The prospect of the world’s strongest ever El Niño cycle has a growing number of money managers racing to prepare their portfolios for the disruption they say is coming.
The climate phenomenon associated with warming across the equatorial Pacific Ocean is fanning crop-damaging droughts and floods. Food commodity prices are rising, and economists are revising estimates for inflation and deficits. These impacts are now feeding into markets already stressed by high debt levels and rising borrowing costs.
No corner of global asset markets will be fully shielded from the current El Niño cycle, says Katie Self, a portfolio manager at Pictet Asset Management.
“It’s become almost a full-on certainty that this is going to be the most extreme El Niño we’ve had in history,” and figuring out how to navigate the disruptions ahead is now “definitely” a priority, Self said in an interview.
Man Group, the world’s largest publicly traded hedge fund firm, warned in July that everything from grid infrastructure to metals and fertilizer could be in El Niño’s crosshairs. T. Rowe Price says it has turned to custom-made models to protect its $165 billion portfolio of emerging-market debt and equities from El Niño. And a number of boutique hedge funds are now building entire investment cases around the weather cycle as it intensifies, Bloomberg has previously reported.
A major concern is that El Niño will impact markets already struggling with a number of stresses, including growing debt reliance, rising interest rates and sudden investor selloffs.
“The current macro backdrop differs” compared with previous El Niño phases, “with higher rates, debt and volatility,” analysts Kamesh Korangi and Rose Choy wrote in a note this week by the Anthropocene Fixed Income Institute. The duo identified Indonesia, Brazil and Colombia as the most vulnerable sovereigns, and highlighted the possibility of “spillover effects globally.”
Though El Niño is associated with the Pacific, investors need to understand that “the knock-on effects are fully global,” says Self, who co-manages the $5.1 billion Pictet Global Environmental Opportunities fund. “There is not a single place in the world that will not feel some kind of a knock-on effect from El Niño.”
Strategies to navigate the shocks ahead span bets on interest rates tied to an El Niño-fueled bump in inflation. The weather phenomenon’s impact on energy markets is also emerging as a key trade for the coming months.
“Winter is the season when these forces — climatic, geopolitical, and structural — are likely to converge most intensely,” Zulfiqar Ali, founder and chief investment officer of energy commodities trading hedge fund ZAMS Asset Management, said in an interview last month. That creates an “unusually alpha-rich environment” for managers “with the analytical edge and risk discipline to navigate it.”
At Pictet, Self says she and her team are looking for companies designing technologies that will help cope with the extreme weather patterns fanned by El Niño. Examples include smart-irrigation equipment providers and solutions that lengthen the roots of plants that help in drought conditions, as well as storm-water drainage and flood protection systems, she says.
“El Niño is a compounding factor,” Self said. The weather cycle itself isn’t new, but “it’s now happening on this much warmer baseline.” Those two forces “are going to interact, interplay and make things substantially worse.”
The physical fallout of El Niño is already dominating headlines. Southeast Asian countries have been battling extreme air pollution from forest fires, India faced its weakest monsoon in more than a decade, and across South America people now face both severe floods and a lack of rain, upending their ability to farm.
For investors whose strategies are exposed to land, agriculture or forests in developing countries, the risks are particularly pronounced.
Jonathan Dean, who leads the natural capital strategy at BNP Paribas Asset Management’s alternatives unit, says he’s closely monitoring carbon-credit projects as El Niño fans forest fires such as those raging in Indonesia.
El Niño-triggered forest fire risk “has put the attention” on mal-adaptation of carbon credit projects, he said.
“It’s always been a fundamental part of our underwriting to understand the potential loss rates from a project, doing the climate research before to be able to identify risk factors within a project region,” he said.
The private equity strategy Dean oversees, which has more than $560 million in commitments from International Finance Corporation and other development finance institutions, has been working with a project developer in Indonesia to “maximize the opportunity,” he said. Insurance and remote-sensing technologies are part of a package of tools fund managers can consider to help assess risks in nature-based projects, he added.
The types of resilience or adaptation needed “are very broad ranging,” Pictet’s Self said. “It’s a really full, global phenomenon.” — Bloomberg