Jake Meyer: In short, the shift towards green energy, supply chain risks (in particular for semi-conductors), and political pressures for deglobalisation all add to the risk of higher long-run inflation, or even stagflation.
Soaring real estate valuations also add downside risk to this sector and associated investment vehicles.
Looking first at the transition to green energy, with more and more countries going down this route, demand for green-energy materials inputs (e.g. copper and lithium) will increase. In relative terms, global demand for commodities not party to the transition (such as coal), will fall.
The direct exposure of insurance investors to commodity prices is often limited. However, countries with a strong supply of these commodities will be affected by the transition.
This will also influence interest rates in and exchange rates of countries with significant commodity price exposure, in turn impacting investment returns.
"In relative terms, global demand for commodities not party to
the transition (such as coal), will fall."
Sectors with exposure to these prices (e.g., the mining and energy industries) will be affected by this shift, creating both risks and opportunities in segments of the corporate bond and equity markets.
Further, bottlenecks or barriers to rapid production of green energy inputs or other sectors affected by this transition will add risk to the global inflation and long-term yields outlooks. Here too, insurance investors will be exposed.
Shifting regulations related to ESG investing and economic activity are also a key risk. Reporting requirements and transparency related to the criteria for ESG compliant investing remain concerns, with changes in this landscape likely able to significantly disrupt economic activities and valuations.
Given the ongoing uncertainty about the specifics of the ESG movement, associated transition risks may be more widespread than considered at present.
With respect to semi-conductor supply chain risks, demand was rising strongly pre-pandemic. While rising electronics sales was an important factor, the shift of the auto industry towards relatively semi-conductor intensive types of autos (electric vehicles and SUVs) was a key cause.
With the push for further transition to electric vehicles, this structural rising demand for semi-conductors is unlikely to reverse.
"Any shocks to semi-conductor supplies will add to
upside inflation risk globally."
Given the long-lead time for the building of production capacity for semi-conductors, and current concentration of output still mostly in southeast Asia, this key input is exposed to further shocks. And any shocks to semi-conductor supplies will add to upside inflation risk globally.
However, capex in this sector is high, and there is a push towards building domestic semi-conductor production capacity.
Meanwhile, US political pressure for deglobalisation increases the risk of large-scale reshoring. Similar movements elsewhere in the world suggest this may be a broader phenomenon.
Reshoring will raise production costs in order to add resilience to the supply chain at the expense of reducing cost efficiency. This could sustain cost-push inflation tendencies.
"US political pressure for deglobalisation increases the
risk of large-scale reshoring."
At the same time, rolling back globalisation reduces long-term GDP growth potential.
With both growth and inflation primary drivers of long-run interest rates, the transition towards reshoring may create disruptions to investments in related industries and countries.
Real estate prices are rising rapidly, with the Case-Shiller index up almost 20% year-over-year. This is likely due to temporary shifts in the composition of demand from the pandemic (as urbanites fled city centres for suburban and rural areas) and rising incomes due to policy stimulus.
"Real estate prices are rising rapidly."
A reversal of these temporary demand increases suggests the potential for a reversion of these price surges, increasing risk for insurers holding real estate-based bonds and/or making direct loans.
However, we believe the likelihood of a repeat of the real estate crash in 2000s is quite low, as lending standards are much stronger and the current cycle was not characterised by the same type of overbuilding as the prior cycle.
