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HOW FINANCIAL BUSINESSES CAN HARNESS POTENTIAL IN WAAS AND BAAS

While the software as a service (SaaS) business model has become a staple for organizations, the benefits of wallet as a service (WaaS) and banking as a service (BaaS) for financial businesses often go unnoticed. This article is meant to shed some light on how banks, mobile network operators, and/or retailers may choose to capitalize on the WaaS or BaaS model for business growth while also breaking down some common uses of WaaS.

SaaS, WaaS, Or BaaS: What’s The Difference?

Digital transformation comes in many ways. SaaS seems to be the most frequently applied acronym for cloud-based services. According to Statista, the SaaS global market accounted for almost $146 billion in 2021. SaaS includes the delivery of all kinds of mobile and web applications, making them available for users on a service basis.

SaaS is a relatively new way of providing cloud-based services to business users on a subscription basis. Unlike conventional software installed on-premises, SaaS products are centrally hosted. This allows businesses to opt for more cost-efficient cloud software instead of forking over server infrastructure. The SaaS model gained much traction in recent years as many IT companies added it to their product portfolio.

While SaaS functions as a blanket term, WaaS has also emerged as a specific delivery model for businesses. This is often confused with banking as a service (BaaS), but these two terms should not be conflated, as there are some important distinctions between these models.

Simply put, when banks go digital, they choose BaaS. Clients are then able to access and manage online assets via API connections. To integrate BaaS into its business operations, a bank can choose to hire an in-house team or bring in external expertise.

WaaS is a horse of a different color. While BaaS is good at improving banking operations, WaaS is designed to equip businesses with digital financial services. In simple terms, BaaS is bank-focused while WaaS is business-oriented. Figuratively, WaaS can be seen as going shopping with your favorite reusable tote bag, while BaaS is like buying a bag from the mall.

In many ways, the WaaS model can address the ever-growing needs of various financial companies that want to have reliable ready-to-use digital services at scale. So, let’s explore what a WaaS business model is and what it can offer.

WaaS Offerings

WaaS is a business model that can enable companies to digitize their business value chain through the seamless integration of various digital financial services at scale. In addition, the WaaS delivery model allows financial businesses to start any B2B quickly and efficiently or B2C finance project online at a lower cost than with traditional out-of-the-box software suites.

Depending on the fintech provider, WaaS can extend to a wide range of digital financial services including e-wallets, digital cards, mobile-based points of sale (mPOS terminals), and cloud-based reward programs for customer loyalty, international remittances, loan management, and more.

This said, companies do not necessarily need to opt for all the WaaS options. Businesses can start from scratch or embed any digital service into a current infrastructure. In this way, WaaS can help test the waters and reach new audiences.

Benefits That May Make WaaS The Right Choice For Your Company

Starting your digital financial business with WaaS can be quite rewarding. First, there is no need to pay a large sum of money for a software package that may not fit easily into your existing business infrastructure. But perhaps more importantly, WaaS lets you follow the pay-as-you-grow approach. It means you can easily add some other services of your choice and pay a fixed price until you decide to scale up.

Among the potential advantages the WaaS delivery model can offer to financial businesses, I’d highlight the following:

  • Easy to launch. WaaS is a quick way to go digital.
  • White-label. Most ready-made software goes by its brand name, leaving you fewer chances to promote your own business as such. At the same time, if you decide to hire an outsourced team, it can end up taking the same amount of time to develop a web or mobile e-wallet app from the ground up.
  • Service range and customization. You can test the waters with one or more WaaS options to see how well they perform in your business niche.
  • KYC compliance. For ready-made software with its architecture etched in stone, it isn’t as easy to adapt services to meet every region’s law and regulation. Service-based models showcase much more flexibility here.

Potential Concerns When Considering WaaS

You should also keep in mind, though, that WaaS might be the wrong option for some use cases. Here are some notable types of businesses for which WaaS is not the right choice:

  • Large-scale banks and retailers. For large enterprises seeking to create their stand-alone app with licensing rights to modify it, subscription-based software would not be the best option for investment.
  • Most businesses in developed countries. Mature markets necessitate integration with all banking services. This is not a concern for regions where financial inclusion is still an issue.
  • On-premises supporters. Due to security concerns, some businesses still have little confidence in cloud-based solutions. These companies may wish to invest in on-premises servers they can own and control.

