Blain’s Morning Porridge – March 22 2021: Interest rates and vaccine wars unsettle markets, and just how distorting might ESG prove?
“Demands are one thing, solutions quite another…”
This morning – As vaccine wars hot up and markets worry about interest rates and central bank action, the theme of price distortion continues to unsettle valuations. One aspect of distortion is in the increasing weight being put on ESG metrics – which should be market positive, but look to be vulnerable to Woke-like “doubleplusungood” groupthink, potentially further distorting markets.
The outlook this week looks – “interesting” as the Chinese might say. On the back of Jerome Powel’s “as long as it takes” promise to keep rates low, and this week’s US treasury auction schedule, I have a feeling this is going to be a critical week. We’ve also got the deepening vaccine war developing in Europe as supplies of the AstraZeneca drug looking likely to be denied from being exported to the UK. The results of the US AZ test show its 100% successful and totally safe, but the Europeans are determined to compound the previous vaccine mistakes with yet more.
Last week felt poised on the edge of something – markets were stressed with fears about inflation and the ability of central banks to keep up accommodative policies. It felt there is a building consensus something’s about to give. But, as one of my colleagues sagely proclaimed: “when everyone else has gone consensus, that’s the time to be a contrarian.” Maybe it’s time to pile back into bonds, gold and the risk-off markets? Or maybe hold your nerve and wait for the next leg up?
Let’s see what happens…
But one thing that has caught my ear was a very earnest young lady on the Radiogram this morning demanding the UK cuts all business and financial links with China over genocide of the Uigher minority. It’s a fair question to ask – an example of why a Social objective should be factored into market outlooks. We know the Boris government will address the issue pragmatically. Much as we dislike how the Chinese surveillance state works, the needs of our economy means we have to work with them.
That set my thinking about how the changing approach towards ESG issues is hitting markets…
Last week I returned virtually to my old university to give a Zoom-style lecture to post graduate students at Heriot-Watt’s Centre for Finance and Investment. The Watt is one of the UK’s premier technological universities, and also has a superb business school. I chose “Distortion” as my topic; talking about the ways in which market breakdowns are driving investment behaviours that seem to make little long-term sense.
The theme was broadly: The more you tinker with financial stability, the less stable it becomes because of the “consequences”.
I illustrated each part of the lecture with anecdotes and tales to illustrate market failure and rising instability. If I get time, I’ll redo it as a podcast, and post it on the podcast page of the www.morningporridge.com website. I intend to do a couple of podcasts each week – short 10-15 min pieces looking at markets – please think about subscribing on your podcast server.
Following the lecture, I became concerned I hadn’t focused enough on the fourth of my distortion themes. It’s the one that increasingly worries me – how laudable Environmental, Social and Governance (ESG) goals are being sucked into the distortion process by a combination of regulation, Woke-like groupthink, and corporate chicanery! I fear the way ESG themes are developing could prove yet another major distortion on markets.
Let me briefly run through the distortion pitch..
I explained how all financial asset prices are ultimately set off the risk-free rate – the yield on government bonds – but how the last 12 years of monetary experimentation and QE infinity keeping the RF Rate artificially low has triggered enormous asset-price inflation. I looked at how relative yields between asset classes don’t reflect relative risks: 3% dividend yield on a stock not the same risk as 3% yield on a bond. Equity prices reflect optimistic upside expectations while Bonds reflect pessimism about being repaid.
Low returns favour investment in financial assets. What’s the point in taking risk to build an expensive new factory, when you can push up the price of the stock by borrowing cash to buy back stock? I used the story of Boeing spending all its cash on stock buybacks to boost its price (and executive bonuses), while scrimping on the development of new green aircraft and compromising safety by stretching the venerable B-737 design, as a perfect example of corporate failure driven by monetary distortion.
I touched on the number of zombie corporates across the US and Europe that have survived solely due to ultra-low rates and mispriced money. The firms survive, but effectively block business niches newer more nimbler firms should be evolving into.
I idly wondered if the success of Gupta’s GFC Alliance was a good example of how ultra- low rates change investment behaviours – making buyers less sceptical of high yielding complex and obscured structures as they desperately seek returns. As is now increasingly clear Greensill’s future receivables supply chain finance scam was just another variation on the classic Ponzi. It looks like some of the dodgier early deals were refinanced using funding raised for later GFC acquisitions.
I went on to raise the issue of regulatory distortion and the bureaucratic imperative to be seen to be doing something in the wake of crisis. As a result of the last leverage driven Global Financial Crisis in 2007-08, global regulators have instituted a whole series of market reforms to address the perceived causes of that crash. In doing so, and by legislating much of the market’s liquidity out of existence through capital charges, they may have successfully set the conditions for the next crisis – minimal real market liquidity.
