Deep Waves: The nexus of climate change and geopolitics

Investment returns are impacted by geopolitics—geopolitical stability is impacted by climate change.

    Kim Catechis

    Kim CatechisInvestment Strategist,Franklin Templeton Investment Institute

    PREVIEW

    A FOREWORD FROM THE SUSTAINABILITY AND STEWARDSHIP COUNCIL

    Climate change is one of the greatest challenges that we face. The impacts are varied, widespread and manifest in different ways, both acute, such as extreme weather events and chronic, including rising temperatures, changing rainfall patterns, and rising sea levels. These impacts have consequences for the way companies operate, which is a constant focus of our work as active investors at Franklin Templeton.

    More broadly, climate change has socioeconomic consequences on the way different countries operate. As necessary resources are impacted, productivity is affected and vulnerabilities of institutions, physical infrastructure and the capacity for adaptation and mitigation are exposed. As populations feel the direct impacts on their own livelihoods, there are a series of impacts both within and between countries and for the governments across the world.

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    Related Content

    This paper looks at climate change through the lens of geopolitics, using case studies to illustrate the impacts that we are already seeing. And we consider some of the potential implications for investors as we look forward. It is a strategic view and should be read by anyone with an exposure to international investments.

    David Sheasby
    Head of Stewardship and ESG
    Martin Currie
    Co-Chair, Franklin Templeton Sustainability Steering Group,
    Franklin Templeton

    INTRODUCTION

    Powerful “waves” are sweeping away established assumptions, fundamentally altering the economic, political and public policy foundations for asset prices. Our original paper, Deep Water Waves, explores how the biggest “waves”—demographics, technology innovation, debt, taxation, geopolitics and climate change—are set to impact investment outcomes in the next decade. This companion paper examines two relatively underappreciated waves—geopolitics and climate change—to demonstrate the interdependencies between them and identify flashpoints that should be monitored. Together, they warrant urgent attention, as they could have a short-term and direct impact on the cash flow generation and rate of growth of investee companies, as well as the strength of sovereign financials in many countries. These impacts imply the restriction of valuation potential and hence investment returns for all asset classes.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio. There is no assurance any forecast, projection or estimate will be realized. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Derivatives, including currency management strategies, involve costs and can create economic leverage in a portfolio which may result in significant volatility and cause the portfolio to participate in losses (as well as enable gains) on an amount that exceeds the portfolio’s initial investment. A strategy may not achieve the anticipated benefits, and may realize losses, when a counterparty fails to perform as promised. Currency rates may fluctuate significantly over short periods of time and can reduce returns. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector—prices of such securities can be volatile, particularly over the short term. Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values-based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.