At the end of the day, BaaS and some other out-of-the-box digital platforms will prove the best fit for some enterprise-grade businesses that largely operate in mature markets and require watertight security.

The Bottom Line

Both the BaaS model and the WaaS model are easy to launch and cost-efficient when compared to ready-made software packages. Both offer distinctive tools for digital transformation to a wide variety of financial industry stakeholders, from wallet operators to telecoms to chain retailers. Depending upon your circumstances, either model may prove the best option to help your company leverage technology to reach emerging markets, implement your online payment infrastructure, reinforce engagement, and more.

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FIVE STRATEGIES TO AVOID THE TRUE COST OF IDENTITY FRAUD

Customers across financial industries are increasingly using services almost entirely online. It’s a consumer shift that was gaining momentum before the pandemic, with the rise of neo–banks, but digital-first services became essential to keeping us financially connected over the last two years when there were physical restrictions and lockdowns. Now, as we enter a post-Covid era, there’s no sign of the shift to digital reversing as 1 in 2 global customers would now rather open a bank account online.

An increase in digital processes and online presence brings with it an increase in opportunities for fraud. In fact, Onfido’s 2022 Identify Fraud Report found a concerning 47% increase in identity fraud since 2019, with financial services remaining one of the highest targeted sectors. 

While the opportunity for fraudsters has increased, scalability has also rocketed as organizations move to online business models. Take, for example, opening a bank account. In a branch, a fraudster would have a limited number of fake sign-up attempts before being recognized and caught. But with fraud online, once a fraudster finds a loophole, they have more opportunities to launch attacks at scale. 

Fraud is also evolving. Organizations are having to deal with a wide range of attacks. From account takeover, synthetic identity fraud, replay attacks to deep fake technology, fraudsters continue to innovate their approach. And to prevent fraud, businesses need to do the same. But are they doing enough to keep up? 

Fraud costs – but do we know how much? 

Figures suggest that global losses from payment fraud alone were $32.39 billion in 2020. This is triple what it was in 2011 and is expected to increase to a projected cost of $40.62 billion by 2027. 

It’s important to point out that these are estimates – and conservative ones. While many surveys seek to understand the accurate scale and cost of fraud to businesses, it’s difficult to unearth the full picture as they don’t consider the associated costs of fraud. That includes the hours banking staff spend rectifying issues, the reputational damage to businesses, as well as personal costs that fraud has on victims.

What is clear is that fraud remains a serious and costly problem.

Take a proactive, not a reactive approach to fraud

To counter the cost of fraud and combat new and growing threats, businesses need to invest time, money, and resources into fraud risk management. A successful model provides a comprehensive approach to identifying, assessing, mitigating, and monitoring fraud. 

According to the Association of Certified Fraud Examiners (ACFE), the best approach to fraud risk management is proactive rather than reactive. In other words, businesses should not wait for problems to arise before fixing them. Instead, they must take a risk-based approach, identifying how they might be attacked, then measuring that against their risk appetite. 

From there, it’s about putting robust fraud detection and prevention frameworks in place, and analyzing developing fraud trends to stay ahead of emerging fraud trends and techniques. 

Five considerations for effective anti-identity fraud strategies 

  1. People, strategy, and governance: 

The position from the top influences fraud prevention and detection throughout the business. Therefore, fraud risk managers should educate on and enforce the fraud strategy. A successful model also needs the correct culture, as well as the diversity of experience amongst the team. Senior managers should not only employ individuals with forensic and fraud expertise but must bring in those with a customer-centric mindset as the absence of any customer-centricity is often where teams fall down. 

  1. Balance: 

The best fraud set-ups don’t exist in a vacuum. Fraud teams should work with the customer experience and those focused on business growth to achieve a balance between how much risk they take on and how many customers they onboard. Businesses could stop 100% of fraud overnight by not letting any more customers in. But the best fraud strategy understands that a balance is needed, and the team works with the broader business to get that balance right. 

