GIC CEO Lim Chow Kiat recently talked about three key challenges facing investors today and how GIC is adapting to these new realities. These are an edited transcript and recording of the keynote speech he delivered at the Global Asset Management Forum (GAMF) 2022 Shanghai Summit.

Good morning. I am honoured to have this opportunity to share some of GIC’s thoughts with you. While my comments are focused on the global environment, and not specifically on China, GIC takes a deep interest in the country given its importance.  We have a long history of investing in China, including having offices in Beijing and Shanghai.

We see the investment world, like the larger world, in transition.  In other words, we are in between moving from an old state to a new state.

In transition, we tend to experience high volatility and uncertainty. The past two years were a good example.

The Covid-19 pandemic, at the beginning, saw the largest and fastest contraction of global GDP. This was followed by an equally impressive recovery that was twice as fast as what we experienced following the Global Financial Crisis (GFC).

Financial markets mirrored that trajectory. The S&P 500 Index suffered a 31% drop within one month from mid-February 2020. But it recovered all the losses within six months, in contrast with seven years after the dot-com crash and six years after the GFC crisis.

The recovery was achieved by infusions of staggering amounts of monetary and fiscal stimulus. Interest rates were rapidly cut to zero while governments spent about 10% of GDP in stimulus. Central banks pumped US$10 trillion into the economy.

Public debt in developed markets ballooned to more than 120% of GDP – surpassed only by the post-WWII peak in 1946.

We are now paying the price. Global inflation has broken out of its 40-year downtrend. It will reach close to 8% this year – the fastest pace since 1981.

The removal of stimulus and the rise in interest rates this year have also been equally rapid. Global interest rates have more than doubled from record lows last year. Some of them are back to levels before the GFC. Quantitative easing has become quantitative tightening, and containing inflation may see more interest rate rises.

Most asset classes have seen negative returns. A balanced portfolio of 60% equities and 40% bonds has just experienced one of its largest drawdowns, falling 16% in the first six months of 2022. This is the lowest one percentile of six-month returns since 1971.

A world in transition

While Covid-19 was the obvious cause of the extraordinary developments over the past two years, it is more accurate to say that it simply accentuated a few transitions already in the works.  As the saying goes – things happen “gradually, then suddenly”.

There are three main transitions warranting investor attention: a change in the inflation regime, a new geopolitical landscape and a new energy situation.

Allow me to elaborate on these three transitions.

A new inflation regime

The first transition relates to the new inflation regime. For 40 years, price stability has benefited from globalisation, demographics, technology and policy discipline. This phenomenon is well understood.

This has in turn benefited financial assets to a great extent. It is the biggest market story of the last 40 years. The lower cost of financial capital, showing up as a lower and lower discounting factor for future cash flows, greatly expanded the present value of financial assets. It has also allowed relentless credit creation, adding to financial gains.

Price stability is, however, now under threat. Although inflationary factors such as the Covid-19 disruptions are expected to dissipate in the short term, and there is still a window to contain the current inflation spike given the still moderate inflation expectations, there are reasons to believe that the inflation process has structurally changed.

Inflation is likely to be higher going forward.

Firstly, globalisation is reversing. Fragmentations and frictions are appearing as countries and businesses prioritise resilience over efficiency for their supply chains. The result is persistent cost pressures for goods inflation.

Secondly, demographic headwinds continue to mount. Aging reduces the productive capacity of the economy, driving up prices.

Thirdly, increased government debt loads may lead central banks to tolerate higher inflation over the next cycle.

A changed geopolitical backdrop

The second major transition is in geopolitics.

For the last few decades, investors were generally immune to geopolitical risk. In fact, it has been the case of reaping the peace dividend brought by the end of the Cold War. For investors, occasional geopolitical flareups were often buying opportunities.

