What Can Central Banks Do to Take the Paris Agreement Seriously?

Bruegel

Energy

Economic

Summary:

Central banks should take a macro approach to managing system-wide risks stemming from the climate transition.

Executive summary

Since the Paris Agreement on climate change was signed in 2015, its 195 signatories have seen financial instability resulting from the climate transition increase by approximately one third, in the context of still-increasing global emissions. In the European Union, emissions have fallen but banks have not fully internalised the costs of transitioning to net-zero. Banks continue to finance the expansion of the fossil-fuel industry. At the systemic level, this is trading a pretence of financial stability now for a more disorderly transition scenario with greater financial instability later.

Central banks are increasingly using microprudential supervisory tools to address climate-related financial risks. These tools include reviewing banks’ risk-management processes and giving warnings over shortcomings in banks’ risk models. This approach is helpful, but has so far failed to address the build-up of climate-transition-related imbalances in the financial system. This situation echoes the run-up to the 2007-2008 global financial crisis, when supervisors were busy reviewing the implementation of the latest Basel risk models by individual banks, while failing to see increased imbalances in the financial system caused by rising housing prices.

This Policy Brief proposes that central banks should take a macro approach to managing system-wide risks stemming from the climate transition. It is necessary to treat climate as an endogenous, and in many jurisdictions legally-mandated, transition, rather than an exogenous risk. The policy aim for central banks, in their macroprudential supervision capacity, should be to minimise financial instability during that transition. This Policy Brief argues that, all other things being equal, the steadiest path towards net-zero offers the greatest amount of financial stability. Current proposals to impose systemic risk buffers for climaterelated concentration risk may fail to provide such a steady reduction.

A guided transition is recommended for banks that have been reluctant to hive off profitable loans to high-emitting companies. A requirement for the financial sector to reduce financed emissions by four percentage points annually from 2025 to 2050 would deliver net-zero with the least amount of financial instability.

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Risk Warnings and Disclaimers

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ACY

Economic

Political

Following Trump’s 2024 victory over Kamala Harris, which secured him a second term, substantial policy shifts are expected across multiple domains. Trump garnered 292 electoral votes, capturing pivotal battleground states including Georgia, North Carolina, Pennsylvania, and Michigan, while Republicans reclaimed control of the Senate, setting a strong legislative foundation for his administration.

How Will His Policies Reshape Markets and Global Trade?_1

Fiscal Policy

Trump’s win may signal the continuation or even expansion of the 2017 Tax Cuts and Jobs Act (TCJA), potentially introducing further reductions in corporate and personal tax rates. The administration's approach appears set to focus on expansionary fiscal policies to stimulate U.S. growth. However, with Trump's campaign downplaying debt concerns, the U.S. national debt is projected to rise by $7.75 trillion over the next decade. This strategy is aimed at bolstering domestic investments but could create longer-term fiscal strain.

Trade, Tariffs, and Costs

The re-election of Trump also suggests a return to an assertive trade policy, with a proposal to impose high tariffs—up to 60% on Chinese goods and 10-20% on imports from other countries. This could increase costs for American consumers and potentially instigate inflation within the U.S. economy, as higher tariffs often raise prices on imported goods. Retaliatory measures by affected countries could also strain global trade, particularly impacting economies like China, Mexico, and Vietnam that rely heavily on U.S. trade.

Foreign Policy

Tensions with China are likely to escalate further as Trump has proposed aggressive trade and policy measures targeting Beijing. Additionally, shifts in foreign aid, notably to Ukraine, could alter the geopolitical landscape, influencing the dynamics of the Russia-Ukraine conflict. The administration’s stance on Middle Eastern policies, including oil production and diplomatic relations, may also experience shifts with implications for global energy markets.

Immigration Policy

Trump’s immigration platform, a core part of his campaign, emphasizes stricter immigration controls. Proposed policies include expedited deportations, an extension of the U.S.-Mexico border wall, and a push to end birthright citizenship. These measures may reduce the labour pool, particularly in industries dependent on immigrant labour, which could in turn drive up wages in sectors like agriculture and construction. Economies in Latin America may face ripple effects as remittance flows decline and deportations increase regional challenges.

Monetary Policy and Global Impact

Trump’s potential influence over the Federal Reserve may push for policies aligning with his domestic growth agenda, though inflation risks remain. The strong dollar, driven by Trump’s trade and monetary policies, could create ripple effects in global economies, especially those holding dollar-denominated debts. Central banks in Asia and the Gulf might face pressures to adopt tighter policies, further amplifying global inflationary trends.