  1. Assessment: 

What fraud risks are your businesses encountering, and how have they changed? If fraud happens, what’s the potential cost to your business? The foundation for the prevention and detection of fraud starts with risk assessment. 

  1. Prevention and detection: 

Knowledge-based passwords or passcodes continue to dominate digital account authentication, despite more than a decade of discussion on why they must be replaced with more secure processes. For instance, Onfido’s research with Okta revealed that 70% of global consumers would be open to biometrics as opposed to using a password to log in. Exploring new authentication techniques that are more robust, yet convenient for users, such as biometrics, will help reduce fraud without deterring customers. 

  1. Technology and analytics: 

Digital banking and other financial services are increasing. Humans alone can no longer keep up with the scale and magnitude of the fraud. To combat the risks associated with this, banks need to employ smarter technology and analytics to detect, deter and prevent fraud. 

Combatting the risk of fraud 

Despite the serious risk that identity fraud presents, many financial institutions still don’t have effective systems in place to deal with it. There’s no singular approach that can act as a silver bullet. But building an anti-fraud strategy around these five key considerations can help combat many of the risks.

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thefintech.info

HOW NFT FINANCE ACCELERATES NFT MASS ADOPTION

There is so much hype around Art and Collectibles (A&C) in the NFT space that you would be forgiven for thinking NFTs begin and end there. Certainly, the vast majority – although not all – of NFT projects to date have been concentrated in A&C. Quarterly studies released by NonFungible paint an interesting picture: by volume, A&C accounted for 91% of the market in Q1 of 2021, down to 85% in Q3. This simultaneously shows the dominance of A&C, while also pointing to the expanding presence of other NFT verticals.

As NFT use cases expand and diversify, the market grows (surpassing USD 40bn in 2021, per  Chainalysis), and the technology’s benefits are increasingly recognized, two questions, therefore, remain: what is holding NFTs back from mass adoption and how can we get there?

In a recent article for Cryptonews.com on this topic, Kiril Nikolov suggests that the holdup is partly the low levels of global crypto adoption (only an estimated 106 million people hold cryptoassets), but primarily the lack of utility and services that can make NFTs accessible and useful in people’s everyday lives. One of the key services Nikolov mentions is the development of financial tools.

Motivated by the importance of developing this new frontier, this article proposes that such financial tools can be defined and grouped under the term ‘NFT Finance’. In the following sections, I will break down what NFT Finance entails, suggest a framework for understanding existing and future financial products, and demonstrate how it can enhance an incredibly diverse range of global industries. Most importantly, I will argue that NFT Finance is the key to mainstream NFT adoption and expanding the liquidity and growth of NFT markets, within and beyond A&C.

What is NFT Finance and why does it matter?

First and foremost, let’s look at what NFT Finance entails. In the first article published in the collaborative research series between CadLabs and NFTfi titled ‘The Advent of NFT Finance’, NFT Finance was defined as ‘the Web3 infrastructure and set of markets for NFT-based financial products and services.’ To understand what this means in practice, it is helpful to draw comparisons with the traditional finance (TradFi), A&C, and real estate industries.
In TradFi, the services that take place outside of the main banking system, or those service niche assets, are termed Specialty Finance. In the world of A&C, the financial services that have developed in recent decades, from art investment vehicles to loan providers and securitization platforms, are therefore considered a form of Specialty Finance. The existence of these financial products enables more activity in the A&C market as players free up capital, conduct more complex transactions and participate in new ways beyond a straightforward artwork purchase or sale, particularly in the secondary market. Similarly, the Financialization of real estate in the 1990s, with the creation of mortgage-based products and derivatives and the securitization of loans, was crucial to that industry’s boom.

The suitability of NFTs for widespread adoption

NFTs can be anything. Any economic activity built around distinct units could therefore benefit from these units existing on a blockchain as NFTs. These benefits, to name a few, include greater transparency, accountability, traceability, efficiency, reliability, and composability. Which industries in particular stand to benefit? To begin with, any that have non-fungible items at their core. Here are a few examples:

Supply chain management: NFTs can authenticate products and ensure quality standards. Thanks to the traceability of NFTs, the origin of products can be verified, and their movements can be tracked at each stage of transport and production. This would be a major advantage for any business reliant on supply chains, from food to fashion and pharmaceuticals. The potential impact of enhanced supply chain management across the globe cannot be underestimated.

