This investment giant says you’re underplaying two risks

The collision of a higher-for-longer narrative and geopolitical risk is hard enough for investors to manage. But Charles Emond, CEO of the $C425 billion ($489 billion) Canadian pension giant Caisse de dépôt et placement du Québec (CDPQ), says these risks are compounded by the fact few investors have ever had to manage them.

Emond, who visited Australia this week to cast his eye over a $14 billion portfolio that includes stakes in the WestConnex toll road, Port of Brisbane, the Sydney Metro project, and energy giant Transgrid, sees two key risks that investors are underestimating.

The first is a stagflationary environment, where economic growth is accompanied by persistent inflation and higher rates. CDPQ’s base case is for a recession (Emond puts the probability at 65 per cent, with the chances of a soft landing at 35 per cent), and it expects central banks will cut rates sooner than the market expects.

But as suggested by Powell’s comments on Thursday night, Emond says it’s too early to declare victory on inflation and CDPQ is watching rates closely.

“There’s not a single variable that has had as much impact on a fund like us,” he says.

Emond puts the chances of a stagflationary environment at 20 per cent. But two years ago, he argues, the very concept was “science fiction” and there are few investment professionals who’ve ever operated in that sort of environment. “The muscle memory is not there yet.”

He says the second risk that has not sufficiently grabbed investors’ focus is geopolitics – but it’s much more than just the current, hot wars in the Middle East and Eastern Europe.

Just as investors are dealing with the end of decades where interest rates kept falling, they now have to face the disintegration of the concept of a global village. For much of the last decade, Emond argues, investors haven’t really had to demand extra risk premium for investing in certain countries, or worried too much about the prospect that some currencies could be devalued.

Now those risks are top of mind. But that doesn’t make them easy to respond to.

“Because the reality is, you have to remain diversified,” Emond says. “If you want to play on the entire map, you probably need to rethink how you’re going to play each country – and it’s not the same recipe everywhere.”

In-house geopolitical advisers

Different asset classes may perform differently depending on the risks in an individual country, he says. In countries with heightened levels of geopolitical risk, a focus on more liquid assets – which the fund can quickly move in and out of – will make more sense.

To assess these risks, Emond has created a geopolitical unit inside the fund called CDPQ Global. Not only does the group work alongside the fund’s investment team, but it has also opened channels with governments and regulators around the world.

Emond says this is important for understanding political and regulatory risks inside different countries, but it also allows CDPQ to promote and protect its own interests.

“We feel in today’s world that geopolitics is now a risk or a component that needs to be factored into every investment decision,” he says.

Addressing rising interest rates and rising geopolitical risk is one reason Emond is keen to boost CDPQ’s exposure to Australian infrastructure to $11 billion from $7 billion in the next five years.

Real assets have become an important hedge for the fund against inflation, with infrastructure and real estate rising to 13 per cent of the portfolio from 6 per cent five years ago. Emond says about 85 per cent of the infrastructure portfolio is inflation-linked, in that the fees and charges those assets earn are linked to the consumer price index.

He now wants to take real assets to between 20 per cent and 25 per cent of the portfolio in the next five years. In Australia, the fund is keen to build on its Transgrid investment by getting into transmission and storage projects. Public and private partnerships in social assets such as hospitals and schools are another target, while CDPQ’s digital assets such as data centres and student housing are also attractive.

“Australia has become our main market in the Asia Pacific region, and in a complicated geopolitical world like we’re living in, Australia stands out,” Emond says.

Sydney is one of 10 offices CDPQ has around the globe. While all pension funds are increasingly looking to expand internationally, CDPQ has a particular need to diversification, as part of its government mandate is that it needs to invest in the economy of Quebec; Emond has a target to have $C100 billion of assets in the Canadian province by 2026.

CDPQ delivered a return of 4.2 per cent for the first six months of calendar 2023, just above the 4.1 per cent return of its benchmark. For the five years ended June 30, the Canadian pension fund returned an annualised return of 6 per cent, versus 5 per cent from its benchmark.