Impact on the USD

Strengthening Dollar Due to Expansionary Fiscal Policies: Trump’s proposed fiscal policies, such as tax cuts and higher domestic spending, are expansionary. They would likely boost U.S. growth in the short term, leading to increased investor demand for USD-denominated assets and, consequently, a stronger dollar.

Inflationary Pressures Leading to Hawkish Fed Policy: Trump’s fiscal approach could lead to higher inflation, which may push the Federal Reserve toward a hawkish stance to counterbalance rising prices. This could further strengthen the dollar as higher interest rates attract foreign investment into USD assets.

Global Demand for USD Reserves: With Trump's trade restrictions and anticipated stronger USD, global demand for dollar reserves may rise as a hedge against fluctuating currency values in other economies affected by reduced U.S. trade.

Impact on Equities

Trump’s expansionary policies, particularly tax cuts, are generally favourable for U.S. corporate profits and could drive stock market gains, especially in sectors reliant on domestic consumption and lower tax rates (e.g., tech and retail). However, companies dependent on imports (e.g., manufacturing, consumer goods) may face higher input costs due to tariffs.

G10 equity markets could see increased volatility as Trump’s trade restrictions affect global supply chains.

European and Asian markets might experience downward pressure, especially in export-heavy sectors. Investors may shift capital to U.S. equities, given the pro-growth policies expected domestically.

Energy and defence sectors may benefit as Trump’s policies are expected to favour fossil fuel production and increased defence spending. Conversely, sectors like renewable energy could face challenges if environmental regulations are rolled back.

Impact on G10 Economies and Forex Market

Pressure on G10 Currencies: A stronger dollar typically puts pressure on G10 currencies like the euro (EUR), yen (JPY), and pound (GBP). Additionally, tariffs on imports from Europe and Asia would likely weaken these currencies against the dollar as export-driven economies face reduced U.S. demand.

Interest Rate Adjustments Abroad: Major central banks, especially in Asia and Europe, may be forced to respond to U.S. inflation-driven rate hikes by tightening their monetary policies. For instance, the European Central Bank and the Bank of Japan might shift policies to support their currencies against a strengthening dollar.

Commodity-Based G10 Economies: Currencies in commodity-dependent G10 economies, such as the Australian (AUD) and Canadian (CAD) dollars, could face additional volatility. Tariff-driven inflation in the U.S. would likely boost global commodity prices, potentially benefiting these currencies as demand for exports like oil and minerals rises, though not without heightened volatility due to trade disruptions.

In summary, Trump’s victory ushers in a period of assertive fiscal, trade, and immigration policies that prioritize U.S. economic independence and influence. These initiatives may accelerate growth domestically but could simultaneously increase inflation and disrupt global economic stability. This term could redefine U.S. economic and geopolitical strategies, affecting both domestic markets and international relations significantly.

To stay updated on all economic events of today, please check out our Economic calendar

Risk Warnings and Disclaimers

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Goldman Sachs

Economic

Energy

In Europe, the capacity of renewable energy sources is growing very rapidly, while traditional power plants are slowly being decommissioned. That’s creating a unique new opportunity for investors amid the emerging demand for battery storage, which provides balance to electricity markets.

“With energy storage, there's a new and interesting asset class emerging, and the business model is fundamentally different to that of wind and solar,” says Ingmar Grebien, who leads GS Pearl Street and is a managing director in Goldman Sachs Global Banking & Markets. GS Pearl Street is a platform for trading and financing solutions for clean energy technology. Overall, total energy storage in Europe is expected to increase to about 375 gigawatts by 2050, from 15 gigawatts last year, according to BloombergNEF.

We spoke with Grebien about electricity market trends, energy storage technologies, as well as the investment and financing opportunities emerging from these technologies.

European Energy Storage: A New Multi-billion-dollar Asset Class_1

What sort of challenges does the rise of renewables pose for European electricity markets?

By 2050, you'll have about 72% of electricity produced by wind and solar in Europe, which is a massive increase compared to the 30% we have currently, according to BloombergNEF data. This is really a profound structural change in the electricity market. And it's here to stay. Now, that's great from a decarbonization perspective. But it also results in issues with regards to the timing and certainty of supply, because renewables are intermittent sources of power. When there's no wind or no sun, there’s also no power production. Imagine a world where the light switch only works if the sun shines or the wind blows.

As renewables penetration rises, there are increasing imbalances between consumption and production. That can result in market volatility and in some instances extreme price scenarios. For example, some European markets such as the Netherlands or Belgium have already started to see a significant increase in negative hourly prices directly correlated with the rising share of solar and wind power.

Energy storage is the key to shifting electricity and resolving those structural issues in a low-carbon way.