Patents & intellectual property: NFTs can be used to transfer ownership. Records of patent owners can be held on the blockchain and tokens containing self-executing contracts can transfer the legal rights associated with patents upon token transfer. A notable development in this space is a partnership between IBM and IPwe to create the infrastructure for a global patent marketplace where tokenized patents can be traded via NFTs. The utility of this platform will go further than simple sales transactions, also enabling participants to license, finance, research, and commercialize patents. This is a key indicator of how NFT integration in an existing industry can be enhanced by the creation of additional financial products and systems (NFT Finance) that bring flexibility, liquidity, and efficiency.

“The use of NFTs to represent patents will help create completely new ways to interact with IP. This is expected to benefit not only large enterprises that have significant intellectual property, but it will bring new opportunities to small and medium enterprises and even individual IP owners. We believe it will usher in new offerings by financial services firms and corporations to promote the evolution of a new patent asset class.”

                                                                           IPwe CEO Erich Spangenberg.

Real estate: NFTs are not just fundamental to virtual real estate in the metaverse, but are already being used to facilitate physical transactions. In February 2022, the first NFT-linked house sale took place in the US through Propy, a startup that is combining real estate with NFT lending. In this case, the NFT was linked not to the housing deed but to the ownership of the LLC that owns the physical asset. This is just the start of experimentation in this industry, with many potential applications of NFTs now being recognized and the development of DeFi mortgages underway which will doubtless encourage more NFT-based transactions in the space.

The above examples demonstrate how NFT Finance products are developing organically as NFT usage accelerates in non-A&C related industries, and the huge potential for NFT Finance to facilitate broader NFT integration. However, it also highlights the need for further research into and development of the possibilities of NFT Finance in broad terms, rather than on an industry-by-industry basis.

To do this, we need a framework for categorizing the main types of NFT Finance infrastructure that can be applied across all industries.

A framework for NFT Finance

In the recently published article series ‘The Advent of NFT Finance’, a framework for categorizing NFT Finance products, based on TradFi market infrastructure, was proposed by Giulio Trichilo and Jonathan Gabler. This categorization is useful not only for grasping the mechanisms of NFT Finance, but it offers a broad framework for understanding and further developing the space. With this in mind, let’s break these down and see how each category works in practice by exploring some innovative platforms already in operation.

  1. Debt-like: the creation of fixed-income instruments that result in a cash flow based on NFTs e.g., a peer-to-peer loan where an NFT is used as collateral.
  2. Equity-like: the creation of any instrument enabling the ownership of fungible items backed by non-fungibles e.g., fractionalized tokenization of NFTs via ERC20s.
  3. Aggregation-like: the creation of investment vehicles, aggregators, or market-making utilities that enable individuals to become market participants solely based on upfront capital, with no technical knowledge required – such as index tracker funds or an NFT automated market maker.

The majority of debt-like products in existence are lending platforms. Borrowers benefit from liquidity without having to sell their assets, while lenders benefit from a profitable APR (annual percentage rate). Transactions are executed via smart contract and if the borrower defaults, the lender automatically receives the collateralized NFT – the most commonly listed collections include CryptoPunks, Bored Apes, Art Blocks, and VeeFriends, to name a few!

In the equity-like category, we have seen the rise of NFT-based securitization products which enable the part-ownership of non-fungible items. The Particle Collection, for example, is pioneering the collective ownership of traditional blue-chip art – by acquiring paintings which are then sub-divided into 10,000 individual NFTs (or Particles), which can be collected and traded. The first artwork to be Partialized was Banksy’s ‘Love is in the Air’, purchased for USD 12.9m at auction in 2021. The physical work, along with all future acquisitions, will be installed in a forthcoming non-profit Particle Foundation – both physically and in a metaverse museum.

When it comes to aggregation-like instruments, DAO-managed indexes are a thriving example. The Index Cooperative, a DAO (decentralized autonomous organization) currently has over USD 400m in assets under its management with a variety of investment opportunities linked to the crypto space for individuals and institutions. These investment vehicles are being met with sharply rising demand, with the number of index holders at Index Coop alone growing from 5,000 to over 30,000 for 2021.

