The Seven (+1) Trends That Matter
As long-term investors, we tend to ignore - for the most part - the vicissitudes of daily market activity and the attendant yammering of the always-on news cycle. If we were traders, glued to our monitors to ferret out the slightest mis-pricings in the market, our stance would be different. But we aren’t. We are focused on capturing steadily compounding after-tax returns in addition to generating durable, measurable social and environmental value. In this pursuit, our passion is to consistently reflect the values, dreams, concerns, and demands of the families and foundations we support.
It also bears observing that much of the capital we allocate is deployed in private markets. This means that we can not allow our decisions to be influenced by shiny trends, nor our approach to investing to be distorted by attention-grabbing headlines. Sometimes this means we miss early runs in new ideas. More often it means we avoid reacting to market ephemera. Either way, the relative liquidity of the portfolios we build requires a relentlessly thoughtful approach, mindful of the reality that liquidity walls are terrible things to smash into, and the unique need for patient capital that so many impact strategies require.
Doing this successfully, over time, demands a mindset that separates the signal from the noise in order to identify material trends. Some may immediately impose a material impact on portfolio outcomes, both financial and impact. Others may percolate along for years, gently nudging the portfolios we build in one direction or another. But the trends we pay attention to all have an impact on our approach to diligence, portfolio construction, and, eventually to the impact we pursue.
Keeping that frame in mind, here are the Seven (+1) trends that currently fascinate us, and that are helping to shape the way we think about deploying capital toward an always-unknowable future:
The gradual exit from high rates
The surprising importance of fiscal policy
The shifting sources of global growth
The repricing of risk
The elevated profile of private credit
The growing intolerance towards B.A.U.
The persistent volatility of inflation
The economic impact of generative AI
The gradual exit from high rates
Inflation is now in the 3-4% range but the hit to central banks’ credibility has been considerable. They will continue to act in a hawkish manner until they are sure inflation has been defeated. But their fixation on an inflation-data-dependent approach, combined with the long lags of monetary policy, risks harming the economy in the medium term. With the most recent inflation surprises coming in on the downside, the case for lower rates later in the year has become stronger. If this scenario unfolds, a further upward move in equity prices is possible, likely accompanied by a continued ratcheting down of yields, particularly in the public fixed-income markets. We anticipate this will benefit our impact-oriented credit strategies as interest pressure abates and the delta between conventional fixed-income and private credit widens. Further, as the cost of capital ratchets lower, growth-driven strategies like venture capital should experience an easing of margin pressure, possibly elevating exit valuations.
The surprising importance of fiscal policy
Since Keynesian economics lost much of its credibility and influence in the mid-80s, fiscal policy has become a broadly dismissed driver of economic growth. Yet it has been crucial in creating the conditions for the dramatic relative outperformance the US has experienced since the Covid pandemic first washed across the globe. And while the US enjoys a tremendous amount of fiscal space due to an accelerating economy, strong wage gains, and tapering inflation, other countries are much more constrained. That may well solidify US economic leadership for several years into the future. Most importantly for impact, the material tailwinds we see continuing to develop relative to climate risk (on this singular dimension, we are actually quite sanguine about the anti-climate headlines coming from the far right - markets are more powerful than politics) should benefit the deployment of climate technology, even as financial returns may compress as cost of capital drops due to increased capital flows.
The shifting sources of global growth
Led by historical private sector investment, catalyzed by an expansive fiscal policy, the US is outperforming the global economy (with important consequences for the US dollar). Partly powered by a return of business dynamism and government led investment in new sectors, which is in turn driving record tax revenues, the US is beginning to experience the durable benefits associated with having more fiscal room than other countries. Meanwhile, China is struggling as it suffers from insufficient demand and is experiencing economic indigestion as it tries to digest two decades of overbuilding excess capacity - primarily in housing and manufacturing - and is thus exporting deflation to the rest of the world. Constrained by politics and a slow post-Covid rebound, Europe’s recovery is lumpy. Latin America, and in particular Mexico, is experiencing a resurgence that has echoes of China in the late 1990s. The persistent low price of hydrocarbons continues to put pressure on oil-producing nations. This tectonic reorienting of the sources of global economic growth will have subtle but profound consequences for almost every economy, likely for years to come. For impact investors, this means an increased focus on US-based strategies to lower risk, and an increased focus on emerging markets for elevated additionality (and, likely, higher financial, geopolitical, and currency risk).