What opportunities does energy storage offer for investors?

With energy storage, there's a new and interesting asset class emerging, and the business model is fundamentally different to that of wind and solar.

Wind and solar assets generate revenues by selling electricity and therefore depend on the absolute level of electricity prices. The rapid increase in renewable assets that all generate at the same time and with low marginal cost of production means that there's a long-term risk of lower electricity prices, lower capture rates, and lower revenues for those assets.

The exact opposite is true for energy storage. Energy storage is shifting electricity, and it makes money from buying, selling, and trading the difference between low- and high-priced hours in the market. Storage assets therefore depend on price spreads, which tend to be higher with more imbalances. Imbalances, in return, are driven by more renewables. Energy storage is therefore well-positioned for an electricity market dominated by renewables and represents an interesting new asset class. It’s also a potential hedge for players who already have classic renewable portfolios.

Compared to classic renewables, energy storage has really only become an investable asset in Europe over the last few years on the back of technology advances, market price signals, and government support mechanisms. Overall, market research such as BloombergNEF predicts that grid-scale energy storage in Europe will increase to about 375 gigawatts in 2050 from 15 gigawatts last year.

Goldman Sachs, through its GS Pearl Street platform, is at the forefront of financing energy storage projects across Europe and provides market leading trading and route-to-market services.

European Energy Storage: A New Multi-billion-dollar Asset Class_2

What are the key technologies to watch out for in the storage space?

For short-duration energy storage projects, utility-scale lithium-ion batteries have emerged as the dominant technology choice. The average cost of lithium-ion battery packs has decreased by more than 80% over the last decade due to technological advances and economies of scale. At the same time, the performance and the longevity of the technology has improved. This has resulted in lithium-ion becoming a bankable technology. But the final verdict on energy storage technology has not been made, in particular for longer-duration storage applications

There's a range of other new technologies that could solve the problem. Sodium-ion batteries for example are potentially a hot contender for large grid-scale storage systems, where high energy density is less important. Other technologies such as liquid air storage, flow batteries, compressed air storage, and gravity applications could all solve the long-duration energy storage problem for electricity markets. However, for the moment these alternative technologies tend to be less mature compared to lithium-ion storage systems.

What are the key revenue drivers for storage providers?

For short-duration energy storage assets, there are really three key revenue streams for energy storage assets in Europe.

The first one is capacity payments, which have become a broadly implemented policy measure by governments to support system reliability and incentivize the installation of certain new power asset types. Capacity contracts tend to be bilateral contracts with governments, for up to 15 years. They're awarded by auction, and storage providers essentially get paid to build the assets. They provide a fixed revenue stream, the amount of which varies country by country.

The second revenue stream is ancillary services. These are market mechanisms designed to provide a service to the grid operator, who must ensure that consumption balances perfectly with production at any time and address any resulting frequency deviations from imbalances between electricity consumption and production. To do that, they need to be able to call on assets to perform certain actions such as ramping up or down at very short notice. Ancillary services are procured by the grid operator on a daily basis, with storage assets free to participate in the various auctions the asset qualifies for.

The third type of revenue comes from wholesale markets, and it’s really arbitrage trading. You're buying electricity more cheaply in one hour and selling it at a more expensive price in another, thereby making money on the spread between how much you pay for charging the battery and how much you pay for discharging it.

Revenue models can vary significantly country by country. In the UK, the business model relies almost entirely on wholesale trading and ancillary services. There is a capacity market, but it’s a relatively small portion of the overall revenue. In Italy, it's the other way around — in some instances your business model can be driven by a capacity market and long-term contracts with the grid operator.

How important are power trading strategies for storage providers?

Absolutely vital. In contrast to wind and solar, where the asset owner simply sells power into the grid when produced, energy storage assets are power trading assets. Different revenue streams can be stacked, and continuous trading decisions have to be made on whether to buy power, sell power, or participate in ancillary services.

The trading of storage assets is often contracted to so called “route-to-market providers” — large utilities or independent trading houses with 24/7 trading teams. Trading strategies are becoming increasingly sophisticated with a strong reliance on technology and big data analytics. In the UK — the most advanced battery market in Europe — there are currently 23 entities trading energy storage assets. Trading results are publicly visible on leaderboards, allowing asset owners to benchmark performance.

Our experience with GS Pearl Street has been that in order to achieve top-quartile trading results for energy storage assets you need to tap into the best of new and old worlds. A state-of-the-art trading technology stack and high degree of automation are extremely important, but we equally value having experienced human traders in the loop.

Is there a risk of cannibalization if installed capacity grows too quickly in one country?