The value of NFT Finance

NFT Finance is not an accessory to the NFT space but will prove fundamental for the mass adoption of NFTs beyond the limited sphere of Art & Collectibles. As outlined in this article, NFTs can enhance industries from supply chain management to real estate – with NFT Finance unlocking new opportunities for individuals and institutions to participate and profit.
Due to the nature of DeFi composability which is unique to blockchain infrastructure (as are NFTs), there is an unprecedented level of interoperability between NFT markets and NFT Finance compared to traditional markets and their respective Financialization.

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HOW WOULD A FINANCIAL ADVISER START THE NEW TAX YEAR?

It’s important to get your finances in shape to start the new tax year with a bang.

Here’s how two of our expert financial advisers would start the new tax year.

Pension, ISA, and tax rules can change, and any benefits depend on your circumstances. Different tax rates and bands apply to Scottish taxpayers.

This article isn’t personal advice. If you’re not sure what to do, ask for financial advice. We can advise you on how to make the most of your tax allowances through financial planning, but if you need complex tax calculations we recommend speaking to an accountant.

Use your ISA and pension allowances

ISAs are one of the easiest and simplest ways of saving money. This tax year you can add up to £20,000 to an ISA. Once it’s in there, you won’t have to pay UK income or capital gains tax on that money. You don’t even have to fill in a tax return for it.

It makes sense to use your ISA allowance early, as the sooner the money is in an ISA, the sooner you won’t have to pay UK income and capital gains tax on it. It also means it then has more time to grow.

If investing in an ISA, like a Stocks and Shares ISA, isn’t right for you, you can still use other ISAs to save tax, like a Cash ISA. If you don’t need your money for at least five years, it’s usually best to invest it in the stock market. A Cash ISA can be a good option if you’ll need the money before then or have a short-term goal in mind.

Remember unlike cash, all investments can rise as well as fall in value, so you could get back less than you invest.

Investing in a pension, like a Self-Invested Personal Pension (SIPP), helps you save for retirement, and it can also reduce your tax bill. It’s a win-win.

If you’re a UK resident, under 75, the general rule is you can add as much as you earn each tax year and receive tax relief. This is usually capped at £40,000 a year. But anyone who earns over this might be able to make use of the carry-forward rule and add more.

HOW TAX RELIEF WORKS?

Remember though, money in a pension can’t normally be taken out until 55 (57 from 2028), when up to 25% is usually tax-free with the rest taxed as income. Your allowance could also be less than £40,000 if you earn over a certain amount or have previously accessed benefits from a pension.

HOW MUCH CAN YOU PAY INTO A PENSION?

With the freeze on income tax thresholds until 2026, more people are likely to end up paying more in income tax. Making pension contributions from your income could mean you slip back under a threshold and pay less tax. As with ISAs, you don’t have to pay UK income tax or capital gains tax within a pension.

Did you know?

Pensions also don’t usually count towards your estate for inheritance tax purposes. Contributing to a pension could be a tax-efficient way to pass on money to loved ones.

Make the most of the power of regular saving

Investing monthly is one of the most powerful ways to build wealth. It’s all down to ‘pound cost averaging.

Drip-feeding money into investments, rather than investing a lump sum, helps smooth out the ups and downs in the stock market. It essentially averages out the price of buying investments, so you’re not going all-in at one price.

This can be beneficial when the price goes down as you’ll buy more units or shares. However, when the market rises above the original price, fewer units are bought.

The start of a new tax year is a great way to get into better savings habits.

It’s important to plan your regular savings ahead of time, especially if you’ll be using a tax wrapper like an ISA or SIPP. A good time to plan is at the beginning of the tax year. That way you can calculate how much of the allowance your monthly contribution will use up.

For example, £500 every month into an ISA will use £6,000 of your £20,000 ISA allowance in 2022/23. This means you’ll have an allowance of £14,000 to use before 5 April 2023.

Review the risk in your portfolio

Understanding risk is important. You need to be comfortable with the ups and downs that come with investing in the stock market. You can find a level you’re comfortable with by diversifying and using the right mix of investments (your asset allocation). The level of risk within a portfolio is often based on your goals and investing time frames, so step one is to nail those down.