This has changed. We are now contending with a drastically different geopolitical backdrop. The peace dividend has ended. Instead of concentrating on cooperation to address multiple global challenges, the major powers are focusing on competition, and even confrontation. Investors can no longer afford to ignore this.

Covid-19 has revealed the extent of trust deficits in the world. Vaccine hoarding and the struggle to launch COVAX – the ambitious international Covid-19 vaccine program — are two clear examples.

The diversification of supply chains is a legitimate and rational response to these new challenges. Having alternative suppliers and building buffers make sense for a world more prone to disruptions. But the risk is rising that this trend is swinging towards the extreme end of onshoring and “friend-shoring” for production. These shifts are not just affecting trade flows but also cross-border capital flows and investments. Never mind their efficacy, there is a clear cost to businesses and consumers.

The energy transition is upon us

The third transition is the energy transition, which comes with three goals – affordability, security and sustainability.  Each of these goals are highly challenging, and meeting all of them would involve significant trade-offs.

It is also pressing. According to the International Energy Agency (IEA), the world will need to spend $4-5 trillion per annum for the next three decades to get to net zero by 2050. Given that we spent less than $800 billion on the energy transition last year, activity and spend need to be rapidly ramped up by five to six times. The price of carbon will also have to be higher over the long term.

What are the implications for investors?

The implications for investors and portfolios are profound.

The boost to asset valuations from ever-decreasing interest rates are very likely to be behind us. Lower and lower interest rates have been a key feature of the investment market for the last 40 years and without it, broad asset returns are expected to be lower across the board. Beta returns are going to be less attractive and reliable.

In the more challenging environment of higher inflation, the winners are logically likely to be real assets. With cash flows tied to inflation rates, their top lines are protected.  However, they too are not immune to higher real interest rates.  If they use leverage, one would also need to pay close attention to refinancing risks.

The increased significance of energy cycles, as well as the changing nature of globalisation will impact how portfolios are invested in emerging markets in particular. What countries import and export would matter more, including, for example, different types of commodities. More than ever, investors will be forced to scrutinise the impacts on individual emerging markets and differentiate allocations accordingly, rather than treat them as a block. The difference between the winners and losers will be stark.

How should we adapt?

Let me share how GIC is responding to these challenges and uncertainties. At the most basic level, we have doubled down on our core investment principles. These include a continued commitment to portfolio diversification; taking the long view; and to prepare, not predict. Knowing our strengths and limitations would be particularly important.

Already, value is being restored in short duration credits, with both risk-free rates and credit spreads expanded.  Or in the case of longer term securities, the yield on 10-year US government inflation linked bonds (TIPS) has already risen by 200bp to almost 100bp, which means one can lock in the higher real yields to deliver with high certainty a return above inflation of 100bp per annum for the next decade. The return is low, but so is the risk.  In other asset classes, similar developments are playing out.

In the important area of the low-carbon transition, we are proactively redeploying our capital. We view the investment universe as comprising three categories – new technologies, transition businesses and stranded assets.

We are very active in investing in the first category – new technologies, such as renewable energy, battery manufacturing, electricity grid software, green hydrogen, carbon removal, and even nuclear fusion.  The opportunity set is currently relatively small, but we see great potential.

The bulk of the investment universe is in the second category – transition businesses. We engage with and support our investees’ transition efforts, including providing them with transition finance, such as to enable electricity utility companies to move from carbon-intensive to green energy.

For the last category – stranded assets, or assets with little prospects of transitioning, we avoid investing in them.

We are also strengthening partnerships with like-minded actors across both the public and private sectors to catalyse meaningful climate action and collaboration.

Conclusion

The three transitions I spoke of are not foregone conclusions. The window of opportunity to limit the most negative impacts from these is still open, but it will take the public and private sectors working in tandem to do so.

I mentioned earlier that these transitions are occurring against a backdrop of a breakdown in trust across various parties. This Summit helps to foster dialogue and build trust. I am glad to have the opportunity to share and learn from all of you. Thank you for your attention!