That’s a complex topic. To get a better understanding, we should explore the different revenue streams separately.

The parameters for ancillary services are defined by the grid operator, which has finite capacity requirements for each service. While this requirement might vary over time, it’s often not a direct function of renewables growth. As a result, ancillary services tend to saturate more quickly. A good example is the UK market, where services for frequency control such as dynamic containment (DC), dynamic moderation (DM), or dynamic regulation (DR) have decreased in value over the last two years due to saturation. At the point of saturation, ancillary service revenues start to converge with wholesale arbitrage — the alternative revenue stream for energy storage.

In wholesale arbitrage, trading storage assets shifts electricity from times with high renewable production to times with low renewable production. How much energy storage capacity is required to shift a country’s energy is a function of the total electricity demand, power stack, and renewables penetration. It’s therefore important to look at energy storage in the context of the overall market and its flexibility requirement.

In the case of the UK, there is currently around 4 GW of energy storage capacity operational. That’s not enough to shift energy across all hours. However, the additional battery pipeline of circa 16 GW committed under the capacity mechanism will get us closer to it.

From an investment perspective it’s very important to diversify across countries as well as revenue models in order to mitigate these risks. While headwinds for new projects will likely lead to some consolidation in the UK market over the medium term, other continental European markets are only at the start of the energy storage build out and have different flexibility requirements and opportunity sets.

How do investors know which markets are attractive for energy storage trading?

Spreads, spreads, spreads. We are a big subscriber to the view that margins across the different energy storage revenue streams will ultimately converge as the installed energy storage capacity grows. As described, when ancillary services are saturated, it’s the wholesale arbitrage trading — respectively, the price spread between buying power cheaply at a time when there is too much of it, and selling it more expensively at a time when there is not enough supply — that drives the profitability of energy storage assets.

Wholesale arbitrage trading opportunities are influenced by near-term factors such as a country’s marginal cost of power production, as well as by longer-term factors such as a country’s renewables penetration. In Europe the marginal cost of power production is often still determined by gas, coal, and carbon prices.

Wholesale spreads across Europe therefore were very high by historical standards throughout the energy crisis on the back of high fuel prices and have subsequently corrected and declined. Generally wholesale spreads in most European markets remain at attractive levels for energy storage providers and these will continue to benefit from the trend towards renewables.

European Energy Storage: A New Multi-billion-dollar Asset Class_3

How much investment is required to satisfy Europe’s energy storage needs?

Given the clean energy targets that we see across Europe by 2050, we in Global Banking & Markets believe that building all that energy storage capacity will take up to $250 billion in capital investment. This will require a mix between residential units and grid-scale energy storage.

The financing landscape for grid-scale energy storage has started to move over the last 12 to 24 months, and we’re seeing a broader range of project financing structures being offered. Historically most projects have been financed on the back of so called “floor contracts” — route-to-market agreements with a revenue floor. As the market is evolving, lenders are also starting to become comfortable with merchant battery financing.

But there's a big question mark around whether the market is deep enough to finance all the policy targets and the corresponding energy storage build out in Europe. The financing landscape is also relatively nascent if you compare it to the wider renewables and infrastructure sector. It's important for the energy storage financing market to grow and become more institutionalized, which means a broader involvement from a broader range of financial institutions and funds. Our experience with GS Pearl Street in the context of financing larger energy storage projects has been that there is a great amount of interest among lenders and financing counterparties, but business models and technologies for energy storage often still require explanation.

To stay updated on all economic events of today, please check out our Economic calendar

Risk Warnings and Disclaimers

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JPMorgan

Political

Economic

Former President Trump has been declared the winner of the U.S. Presidential election.

Equity markets have rallied strongly in response, while Treasury yields and the U.S. dollar have surged. However, uncertainty looms over future policy implementation and its implications for various parts of the market. Still, simply clearing the election hurdle is improving policy visibility, reducing volatility and increasing the flow of capital into risk assets.

Greater policy change under a “sweep” could affect economic growth, inflation and market performance. We will learn more about this administration’s policy direction, and its investment implications, in the months and quarters to come. However, investors will also begin to pivot back to the present macro and market landscape, where fundamentals remain supportive for risk assets. Earnings growth is broadening, economic growth is resilient and the Fed is gradually easing its tight monetary policy stance. On the other hand, the budget deficit is likely to remain elevated, placing a floor on long-end Treasury yields.

Republicans to hold the pen on policy

A Republican-controlled Congress would give the party significant control over the legislative agenda, although the size of that majority will be important. With a Republican Senate, President-elect Trump will be able to confirm politically aligned nominees relatively easily and push major agenda items, like deregulation. Should Republicans also win a majority in the House, broad tax and immigration policy could also pass.

