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As the IPCC publishes gloomy report, this is the route to net zero

Rain in London in August, wildfires in Greece and Italy, floods in Bangladesh: can anyone still really deny that global warming is at a crisis point?

The role of human influence on the climate system is undisputed. That’s the stark message from the IPCC report on climate change published earlier this week.

The science is clear. As global surface temperatures rise, each of the last four decades has been successively warmer than the decade that preceded it. The report also highlights the likelihood of human influence on precipitation changes since the mid-20th century, which has a marked impact on weather patterns, leading to weather extremes and the shifting of seasons.

The sobering report emphasises that future emissions are likely cause future additional warming, but that total warming will be driven by carbon emissions that have already taken place. Global surface temperature will continue to rise until at lead the middle of the century under all emissions scenarios, and global warming of 1.5°C to 2°C will be exceeded during the 21st century unless deep reductions on CO2 and other greenhouse gas emissions occur in the coming decades.

Future annual emissions of CO2 across the five scenarios
Carbon emissions from the change in global surface temperature
SSP1-1.9 represents warming by 1.0°C to 1.8°C
SSp2-4.5 represents warming by 2.1°C to 3.5°C
SSP5-8.5 represents 3.3°C to 5.7°C

Source: IPCC, Climate Change 2021

Thankfully, the report also highlights that we can still reverse most of the potential damage (with a temporary rise over 1.5°C predicted for the middle of this century) if we act now, but the window of opportunity is getting narrower and narrower. Some of the damage will take millennia to rectify.

An all-inclusive approach is key in driving lower emissions

Seeking emissions reductions must be a core focus for fixed income and equity managers alike.

However, this does not mean ignoring the higher-emitting sectors in favour of lower-emitting sectors – the latter will have limited impact in their ability to drive down carbon emissions because they are already low in the first place. That’s why we don’t exclude any avenue in our climate bond strategy.

To reverse global warming and aim to reach net zero by 2050, the higher-emitting sectors are key to driving meaningful impact on lowering carbon emissions, and the IPCC report reinforces just how critical this is. We invest in sectors such as oil & gas, utilities, transport and industrials because these issuers have the largest positive impacts in driving lower carbon emissions to meet the Paris Agreement’s targets and therefore more successfully address the challenge of climate change.

Engagement is key

For example, the oil majors have been reducing their investment in their upstream businesses and investing in low-carbon and other non-fossil fuel assets. It’s no coincidence that increased engagement has coincided with this transition.

This needs to be accelerated and we must push issuers top adopt more aggressive measures for the energy transition and emission reduction. Engaging with both the private and public sectors is the only way we can mitigate the catastrophe we potentially face.

As investors, we have a responsibility to exert all of the influence we can – and that’s our route to net zero. The alternatives are inaction or even worse, selective engagement that looks good on paper but fails in reality to address the bigger picture. These options would mean we have already lost in our efforts to combat climate change.

Despite the climate risk challenges, there are many other market drivers that still keep us occupied.

Treasuries and US employment
The markets have twice challenged the key 1.12% level on the 10 year US Treasury, and after staring into the abyss of a potential move to 1% have moved back from the precipice. We believe the middle of the range on the 10 year US Treasury is somewhere around 1.25%.

Employment numbers arrived this week - the Federal Reserve’s primary focus – and while the ADP National Employment Report was disappointing, the Nonfarm Payroll number slightly exceeded expectations. This has now made the August number a key indicator of the continued employment revival in the US and therefore raises the prospect of potential tapering.  

Conflicting signals
Inflation is over 5%, nominal yields are trending lower and real rates have continued to decline.

In previous commentaries, we have examined many of the potential reasons why. However, the disparity between what is going on in the real world in comparison with US Treasury yields is in my opinion stark and unsustainable in my opinion.

American economist and former president of the New York Fed Bill outlined the conundrum very clearly in a recent article on Bloomberg: “See if you can figure out which of these data points conflicts with the others: The US economy grew at an annualised inflation-adjusted rate of 6.5% last quarter; it added an estimated 850,000 jobs last month; consumer prices have risen 5% over the past year; and the 10-year Treasury note yield has recently fallen to 1.2%”[1].

His conclusion? Once short-term interest rates begin to rise and tapering is withdrawn, yields will have to move higher. The issue remains timing: should policymakers allow inflation to rung hot for a longer transitory period before it begins to move the market, or should the focus move to the gradual slowdown we are expecting in 2022 to a more trend like trajectory.

Even in this scenario, yields are too low. It’s no surprise, therefore, that the messaging from Fed is becoming more hawkish.

We’ll be keeping a close eye on inflation data this week. Furthermore, the Delta variant is still playing its part in tempering confidence, although we believe this is temporary given the accelerated vaccination programmes in the developed world.

Earnings still surprise
While fundamentals seem not to matter anymore, Q2 earnings have been stellar.

According to Bloomberg data, over 80% of S&P companies that reported have beaten Earnings per Share (EPS) expectations. We are hearing more on the inflation theme in outlooks and more caution for 2022. Having said that, analysts expect the Russell 2000’s 2022 EPS to rise around 19% year on year, compared with approximately 10% for the S&P 500[2].

Emerging Market headwinds
Emerging markets have been interesting. China continues to crack down on domestic technology companies, and even the biggest and best have not been spared. This has resulted in a swift collapse of confidence in the China market. Evergrande’s rapid fall from grace is a case in point and illustrates the potentially dangerous real estate bubble the People’s Republic faces.

The company was supposed to be too big to fail, but with bonds now in the 40s, the market is telling us something different. The rise in idiosyncratic risk, predominantly as a result of the actions of various leaders in key emerging market countries – Brazil with Bolsonaro, Russia and Putin, Turkey and Erdogan, India and Modi, China and Xi, left-leaning new governments in Peru and Chile….the list goes on.

Drifting and positive
Summer is upon us and I would expect things to drift until we resume in September. In our view, the Nonfarm Payroll number will be a key indicator, and we could perhaps hear something significant from the Fed’s meeting at Jackson Hole later in August.

I would expect some weakness in risk assets as we move into the September/October period, but more temporary perhaps as a result of more colour on tapering (or not). For choice, we remain positive but with a bias toward shorter durations.

[1]https://www.bloomberg.com/news/videos/2021-07-09/labor-market-is-both-loose-and-tight-bill-dudley-says-video 
[2] Bloomberg, August 2020 

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Andrew Lake

Head of Fixed Income

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