You should review your portfolio once or twice a year to make sure it still meets your goals, attitude to risk, and any changes in your circumstances.

WHAT YOU NEED TO KNOW ABOUT RISK

If you’re an HL client, you can check if you’re using the right mix of investments by using the ‘Portfolio Analysis’ tool on the ‘My Account’ screen when you’re logged in.

Don’t forget about tax

When you’re reviewing your investments, it’s important to think about tax too.

Some investments are taxed differently than others. For example, income from dividends is taxed differently compared to income from corporate bonds & government bonds (gilts).

This is particularly important if you are or are about to be drawing income from your portfolio.

Income from your investments is taxed at a basic, higher, or additional rate.

Dividends Bonds and gilts

  • Basic rate                  8.75%                 20%
  • Higher rate              33.75%                 40%
  • Additional rate        39.35%                 45%

You might also have a personal savings allowance and dividend allowance to offset some of this income before it becomes taxable.

The rates a Scottish taxpayer pays on dividends and savings income are determined by the UK bands, not the Scottish bands. This also applies to capital gains tax.

Diversification

Holding a mix of different types of investments that invest in different sectors and parts of the world is the best way to diversify.

  • Types of investment or asset classes – cash, bonds, funds, shares, and property are the main ones, and they’ll all have different risk levels. The idea is that they have different drivers of returns – each will perform differently at different times. As your age, goals, and risk appetite change, then you’ll probably want to change the amount you have in each asset class.
  • Geography – why stick to one country, when you can have the world? Just like asset classes, different stock markets around the world are driven by different things. And often, the best-performing stock market will change from year to year.

It might feel uncomfortable to put some of your money into areas that aren’t doing well – but when the tide turns, and it usually does, you’re more likely to be in the right place at the right time.

Beware of capital gains tax

Every year, you can grow your wealth without paying capital gains tax.

The capital gains tax allowance is £12,300 and has been frozen until 2026. Any gain above that which falls within the basic-rate tax band is normally taxed at 10%. Any part of the gain which falls into the higher or additional-rate bands is normally taxed at 20%. But higher rates can apply to residential property.

One way to use your capital gains tax exemption is by selling investments not sheltered from tax and reinvesting into a more tax-efficient account, like an ISA or pension. Although there may be exit charges and different features and costs associated with these accounts so make sure you check first.

Doing it this way means you don’t pay any capital gains tax on the sale of your investments once they’re in an ISA or pension. Your future investment is also then sheltered from tax. Keep in mind though that you can’t usually take money out of a pension until at least age 55 (57 from 2028).

Make use of the spousal exemption

If you’re married or in a civil partnership, there are rules around gifting assets. These can be helpful but a little complicated to get your head around.

You don’t normally have to pay capital gains tax on gifts to a spouse. You can also divide your assets to make better use of each capital gains tax exemption.

This means couples can have a combined allowance of £24,600 (£12,300 each) and share assets between them without triggering a capital gains tax bill. To help cut your tax bill, even more, the assets can be held by or transferred to the spouse paying the lower rate of tax.

Just remember, once an asset is gifted, you can’t normally take it back.

You could also pay less income tax as a couple if gifting brings one of you under a tax threshold without tipping the other over one.

If one spouse is a non-taxpayer, and the other is a basic-rate taxpayer, the non-taxpayer can give £1,260 (10%) of their allowance to their spouse in the current tax year.

This means the basic rate taxpayer could earn is £13,830 before they start paying tax, rather than £12,570.

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THE GOLDEN RULE OF INVESTING

Happy Financial Literacy Month.

We want to thank you for being a faithful reader of Wealth Daily, where we show you how to generate more wealth for you and your family, all for free.

National Financial Literacy Month was created in 2004 to help U.S. citizens learn and develop healthy financial habits. So, you’ll be seeing a lot of personal finance articles and financial gurus coming out of the woodwork to give quotable advice.

With the pandemic-related widening of the wealth gap, there’s now a huge demand for financial literacy.