With election uncertainty behind us, investors will focus on future clarity on policy priorities and implementation vs. what was proposed.

Fiscal: President- elect Trump aims for a full extension of the 2017 Tax Cuts and Jobs Act (TCJA), keeping a 37% top tax rate, and potentially reducing the corporate tax rate from 21% to 15% for domestic manufacturers, though Congress will hold the final pen on the parameters of the bill. Altogether, Trump’s proposals have been estimated to increase the deficit by $7.5tn over a decade relative to the CBO baseline, raising debt to 142% of GDP1. However, narrow margins in the Senate and House, and the risk of stoking a bond market reaction, could limit a full implementation of campaign proposals.

Trade and tariffs: Higher tariffs on China and on trading partners generally seem very likely, but there is uncertainty around what constitutes a tariff “threat” versus actual policy intent from Trump’s campaign. President-elect Trump would have considerable executive authority to impose tariffs and has suggested a 10% tariff on all imports and a 60% tariff specifically on Chinese imports. Trade talks will also address renegotiating the USMCA trade deal, but major changes would require Congress. Ultimately, trade negotiations could yield a range of outcomes, while the potential for retaliatory tariffs and inflation likely prevent full implementation of campaign promises. The ongoing trend of “friendshoring” and “nearshoring” should continue, as companies diversify supply chains while trying to stay competitive.

Immigration: Republican-led reform is possible and would likely increase border funding with much stricter asylum measures. Economic reliance on immigrant labor combined with deportation challenges should prevent mass deportation, but efforts could still restrict the number of asylum seekers attaining work authorization. Looking ahead, there are prospects for legal immigration reform as well.

Defense: The U.S. commitment to NATO and Ukraine will likely diminish. The U.S. won’t be seen as providing the security guarantees, money and weapons it has done in the past, which will bolster defense spending for the rest of the world – particularly in Europe.

Energy: The IRA is likely to remain in place for reasons we discussed here, but some provisions may change (particularly on EV credits). The fossil fuel industry may benefit from weaker regulatory constraints, but increased production could lower prices.

Regulation: President-elect Trump has argued for broad deregulation, but it is difficult to estimate the magnitude of potential reform. Big Tech may see mixed impacts, while regional banks and energy companies stand to benefit most from looser regulations. Additionally, the perception of less anti-trust enforcement could boost corporate M&A moving forward.

Finding the signal through the noise

The positive equity market reaction has focused on the prospects of pro-growth policies and deregulation, overshadowing the risks of tariffs and rising deficits. As such, beneficiaries of deregulation such as small caps, banks, onshore energy and steel producers and cryptocurrencies have risen today. The bond market has been more sober, focusing on the likelihood of an even wider deficit pushing rates higher, with the yield curve steepening as long-end yields rose more than short-term rates. Notably, this trend has been ongoing, with the U.S. 10yr rising from 3.7% to 4.6% since the Fed cut rates on September 18th. Elsewhere, currencies have reacted to potentially higher U.S. yields and tariffs, strengthening the dollar across the board. While many of these market reactions were anticipated, they may not be sustainable.

We now know the election outcome, but investors still lack clarity on policy implementation, a key indicator for investment implications. Indeed, actual policy action often differs from campaign rhetoric. As such, we would exercise caution against chasing recent market movements and suggest focusing on what we do have clarity on.

Market implications (so far) of a Red Sweep

U.S. equities: Before this result, U.S. equity fundamentals were strong and improving, and a likely Red Sweep boosts some value, cyclical and small/midcap sectors that have underperformed. This should provide further support behind the broadening out of market performance. Sentiment has also been bolstered by prospects for more M&A and IPO activity, while Big Tech anti-trust enforcement seems less-than-feared under a Harris administration. U.S. equities remain supported - although risks around higher long-end yields and tariff implications don’t seem reflected in market prices and could generate volatility ahead.

Rates: Long-end yields will likely stay elevated due to increased Treasury issuance and a potential “risk premium” on U.S. fiscal challenges. Short-term rates will focus on the Federal Reserve’s actions from here, with an expectation of further rate cuts ahead this year (including tomorrow at the November FOMC meeting) and in the beginning of next year.

Corporate credit: Before this result, both investment grade and high yield corporate credit were supported by strong fundamentals. This should continue to be the case post-election, with performance likely to remain supported especially in high yield given its lower duration versus investment grade.

