According to scientific assessment, record-breaking heat waves, severe flooding and drought, wildfires and hurricanes are all becoming more frequent and intense as a result of climate change. Last week’s Hurricane Milton, which hit the Florida coast, for example, was one of a number of devastating storms to hit the region this year, causing millions of homes and businesses to lose power alongside multiple fatalities.
In this context, George Cotton, commodities portfolio manager at J. Safra Sarasin, explained to PA Future why understanding and mitigating extreme weather is becoming a bigger priority in terms of risk management, and how portfolio managers can make better investment decisions as a result.
Why are portfolio managers increasingly thinking about extreme weather in their investment risk assessments?
August proved to be a very interesting period for financial markets. We had an abrupt shift in risk appetite that was partly triggered by a disappointing jobs report. Much ink has been spilled about the impact of the Yen carry trade unwind and various crowded positions.
What was not discussed was that during the period of observation over which job growth was measured, there was an unusually high number of absences from work due to bad weather. More than 460,000 people couldn’t work in July due to Hurricane Beryl, which was the highest number of weather-related absences for July since records began and 10 times the seasonal average. Clearly, the labour market has been weakening somewhat, but the fact that weather events clouded the picture, and this factor was not considered due to historical seasonal patterns, illustrates one key takeaway: data is becoming more noisy due to the impact of extreme weather events.
The additional noise makes underlying trends in economic data harder to gauge. This further compounds the uncertainty in conventional economic data, which has prevailed since Covid, alongside other structural shifts like work from home, the gig economy, immigration and migration.
Which industries are most at risk of extreme weather events?
Historically speaking, weather, as it impacts employment data, has been most critical to account for in agricultural industries. But now that agriculture comprises a smaller part of employment and the overall economy, the impact and possible disruption on other areas have less of a historical precedence, and are harder to predict or model. The aforementioned weather events impacted all industries. Even in areas where remote working dominates, these industries are not immune as energy and telecommunications infrastructure is at risk from outages.
So, where does this leave us with asset allocation in traditional developed market asset classes like US equities and European fixed income? It means that asset allocation needs to be adaptive to abrupt regime shifts, as these kinds of unforecastable events induce more volatility in asset prices. At the same time, investors should also think about what kind of asset classes and return streams can add resilience to portfolios, as weather-related supply and demand shifts can drive interesting return opportunities in alternative asset classes like commodities.
What are some of the measurable weather phenomena that you can make use of in informing your investment decisions?
If we think about the typical forecast horizon for tactical asset allocation committees, it’s usually in the three to nine months range, which is arguably the hardest period over which to forecast. Introducing weather forecasts and weather data into investment decision-making runs up against the limitations of metrological models, which only have any efficacy at predicting in intervals of up to 10 days, far shorter than what would be required by investment committees.
The only major climate phenomena that we currently have a good understanding of, which can be used to make inferences about weather over intermediate timeframes associated with asset allocation is the El Nino-Southern Oscillation (ENSO).
This system is driven by a complex set of interactions between the atmosphere, sea surface temperatures and trade wind direction. The procession of this cycle allows us to make quite concrete inferences about general weather patterns over the next six to 12 months in particular regions. The implications of this climate pattern for weather can be quite dramatic in many emerging markets and coastal regions in the US. It is often a determinant of growing conditions for key agricultural commodities yields, but also has implications for offshore oil production in the Gulf of Mexico.
What kinds of commodity-related moves were related to weather in recent years?
The strong El Nino conditions we saw throughout 2023 wreaked havoc for growing conditions in tropical regions, with dramatic impacts on global cocoa yields. Cocoa production is highly concentrated in west Africa because of the stable climate, and cocoa production processes require very stable temperatures and humidity. Heavy rains and dry spells helped the proliferation of black pod disease. This pushed the cocoa market into a major deficit for the first time in decades and caused a massive run-up in cocoa futures prices. Now, we are seeing drought conditions emerge in Vietnam and Brazil, which is causing significant repricing in the coffee market, a story that could soon be attracting mainstream attention soon enough.
More recently, we have seen this climate system shift towards a neutral stage before likely moving to El Nino. Such a shift was partially responsible for the aforementioned hurricane activity and flooding which has affected certain US states. However, as it turned out, this year high levels of rainfall in the US came at exactly the right moment for US corn and soybean farmers, which will likely result in record production for those commodities this year. This has kept prices particularly low and has been compounded by the fact that Chinese agricultural importers seem to have no interest in importing from US producers, as trade relations between the two countries continue to sour.
So, again, it is a situation where politics and weather can intersect to push prices firmly in one direction. But it just goes to show that the broader context is vital, and weather is just one piece of the puzzle.