But with so much information swirling around, it can be difficult to know where to start. Billionaire investor and hedge fund manager Ray Dalio thinks individuals and countries should start by following the “golden rule” of finance. This is his theory:

It’s most often the case that a nation’s greatest war is with itself over whether or not it can make the hard decisions needed to sustain success. As for what we need to do, it comes down to just two things: Earn more than we spend and treat each other well.

And that’s exactly why investing is so important. You give yourself a true shot at earning more than you spend.

The problem is many of the companies we can invest in are beholden to what Dalio calls the “new world order.”

We can see it in action with our country’s changing energy policies. As the U.S. goes green, other countries are laughing all the way to the bank.

Wise investors know this leaves a door open to new energy opportunities.

Your Neighbors Are Better Than You

President Biden’s made it abundantly clear that the U.S. is going green. But with that comes heavy regulation in the energy sector, which is why we’re seeing more and more companies using environmental scorecards.

This week, the Securities and Exchange Commission shut down a proposal that would require companies to disclose their climate change vulnerabilities, saying “We are not the Securities and Environment Commission — at least not yet.” We’ll see more of these proposals and their inevitable approval in the coming years.

In JPMorgan Chase CEO Jamie Dimon’s annual shareholder letter this week, he said the U.S. needs a “Marshall Plan” for energy security in the U.S. and Europe.

It’s no secret that energy costs are rising. But lawmakers want to put the onus on the American people by making sure we don’t use more than our allotted share.

You’ve probably received a scorecard in the mail from your energy provider like this one…

energy bill

Resource Recycling Systems created a “Sustainability Scorecard” for its clients. In other words, get a low score and your reputation is tarnished, along with your future sales.

Scorecards are used widely today with the rise of environmentally conscious direct-to-consumer companies like Warby Parker and Allbirds. Investors acted like this was some revolutionary, environmentally friendly business model that would disrupt e-commerce, but both companies have been beaten down, with Allbirds announcing it’s using Amazon to sell its shoes online.

After getting your report, you’ll begin receiving the Wealth Daily e-Letter, delivered to your inbox daily.

Then there’s the Sustainable Apparel Coalition’s Higg Index, which measures the environmental impact of apparel and footwear companies.

When asked about the Higg Index,

“The index helps us stay on track, but I’m disappointed that bigger companies haven’t done more. When we started down that road in 2007, everyone was talking about ‘sustainability,’ and now that word is meaningless.”

                                                                   Patagonia founder, Yvon Chouinard.

Patagonia, a company with more than $1 billion in clothing sales a year, has come under fire recently in San Francisco, with someone hanging fliers around the city urging people to stop wearing the company’s vests, which are seen as a status symbol among finance and tech startup employees.

anti patagonia flyer

Patagonia announced that it’s no longer selling vests with company logos.

It’s not fair to pigeonhole a company that’s done all it can to lessen its environmental impact. For example, company execs advocated for the removal of the Edwards Dam in Maine in 1999 and spoke out against free trade agreements like NAFTA and GATT because they knew the policies would harm sales.

there’s only so much you can do as a company, and you’re not going to please everybody by going green.

And now that the U.S. is trying to lead the green charge by cutting back oil production, other companies are willing to pick up the slack.

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WHAT IS STAGFLATION AND SHOULD INVESTORS BE WORRIED?

Few scenarios alarm economists and investors as much as stagflation a toxic combination of economic stagnation and inflation. This unfortunate mix is usually associated with the 1970s, when two separate oil shocks an OPEC embargo in 1973 and a drop in production following the Iranian Revolution in 1979 led to a sharp rise in prices and undermined consumption.

Recently, the term stagflation has made an unwelcome comeback in the financial press. Inflation in most of the world has climbed above central bank targets while economic growth has started to moderate. The war in Ukraine has intensified concerns over elevated inflation and the risk of recession.

So, should investors be concerned about a return of stagflation? Why is stagflation such a troubling situation for investors, central bankers, and citizens alike? And is there any way investors can hedge themselves against this particular risk?

What is wrong with stagflation?

It is revealing that it was in the 1970s that economists took to referring to the “misery index”—the sum of inflation and unemployment. Either high unemployment or elevated inflation can reduce the living standards of many citizens, but the two together are especially pernicious.