Dollar: The U.S. dollar may continue to strengthen as was the case in the 2018-19 trade war due to:

The potential for higher tariffs;

The uncertainty about what trade uncertainty could do to global growth, and;

Widening U.S. interest rate differentials versus the rest of the world. However, the U.S. dollar is now 14% stronger than in early 2018 when the Trade War 1.0 first began, limiting some of the upward move versus that episode.

International equities: The stronger U.S. dollar, combined with global growth uncertainties, is likely to generate pressure on non-U.S. equities. In particular, Eurozone, Chinese, and Mexican equities look vulnerable in the short-term. However, investors should maintain some exposure to international equities, as:

The valuation discount of international versus the U.S. has been near record lows,

Chinese policy makers have been on a policy stimulus mode and may ramp stimulus further in response to the election outcome.

Diversification: With fiscal concerns keeping bond volatility high, the stock-bond correlation is likely to stay positive, requiring investors to expand the scope of assets that enhance diversification. In this case, gold and real assets should remain in focus.

3 principles for navigating political uncertainty

The economy and markets have done well under a variety of government configurations

While presidential elections are consequential for their influence on the trajectory of policy, equity market returns through various presidential terms tend to be positive, and ultimately driven by the macro environment.For instance, despite two very different administrations under Obama (’09-‘17) and Trump (’17-‘21), market performance was nearly identical. The S&P 500 returned an average annual 16.3% and 16.0% under each administration.

Policy can have an impact – but it’s often not the strongest driver of returns

Investors often consider how they should position portfolios based on election outcomes. However, it is very difficult to construct reliable investment strategies based on different policy implications.For example, President Trump campaigned vigorously to support the traditional energy industry during his presidency. Yet the S&P 500 Energy index was down -40% under his term, while the S&P 500 Global Clean Energy index was up 275%. On the other hand, Biden campaigned on scaling back fossil fuels and galvanizing renewables and successfully passed a $369Bn commitment with the Inflation Reduction Act. Yet the S&P 500 Energy index has more than doubled and the S&P 500 Global Clean Energy index is down over 50% so far in his term. Macro forces ultimately drove markets: varying supply/demand and interest rate environments mattered more than any policies or intentions by the White House.

The best defense against the unknown is a diversified portfolio

Markets know what to do with risks they know, and an election outcome – regardless of the results – provides some clarity on policy direction. However, Washington still faces significant fiscal challenges and greater policy uncertainty under a Red Sweep compared to a divided government could keep volatility elevated.For investors, the best defense against the unknown risks remains diversification. This message is even more important today given the rise in equity valuations, the concentration of U.S. equities in global stock markets and the concentration of mega-cap growth stocks in U.S. equities. As previously noted, for many investors, this risk is being amplified by a lack of portfolio rebalancing.

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NIESR

Economic

At least half of global GDP is moderately or highly directly dependent on nature, and ultimately there is no economy without its critical services, including clean and abundant water, clean air and food.

Nature across most of the globe has now been significantly altered by multiple human drivers, such as land-use change, pollution, extraction of minerals, abstraction of water and climate change. Statistics on the current state of biodiversity loss and environmental degradation are alarming: the extent and condition of ecosystems has declined in 50 per cent of natural ecosystems, including more than 85 per cent of wetland area lost, and 25 per cent of species are at risk of extinction.

The 2019 Global Assessment Report of the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) further concluded that 14 of the 18 ecosystem services that were assessed had declined since the 1970s. The United Kingdom is no exception. The percentage of UK habitats ‘in favourable or improving conservation status’ has been deteriorating since 2007, exacerbating impacts on its soils, pollinators, air and environmental pollution, water and flood protection. 75 per cent of the United Kingdom is covered by at least one hotspot of natural capital depletion, and 25 per cent is covered by two or more hotspots of natural capital depletion.

The United Kingdom, with its globally interconnected economy, is also exposed to significant global emerging risks.

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UBS

Economic

Understanding company financial reports and calculating stock valuations, together with fundamental analysis of industries, companies, technologies and business models, are some of the requisites in security selection for portfolio management.

At first glance, these disciplines appear to be entirely mathematical and rules-based; surely the most consistent and accurate application of logic should deliver the best estimates of relative value between stocks and result in the optimal portfolio, shouldn’t it?

Not quite. This description is narrow, and oversimplifies the task. While history may teach us valuable lessons about the future, it is not an accurate sextant by which to navigate a course.

The “science” of investment also has a soft side, an “art” or “fuzzy logic” sometimes attributed to “gut feeling”, which requires a rather different skill set. Creative thinking and an understanding of human psychology to understand why people behave how they do in the real world and to evaluate every possible scenario and its implications to the investor is also needed. Understanding both sides – the maths and the art – and their symbiotic relationship, is a craft.

