Why I want me some transition risk

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Traditional hard copy readers may have rejoiced at the jump in quality of this column in the paper last Saturday — if not my fluid self-identity. Somehow Moira O’Neill’s words and photo were inserted into my Skin in the Game template.

So it looked like I wrote it. My name and everything. I revelled in the acclaim for a few days, but now “hold my hands up”, as Britain’s shadow chancellor Rachel Reeves said last week after she too was caught apparently plagiarising by the Financial Times.

Apologies, then. And unlucky for you that it is back to me and my Halloween headshot. Now where were we? My previous column ended with a promise to reallocate a 12 per cent liquidity position after explaining why I wasn’t a fan of cash.

Over the half-term school holidays I did just that. And because I never do anything to my portfolio without writing about it here first, the money was simply redistributed across my other funds.

This has worked out OK because markets have taken a breather of late — finance-speak for “fallen”. Therefore, I could average down, as they also say, which is another silly expression designed to make clients feel better when they’ve lost money.

But I still like the prospects for Japan, especially if the yen stays soggy due to the Bank of Japan fudge this week. There is also a corporate reform angle, with shareholders moving up the pecking order. Likewise, a crappy currency and attractive valuations keep me in UK equities.

The war in Israel and Gaza has intensified, which isn’t great mood music for investors. But the funds I own are still shuffling to their own beats for now

Meanwhile I still believe US policy rates are more likely to squirm south than north, despite Fed chair Jay Powell’s utterings. That should help my short-duration Treasury ETF and even Asian equities. The latter really needs it.

If inflation goes bananas, however, I still have the Tips fund — a basket of Treasury inflation-protected securities — and at least I’m mostly exposed to a broad collection of companies with physical assets. These should hold their value better than cash.

Where do I feel most exposed? And has anything happened in the world since I last wrote that makes me want to change my portfolio?

Sure, the war in Israel and Gaza has intensified, which isn’t great mood music for investors. But the funds I own are still shuffling to their own beats for now. Obviously, if hostilities widen it is a different matter.

That’s because a rising dollar is usually problematic for Asian equities, although my UK and Japanese stocks should offer some respite. I also fear that the US bond market is beginning to notice Uncle Sam’s dire fiscal position.

Should the war become expensive, for example, Treasury yields may rise further. The 10-year note breached 5 per cent while I was away. Again this would weigh on my Asian equity fund.

In the long run, rates do not affect stock returns, but over shorter periods investors and commentators wail like babies. Therefore, US equities would also continue to struggle.

They have fallen 5 per cent since I sold out in early September and are now in correction territory — another stupid euphemism that in this case means they’re down a tenth. This underweighting is by far the craziest bet in my portfolio.

View any long-run chart of the S&P 500 to see why. Am I tempted to go back in yet? On a valuation basis, no. When I wrote in detail over two columns why I was bailing out I suggested that US stocks could be up to 50 per cent overvalued.

That said, the international gabfest on artificial intelligence at Bletchley Park this week has focused my mind on US companies once again, and how they will dominate AI as they have every other new technology since Japan went pop.           

But can AI generate the cash flows to justify the scale of the US stock market overvaluation? Doubtful. So it may be smarter to look elsewhere for opportunities. For example, while the likes of Europe and the UK will be scrabbling over the AI crumbs, the upside is less fanciful.      

No, the only news items of late that have me worried I’m missing a trick are the two mega deals in the oil industry: Chevron’s $53bn purchase of Hess Corporation last Monday, which followed ExxonMobil’s even bigger acquisition of Pioneer Natural Resources earlier in the month.

My portfolio is woefully short on commodities, which I’ve said before are a much better inflation hedge than my Tips fund. This would get hammered anyway if rates followed prices higher. The two deals also suggest that insiders know that fossil fuel demand is not going to disappear soon.

But the main reason I want to own some oil and gas stocks is because high emitting companies outperform, contrary to the “transition risk” nonsense you read everywhere — which confuses volume forecasts with shareholder returns.

The existence of a so-called “carbon premium” is well documented in the academic literature. And boy, does it tie ESG enthusiasts in knots. That’s because one explanation — that transition risk means investors demand higher returns to compensate — is inconsistent with the claim that ESG investing improves performance because it reduces risk.

Nor do responsible investors like the other possible explanation much — that high emitters are making unexpected fortunes. But which is it? Are these stocks riskier or just mispriced? One way to find out is to study the effect of earnings surprises on performance.

And that is exactly what an excellent new joint paper by the London and Sabanci Business Schools has done. It shows conclusively that it is positive earnings surprises that drive the superior returns of high emitters.

An important conclusion from this is that policymakers shouldn’t expect investor and net zero goals to align. And, frankly, I have a fiduciary obligation to make my readers as much money as possible. Are oil and gas stocks good value though? More on that next week. 

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__