The Big Delusion Distorion
I went on to discuss the distortions of market illusion and delusion. I came to the conclusion FOMO – fear of missing out – acts like the market’s gravity, the force which keeps insane pricing rational longer than common sense would expect. Because the market is just an enormous voting machine that collates every participants’ price, I’ve come to understand the market’s key driver: “It’s not what you think you know, but what the market believes that sets prices.” It explains why hot stocks are followed beyond the point of common sense.
FOMO also neatly explains why the market famously stays irrational longer than you can stay solvent. It creates narratives and themes to follow – some of them lead to pots of golds. Many go nowhere. A big theme today is the “disruptive innovation” potential of new technologies and the speed at which they will be adopted and change society – we simply can’t imagine how different the world will look in 10, 20 and 30 years as everything from 3D printing, meatless meat, automations, AI and everything else that’s the new new thing comes in. Winners and losers will abound.
And then I touched on what may become a fourth distortion – and this may concern you:
I am convinced aligning global markets with politics to solve Environmental and Social issues is critical. Government and Commerce need to work together to determine how society allocate between Public and Private goods, and to clearly define their roles in each. Strong corporate Governance should ensure corporates deliver social and environmental objectives that not only benefit their shareholders, but all of society – the ultimate goal of a “stakeholder” society. I see Governance as the most important aspect of ESG – but sadly it’s the one that gets least attention.
ESG is great concept – but I am worried about how bureaucratic and “Woke” the ESG theme is becoming in practice and unbalancing the three legs of the equation in terms of delivery a better environment, better society and a stronger economy. It feels that who shouts loudest gets the attention – as I heard on the radio this morning.
In my day-job in Alternative Investment Capital Markets the first question I encounter to any investment proposal is the ESG gate code: “What will the ESG committee think.” It’s the first thing a fund manager now considers in any investment decision.
All the large investment funds have been marketing pandemic lockdown ESG webinars where terribly earnest young fund manager explain their green investment mission. The big dogs of Fund Management are fully committed to ESG, sagely pontificating on the journey they are curating for investors in their vision of a sustainable environment. It’s now setting the agenda – because asset management CEOs are convinced ESG pulls in investment funds.
Some say ESG is still in a “chaotic” evolutionary stage as some 160 different voluntary ESG reporting standards and 64 standards-setting agencies worldwide compete for band-width. The volume of funds with a Green or ESG related theme has doubled to $1.7 trillion over the past year. Predictably, assets perceived to be ESG “good” have risen in price, incentivising the “greenwashing” of less pristine investments. ESG proponents say ESG funds outperform – which is exactly what you would expect when everyone is now trying to buy scarce ESG compatible assets. It’s not that green investments are outperforming – their price is distorted by the market’s need to buy them.
According to Fund Performance analyst Morningstar, nearly 250 existing funds were rebranded as ESG, Green, Socially Responsible, or Sustainable in the last quarter of 2020. New funds claiming ESG credentials outnumber unbranded firms by at least 10 to 1. Only an idiot would try to finance any new business or project without first carefully outlining its ESG credentials.
The plethora of ESG Standards, Taxonomies, and Principles bombarding the market are confusing, contradictory, and ambiguous in detail, but they are generally aligned around the single big feature everyone thinks they can agree on – the environment and a general conclusion anything involving fossil fuel is bad – which is far too simplistic. Any dissent on the topic – as we’ve seen on UK coal – is quickly crushed. Set rules, and the market will immediately look to arbitrage them.
Even as the 600 pages of the new EU ESG reporting rules are applied – even as they struggle to define the taxonomy of what is a good/bad investment – it worries me we don’t listen to experts. Any qualified energy scientist will explain how renewable power sources are good, but to meet future energy demands we probably need to factor in gas power for many decades to come. Similarly, while ESG enthusiasts are piling into lithium batteries, qualified mining engineers warn of shortages and environmental and social costs of extracting it.
Solving for the Global Environment is critical. The list of issues to cure feels endless – from climate, waste, oceans, soil, resources and the rest. There are solutions, but they need to determined in context of a global economy providing for the needs of an economy of 7 billion souls. The social aspect of ESG is an equally important; addressing rising inequalities in income, wealth and opportunity, social instability, and how social media, fake news and the internet is polarising the political process.
Yet, the most import aspect to solve is Governance. 35 years in financial markets, and I’ve learnt a simple very basic truth: Any firm which is not well managed with strong internal mechanisms and communication… will ultimately fail. Any firm that is well managed with clear governance isn’t a guaranteed success – but is more likely to do good.
I fear ESG investment is in danger of becoming the financial equivalent of the Cataclysm of Wokery that now determines everything we are allowed to think, say or write on any social subject. We are all aware of how it increasingly feels “free speech” only remains free if it complies with the lastest doubleplusgood Woke thinking. That was very clear on the radio this morning – yes its bad for the Uighers, but where do we draw the line?
The same thing is happening at a frightening pace in Finance. If ESG dominates investment thinking – that’s dangerous if it further distorts markets.
Five Things To Read This Morning:
Out of time and back to the day job