This edition of the EdenTree CIO View considers the concepts of risk, due diligence and preparedness, which came to the fore during the first quarter of 2023.

• Lessons from the collapse of Silicon Valley Bank
• Reflections on the latest IPCC synthesis report on the science of climate change
• A “not-so-green day” for UK energy and climate policy

Markets in brief

Markets started the first quarter of 2023 in an ebullient mood. Such was the optimism that inflation had been contained without any real economic damage, talk of a “soft landing” turned to excitement about the prospect of a “no landing”. This is a scenario that has never been achieved. The mood changed markedly following the collapse of Silicon Valley Bank and subsequent rescue of Credit Suisse, which were a tough reminder that the impacts of the fastest tightening cycle in the Federal Reserve’s (Fed) history are yet to fully work their way through the economic machinery.

• GFC-era playbook contains fallout from Silicon Valley Bank and Credit Suisse, but highlights risks induced by rate increases

Silicon Valley Bank’s (SVB) collapse in March was a rude awakening for a market that had become complacent about the Fed’s ability to break inflation with little collateral damage to the underlying economy.

Rate rises alone were not the only factor behind SVB’s collapse, a key lender to tech start-ups. They were the straw that broke the camel’s back, exposing poor governance and management and raising questions about whether the regulation of small and mid-sized US banks was sufficient to avoid similar episodes. The main source of SVB’s problems, however, lay in its decision not to hedge the interest rate risk of these investments. When SVB’s interest-rate sensitive depositor base started to withdrawal money en masse, losses were crystalised on the banks investments and it didn’t take much to wipe out the $16bn in shareholder equity.

SVB’s problems took so long to come to light for two key reasons: the fact the bank was not required to report the current market value of the bonds on its balance sheet and lower levels of regulatory scrutiny for banks with assets of less than $250bn – SVB had assets of $212bn.

For investors – particularly responsible investors – two key lessons stand out. The first is the importance of fundamental research and the need to build a mosaic of information that stretches beyond simple balance sheet analysis to the nature and quality of the asset, but also to the culture of the firm and the management team, to ascertain the kinds of risks the organisation might be taking on. The second is that government failure is an ever-present risk, whether that be in banking or climate change.

• A stark warning from the IPCC

Notwithstanding the unique characteristics of current events in the banking sector, the recent episode does suggest parallels to the GFC and, indeed, the lessons it provided in relation to addressing climate change. Lord Nicholas Stern outlined these succinctly in 2008.

“The risk consequences of ignoring climate change will be very much bigger than the consequences of ignoring risks in the financial system...That’s a very important lesson, tackle risk early.”¹

Stern was speaking a mere two years after the publication of his ground-breaking report entitled The Economics of Climate Change: The Stern Review (2006), which was commissioned by Gordon Brown, the UK government’s Chancellor of the Exchequer at the time.

In that context, the latest IPCC Synthesis Report (AR6), which was unveiled during the quarter, some 15 years after Stern’s warning, has made for deeply troubling reading. Published to inform policy makers ahead of COP28 in Dubai later this year, the IPCC AR6 Synthesis Report captures the latest scientific understanding of human induced climate change and the extraordinarily urgent steps required to limit and adapt to its effects.

The report stresses the need to start cutting GHG emissions more deeply to keep the 1.5C goal alive, with peak emissions by 2025 at the latest and a 60% cut by 2035. With global warming already at 1.1C and a 50% chance it will breach 1.5C between now and 2040, the impacts of climate change are already proving more severe and widespread than expected. The planet has the highest concentration of CO2 in two million years, the 2010s was the warmest decade for 125,000 years, and we are witnessing historically significant glacial retreats, sea level rises, reductions in arctic ice coverage, warming seas and ocean acidification. The IPCC has concluded that “there is a rapidly closing window of opportunity to secure a liveable and sustainable future for all.”²

Nevertheless, the 1.5C scenario remains very much alive if the right steps are taken to cut carbon and dramatically ramp up sequestration and carbon capture. A CO2 overshoot is almost certain, but the removal of legacy emissions or net-negative emissions could reverse the global warming process. Rapid, transformational, action is imperative.

• A not-so-green day

Transformational action wasn’t exactly what was delivered by the UK government during the quarter. Forced by a High Court ruling to upgrade its approach to net-zero, the UK government released around 1,000 pages of policies towards the end of March, on what was originally touted as “green day” but was subsequently rebranded by Prime Minister Sunak as “energy security day”.

The policy framework ticked some boxes but certainly lacked the ambition shown by the US (e.g. through its Inflation Reduction Act) and Europe. Combined, the UK’s policy framework is expected to cut emissions by about 55% by 2035, with contributions from every sector. Highlights include more council funding to install car charging points and the requirement that at least 22% of new cars sold next year must be zero-emission as part of plans to ban new petrol and diesel cars by 2030. Tariffs on heat pumps and insulation, and plans to rebalance electricity bills from 2024, will help improve emissions from buildings.

