we will never go this way because it means we will need to have the agreement of every country at every moment in time in the world to do it. We have to send rockets up every day to achieve this. And what will happen when the US or China says no?

The temperature will increase dramatically but we cannot assume that everyone will agree on the same course of action forever. The number of climate events has increased dramatically in the last couple of years and it will not stop. We have to think deeply on these challenges and we must find ways to adapt, to change our way of doing things. Are we ready for that?”