The repricing of risk
Insurance companies are beginning to back away from coastal residential real estate. Reinsurance companies are backing away from coal mines. The SEC has recommended that climate risk disclosures become mandatory. The shipping industry has launched a program of obligatory disclosures and fees (ie: taxes) to force a de-carbonization of the global shipping business. Sovereign Wealth Funds, Pension Funds, and Endowments are beginning to step out of carbon-intensive industries with an eye towards their uncertain future. The markets are always a risk-pricing machine. But it is notable to see how climate risk is beginning to appear in that function. We have long maintained that impact investing reflects a classic example of mis-priced risk: as this risk is gradually re-priced, we see continued opportunities to capture thin slices of high risk-adjusted returns.
The elevated profile of private credit
The Great Financial Crisis introduced a cultural, regulatory, and behavioral shift in banking behavior, and greatly consolidated the number of lenders across the global economy. And the demand for capital simultaneously exploded. This pair of forces gave rise to a private credit sector that has been like nothing we’ve seen since the age of the Dutch and British first funded their colonial ambitions with private capital. Some economists now estimate that the cumulative amount of private credit may be approaching the total amount of outstanding traditional debt. While we find this to be implausible, it reflects just how large the so-called “shadow banking” sector has become. And while we stand in support of alternative sources of capital, and believe it plays an outsized role in impact investing, we recognize that it could become a flash-point for the next financial crisis, just as it was for the GFC. We continue to steadily, and carefully build a coherent portfolio of private credit opportunities, both evergreen and time-stamped. We continue to find innovative, attractive, private credit strategies that generate asymmetrical impact returns and solid risk-adjusted financial returns.
The growing intolerance towards B.A.U.
Business As Usual. A phrase that is anathema to every impact investor. For years, we have howled in frustration as market participants largely shrugged off growing climate risks, environmental degradation, and a wide array of social issues. More recently, and despite the well-publicized (and, frankly, absurd) opposition to ESG investing, the tide has clearly turned. Impact Investing is the hottest topic at business schools around the world. Climate investing is no longer considered a curiosity. Seeking market solutions to social problems is no longer seen as an oxymoron. And the idea that the efficacy of philanthropy has limits is now widely accepted. Overall, this points to a growing intolerance for B.A.U., an evolution in perspective that will have profound implications for nearly every industry, and every economy, on earth. While we are reluctant to draw generalizations across entire generations, it is notable to us that young adults - particularly young financial professionals - are so drawn to building careers in businesses that pursue something more than just profit, a trend that has accelerated sharply over the past five years.
The persistent volatility of inflation
The pandemic demonstrated that second-round impacts from supply shocks are greater than previously assumed *because of the volatility of inflation*, which in turn increases the range of expectations, leading to uncertainty in the markets and hesitation among policymakers. In addition, adverse supply shocks are likely to be more common in the future as global supply chains fragment (one of the reasons US manufacturing is experiencing a resurgence and why the Mexican peso is surprisingly strong as it benefits from near-shoring supply chains). Troublingly, we are also seeing more protectionist measures introduced around the world, a lesson we thought was learned following the passing of the disastrous Smoot-Hawley Tariff Act of 1930. The bottom line? Predicting inflation has become incredibly complicated, with different scenarios playing out in different areas of the globe for different reasons. Very generally speaking, impact strategies are not uniquely positioned relative to inflation. As such, inflation volatility does not have an impact-specific dimension. Nevertheless, volatility breeds uncertainty, which frequently catalyzes inaction. When capital flows freeze or sectors of the market lock, capital becomes more valuable and entry valuations can become more attractive. Particularly relative to impact, where capital is typically scarce, this can create opportunities for material additionality for investors willing to commit capital during times of uncertainty.
The economic impact of generative AI
Enough ink has already been spilled on generative AI to float the entire global oil tanker fleet. As a result, we know that generative AI could prove to be the most disruptive single technology since Johannes Gutenberg cranked out the first printed bible. Or it might become the most over-hyped piece of algorithmic software since MySpace or Snapchat. What is clear is that Generative AI has the potential to increase productivity and raise levels of GDP, perhaps significantly, and at least in the mid-term. The long-term economic impact, on the other hand, is likely disinflationary. And while we are already seeing early business and labor disruptions, the economic impact will likely be surprisingly small in the near term. The thing to remember is that generative AI is a lot dumber than it looks (it is, after all, nothing more than a gazillion machine learning probabilities stuffed inside an algorithm, thereby creating the illusion of creativity), but using it well will make all of us look, and perhaps feel, a lot smarter. At this point, arguments about the eventual impact of AI are as diverse as there are applications of the technology. Lost jobs is a tough reality. New AI jobs are unlikely to offer an impact profile. The efficiency of AI will lower barriers to entry to capital-starved impact enterprises. AI will lower the cost of loan origination and monitoring in emerging markets. Etc. Etc. We could construct impact-related arguments on virtually every facet of AI.