However, the government is banking heavily on nuclear power, including small modular reactors, technology that has yet to be tested at scale. While nuclear will be an essential part of the mix, faster and cheaper deployment of wind and solar technology remains the low hanging fruit in the energy transition, yet the government took few steps to boost policy for these renewables: £160m in additional support for floating wind and plans for a taskforce to create a roadmap for 70GW of solar by 2035.

Another key criticism of the government’s plan was the decision to issue licences for new North Sea oil and gas projects, which may or may not comply with the government’s own “climate compatibility checkpoint.” The IPCC estimates that only 510Gt of CO2 can be emitted to achieve a 1.5C pathway by the early 2050s; current output suggests 850 Gt of CO2 might be emitted by that time, which does not include the UK’s plans for the North Sea. Reliance on carbon removal (via bioenergy with carbon and storage and direct air capture) to achieve the UK’s 2035 climate goals also poses significant risks; the efficacy and sustainability of both remains questionable with neither of these technologies proven at scale.

This policy framework comes a year after the UK witnessed record 40C summer temperatures and in a month when the government’s own statutory climate adviser, the Climate Change Committee (CCC), warned that UK infrastructure is ill-prepared for a warming world.

Summing up

A common lesson across each of the topics in this newsletter is that managing risk requires preparedness. This invariably involves deep research and the testing of assumptions against various scenarios. Moreover, taking careful consideration of “unknown unknowns” typically requires the application of the “precautionary principle” – one of the founding tenets of the UN Framework Convention on Climate Change (behind the COP process) which recognised that gaps in what was already a robust understanding of climate science should not impede action to address the human causes of climate change.

Taking due consideration of unknown unknowns will be acutely important in the coming months. In recent days, markets have digested further data points that show just how sticky inflation is proving to be, with the UK’s CPI for March coming in at 10.1% driven by rising food costs, while core inflation remains at a high of 6.2%. The Bank of England appears to have little choice but to turn the dial on interest rates. The ECB faces similar problems and the inflation picture in the US is not significantly better, with inflation expected to be at around 5% for a considerable time. Bond markets have duly started to price a “higher for longer” scenario, increasing the risk of personal and corporate credit defaults, which could lead to further market disruption.

Policy makers have also awoken to the risks that remain in the US banking sector. SVB was considered a medium-sized bank with no systemic risk. It was therefore below the threshold for a range of stress tests that apply to institutions classed as systemically important. However, taken on aggregate, small and medium sized banks are significant, with small US banks accounting for about 33% of total banking sector deposits, 50% of commercial and industrial loans and 70% of commercial real estate loans before the sector’s problems emerged in March. So, in addition to tighter monetary policy, we would expect tighter lending standards among smaller banks, posing a further headwind to the economy.

No-one has a crystal ball in finance, which is why due diligence and maintaining a risk mindset are crucial for investors. As an investment desk we were particularly careful not to get caught up in the moment of euphoria, and in some cases leant into it during the quarter, tactically trimming positions that appeared fully valued. Our global strategies (including Global Equity and Green Future) have cash buffers which can be deployed opportunistically. Holding defensive cash balances can be a double-edged sword, especially when markets rise, and we have been pleased with the upside capture of our funds due to the robust performance of constituent holdings. And across our investment desk at EdenTree, we also continue to scrutinise balance sheets very carefully to understand the quality of assets and the true risks associated with liabilities to be reassured we are exposing the portfolios to an appropriate level of risk for the potential rewards on offer.

Finally, it is important to stress that times of heightened risk and uncertainty are when our Responsible and Sustainable ethos comes into its own. The cross team due diligence and screening process, along with our valuation awareness in equities, and cautious approach to fixed income, add robustness to the team’s buy and sell disciplines supporting long-term returns for our clients. Many of the problems we have witnessed this quarter have shown the negative outcomes that can result from breaches of trust, which can have many sources from individual action to poor policy making. This underscores the integral role we as an investment house seek to play as responsible stewards of our clients’ financial assets, the environment and society.

Important information

The views contained herein are not to be taken as advice or recommendation to buy or sell any investment or interest. Please note that the value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations, you may not get back the amount originally invested. Past performance is not necessarily a guide to future returns. EdenTree Investment Management Limited is authorised and regulated by the Financial Conduct Authority and is a member of the Investment Association. Firm Reference Number 527473.

Source

1. https://www.reuters.com/article/uk-climate-stern-idUKTRE49Q1CU20081027
2. https://www.ipcc.ch/report/ar6/syr/resources/spm-headline-statements/