Imagine every possible eventuality

Inside every forecast for a business and the valuation of its equity are a multifarious range of estimates and assumptions about the future. How far can a company grow, how much market share can they take, how much room is there for a business to improve its operating efficiency and capital structure? To what extent does a company enjoy economies of scope and scale? Does it have pricing power and power over its suppliers?

Working out all the possible opportunities for a business to grow together with potential hurdles requires imagination. Anticipating disruptive changes in technology, shifts in competitive landscape and regulations, and understanding the nature of systemic risks as well as company specific risks takes creativity and a deep understanding of industries, technologies, business models and strategies.

Combining hard logic skills with the creativity required to produce a balanced estimate of future returns, and then constructing a balanced portfolio with enough diversification to avoid volatility spikes, yet with enough conviction holdings to deliver above market long-term returns, that is the real craft of long-term thematic investing.

Defying EMH

The efficient market hypothesis (“EMH”) states that asset prices reflect all publicly available information and, since this process is dynamic, constant and immediate, it should not be possible to profit from information-based investment decisions.

This hypothesis may be true to an extent, and it fits well with the idea that investment is logical, scientific and maths-based. However, there are a number of holes in the theory. For example, there are approximately 50,000 listed equity securities on global stock exchanges1. The portfolio manager, however much endowed with sharp analytical skills, who attempts to analyse this many stocks, faces an impossibly large task and is likely to come unstuck due to lack of time to build any depth of knowledge in any stock, or simply from overwork, or both. As we know, a little knowledge can be a dangerous thing.

We would rather know a lot about a few stocks, rather than little about many. Narrowing the investment universe into a smaller subset of stocks therefore – particularly stocks that share similar traits, such as industry, technology, business model or theme – allows more time for in-depth analysis and considered judgement. By extension, if the lens is focused far enough, it may allow the portfolio manager, assisted by experts from industry and academia, to become a subject-matter expert.

A “pure-play” approach2 to thematic investing therefore not only produces portfolios with high exposure to favoured themes, but also concentrates the investment universe down to a size which allows for such an information advantage.

Specialist knowledge

A simple example of the importance of industry and technology expertise, is the ability to understand context and jargon. So much information is so heavily codified that important news headlines in the world of biotech, semiconductors, enterprise software, and many other industries, requires significant sector-specific insight to understand. News which represents fall-off-your-seat, shocking and valuable investment information to some market participants, might not even register as significant to others.

Therefore, even if the EMH is correct in its assertion that all information is available to all investors at the same time, it is undeniable that some investors are likely to be better placed than others to understand the significance of the information. By analogy, a daily train commuter is likely to be able to react to delays and service disruptions more quickly and efficiently than a tourist riding the train and visiting the country for the first time.

Our team has a wealth of experience of investing into their designated theme. They are also supported in their analysis and understanding of the technology and industry-specific dynamics by an "Advisory Board" selected from industry and academia.

Rational expectations

Neoclassical economic theory shares some common traits with the efficient market hypothesis, at least in its assumption of uniform and rational behaviour. Specifically, it assumes people have well defined preferences based on price and scarcity, and make well-informed, self-interested decisions based on these preferences.

The trouble with this is that people often behave irrationally. They break the model. They are drawn to high prices thanks to the implicit perception of quality. They make purchases based on nostalgia, the need to attain status, or simply to be different.

A quote attributed to David Ogilvy CBE, founder of Ogilvy & Mather and often described as the father of advertising, sums up the problem of trying to rationalise human behaviour: “Consumers don't think how they feel, they don't say what they think, and they don't do what they say."

If our underlying motivations for doing something are different to what we tell people and perhaps even different to what we tell ourselves, then this might explain why so many apparently economically rationale theories do not work in the real world. If economics is itself a soft science, in the sense that it is a study of human behaviour, then perhaps more of the task of fundamental analysis and stock selection is art rather than science. Put another way, and to quote Ogilvy’s colleague Rory Sutherland, “The fatal issue with logic is that it always gets you to exactly the same place as your competitors.”

Creative thinking

On the surface, investment analysis appears cold, logical, mathematical and precise, as many of us perceive economics to be. But under the surface the process is more complex, nuanced and requires creativity, imagination, and in-depth knowledge. This soft science of analysis, prediction, and valuation is a real craft.

In a world of logic-based conformity, quantitative data analysis, and a growing choice of AI-enabled stock selection tools, the softer, creative side of security analysis may prove to be the differentiating factor in alpha generation and the discovery of idiosyncratic value.