Inflation erodes the spending power of wages and savings, undermining consumer spending and confidence. Meanwhile, high unemployment also chips away at demand in the economy. This is why stagflation is feared more than a standard recession. Stagflation also represents a painful dilemma for central bankers: If policy is tightened to combat inflation, unemployment is likely to be exacerbated. This leaves policymakers with no easy options.

Finally, a stagflationary environment is problematic for investors, harming both equities and fixed income. First, higher inflation can erode profit margins—especially for companies that are unable to pass on higher costs to customers. For fixed income investors, inflation reduces the real spending power of coupon payments on high quality government bonds. Even the value of cash is eroded swiftly, leaving few places for investors to hide.

Is stagflation a significant risk at present?

We see some parallels with the 1970s at present. But talk of stagflation is still overstated, in our view.

First the parallels: On the price front, as in the 1970s, energy prices have risen swiftly. The Russian invasion of Ukraine has disrupted supplies of both oil and natural gas. Fears of a sudden drop in Russian output briefly pushed the price of Brent crude as high as USD 139 a barrel on 7 March, for an increase of close to 75% since the start of 2022.

Even after the subsequent decline, the price is still around a third higher year-to-date, as of 1 April. Also, the important role of both Russia and Ukraine as exporters of grains and fertilizer has pushed food prices higher. Even before the full impact of the war, the FAO Food Price Index hit a record high in February 2022, up around 20% on the prior year.

Meanwhile, worries over economic growth have intensified. The yield on the 2-year US Treasury climbed above the 10-year yield in late March, a popular gauge of recession fears among investors. A sustained rise in energy prices would also sap the spending power of consumers worldwide. Meanwhile, investors have become concerned that central banks—especially the Federal Reserve—will be forced to raise rates aggressively to curb inflation.

While investors are right to take such risks seriously, our base case is that a recession can be avoided and that inflation will subside into 2023. Current economic conditions look more benign than during the years of stagflation in the 1970s. For comparison, in 1975 the US economy contracted 0.2%, core inflation averaged 9%, and unemployment stood at 8.5%. At the time of writing, the US economy is on track to grow by around 3.5% in 2022, with unemployment below 4%. We see inflation falling from 5.8% in 2022 to 1.5% in 2023. Economies still have considerable momentum from a normalization of economic activity as pandemic restrictions are lifted.

The global economy is less vulnerable to higher energy prices than in the past, with the energy intensity of global GDP declining by more than 50% since the early 1970s. Finally, central bankers now stand ready to combat inflation. Fed chair Jerome Powell recently reiterated that policymakers “will take the necessary steps to ensure a return to price stability.”

What does this mean for investors and should you seek protection?

The first conclusion for investors is not to panic. The financial press or pundits often indulge in predictions of impending doom that aren’t realized—such as forecasts of hyperinflation following the 2008 financial crisis. In our view, talk of stagflation falls into this category. At present, consumer balance sheets are strong, following savings accumulated during pandemic lockdowns. Business profits are rising fast and have already surpassed pre-crisis levels.

Central bankers are eager to keep the economic recovery on track, while being willing to clamp down on inflation if needed. This is not to say that investors should ignore the threat of sustained higher inflation combined with slowing economic growth. What might be called “slowflation”—while not our central expectation—remains a possibility.

Given high levels of uncertainty, we do recommend investors add to hedges, including defensive sectors such as global healthcare. We also believe energy and commodities represent an effective hedge against the threat of a more sustained war in Ukraine or a sudden drop in Russian energy supplies.

But since we don’t see a period of stagnant growth, we see the recent volatility as offering a more attractive entry point for industries such as 5G, automation and robotics, smart mobility, and consumer experience. For investors strategically underexposed to Chinese equities, we see now as a good time to diversify into a market that is cheap, oversold, and likely to gather momentum over the rest of the year.

See the full report: CIO tutorial: What is stagflation and should investors be worried?, published on 4 April 2022.

Main contributors: Christopher Swann, Paul Donovan, Brian Rose, Vincent Heaney, Frederick Mellors and Alison Parums

This content is a product of the UBS Chief Investment Office (CIO).

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