To stay updated on all economic events of today, please check out our Economic calendar

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Economic

The stock market is a crucial component of the global economy, offering a platform where individuals and institutions buy and sell ownership stakes in companies. To the casual observer, it may seem chaotic, with numbers and prices constantly shifting. However, the stock market operates on a set of rules and principles that make it both organized and predictable to a certain degree. Understanding how it functions helps investors make informed decisions, assess risk, and recognize opportunities for potential returns.

What Is the Stock Market?

At its core, the stock market is a network of exchanges where stocks (or shares) of publicly traded companies are bought and sold. Shares represent fractional ownership in a company, and when you buy a share, you essentially purchase a small part of that company. Some of the world’s largest stock exchanges include:

New York Stock Exchange (NYSE):Known as the largest stock exchange by market capitalization, where well-established companies list their stocks.

NASDAQ:Home to many technology giants like Apple, Amazon, and Microsoft.

London Stock Exchange (LSE)

Tokyo Stock Exchange (TSE)

Each exchange operates as a marketplace where stocks of various companies are listed, and investors can buy or sell shares of those companies.

Why Do Companies Go Public?

When a company wants to raise capital to fund growth or reduce debt, it may choose to go public by offering shares through an Initial Public Offering (IPO). By issuing shares, companies receive an influx of cash from investors in exchange for ownership. Public listing brings in funds that companies can use for expansion, research, development, or other projects, while also allowing shareholders to buy, sell, or trade their shares.

Key Players in the Stock Market

Individual Investors:Everyday people who buy and sell stocks, either directly or through retirement accounts and mutual funds.

Institutional Investors:Organizations such as pension funds, mutual funds, and hedge funds that buy stocks in large volumes.

Market Makers:Financial institutions or firms that facilitate trading by buying and selling stocks, helping maintain liquidity.

Regulatory Bodies:Organizations like the U.S. Securities and Exchange Commission (SEC) that oversee trading to ensure it is fair and transparent.

How Are Stock Prices Determined?

Stock prices fluctuate based on supply and demand. If more people want to buy a stock than sell it, its price will rise. Conversely, if more people want to sell than buy, the price falls. This dynamic reflects the perceived value and potential of a company based on various factors, including:

Company Performance:Revenue, profit, and growth rate are primary indicators of a company’s value. A company that performs well will typically see its stock price rise as investors anticipate higher returns.

Economic Conditions:Interest rates, inflation, and GDP growth can influence investor sentiment. For instance, lower interest rates make borrowing cheaper, which often boosts stock prices.

Market Sentiment:Investor perception or overall market mood also plays a role in stock prices. News events, technological advancements, and even global events like pandemics can lead to drastic shifts in market sentiment.

Earnings Reports and Financial Statements:Quarterly earnings reports provide insights into a company’s performance and growth prospects, impacting stock prices.

How Stocks Are Traded

Most stock trades occur on exchanges, though some are conducted off-exchange in over-the-counter (OTC) markets. Trading can be conducted electronically, often facilitated by brokers or trading platforms.

Bid and Ask Prices:In the stock market, the "bid" price is the maximum amount a buyer is willing to pay, while the "ask" price is the minimum a seller is willing to accept. The difference is known as the "spread."

Market Orders:A market order allows an investor to buy or sell a stock immediately at the current market price.

Limit Orders:A limit order sets a specific price at which a trader is willing to buy or sell, providing more control over trade execution.

Stock Indices:Indices like the S&P 500 or the Dow Jones Industrial Average track the performance of groups of stocks, providing a snapshot of market health.

The Role of Technology in the Stock Market

Technology has revolutionized stock trading, making it accessible to individuals worldwide. Automated trading systems and algorithms now account for a significant portion of trades, with trades often executed in fractions of a second. Online trading platforms allow users to monitor prices, access research, and execute trades seamlessly, expanding accessibility to all types of investors.

Key Data: Stock Market Returns and Volatility

Historical Returns:Over the long term, stocks have offered an average annual return of about 7-10% after inflation.

Market Volatility:While stocks offer potential for returns, they are also volatile, especially in the short term. For example, during the 2008 financial crisis, the S&P 500 fell by nearly 40%, only to rebound in the years that followed.

Conclusion: The Stock Market’s Role in Wealth-Building

The stock market plays a pivotal role in wealth-building and the overall economy, enabling companies to raise capital and investors to grow their wealth. For individuals, investing in stocks can be a valuable tool for building wealth over time. However, it’s essential to approach the stock market with a clear understanding of its mechanics, risks, and long-term potential. By learning how the stock market works, investors can make informed decisions and navigate its complexities with greater confidence.

To stay updated on all economic events of today, please check out our Economic calendar

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