It is becoming evident that if not the virus, the response to it, will cause recession. Fighting the virus is the responsibility of health authorities, not central banks and treasuries. Treasuries can help financially of course.

Central banks and treasuries should concentrate on mitigating the economic costs of the virus and our containment measures. There are many ways to do this of varying efficacy.

We have already seen the US Fed’s response: a 50 basis point rate cut in between FOMC meetings. Investors are asking for more rate cuts. The Fed was right to cut rates, but for a specific reason, and perhaps not the reason hoped for by many asset owners. The Fed needed to mitigate yield curve inversion which clogs the bank credit channel. At least some investors will hope it props up the stock and corporate bond markets. The Bank of England has also cut rates. At this time the ECB has yet to act.

The risk is that governments act to boost the economy from the top down yet again. That would involve rate cuts and bond buying, a campaign that lifts the economy from the richest to the poorest. At a time of high inequality, and when a pandemic threatens a sort of healthcare apartheid, this is not efficient. What is needed is a bottom up policy of supporting the economy. Buying bonds, stocks, ETFs, assets, will not help. We need two things. Universal basic income and loan support for SMEs.

Universal basic income has high impact as the poor consume more of their incremental income. It will not exacerbate the existing income inequality. Wealth inequality is being addressed somewhat as asset markets fall.

SMEs are the marginal employer and driver of economic development and growth. They will require support as credit tightens as it has and will continue to do in this pandemic. The ECB’s TLTRO is a good example of how to do this, but collateral standards must be relaxed.

Budget deficits will result. Late last year, central banks implored their treasuries to turn on the fiscal taps. Political realities stood in the way that are now moot. The path is paved for fiscal stimulus. The opportunity presents to have a progressive program to mitigate against the economic cost of the COVID 19 pandemic.

In mid-January we noted the following:

Valuations were high. Equity multiples were high, credit spreads were tight and real estate cap rates were low. Whatever it was an investor considered buying, large numbers of investors had already bid prices up and were squatting on large quantities of inventory.

Economic growth was slowing. The global trade war had sapped some of the vitality out of the global economy and the age of the recovery phase was beginning to manifest in some fatigue. Around Q4 2019, there seemed to be some stabilization in high frequency macro data such as PMIs, indicating the potential for a cyclical rebound in economic activity, but the longer term prognosis was not as optimistic.

Central banks were close to or at their capacity for monetary stimulus. The ECB was well into negative policy interest rates and already doing QE. The BoJ’s negative rate and bond buying policies are so entrenched anything else would be a shock to the market. The PBOC was already stimulating the economy through reserve requirement cuts, rate cuts and expansion of open market operations like repo. Among the majors, only the Federal Reserve had much room for rate cuts. And even the Fed had already been forced into bond buying by technical ruptures in the financial infrastructure.

The strategy going into 2020 had included the following:

Reducing equity exposure and running a closer allocation to the MSCI World Index, as macro risks were high and it was not clear how the chips would fall if the market corrected.

Being careful with duration. If monetary policy lost its edge, fiscal policy would be engaged, and deficits and big debt burdens tend to steepen sovereign curves. The only way to buy duration would have been to focus on the short end which would mean increased notional exposure, itself a risk.

Prefer IG to HY, senior secured to senior unsecured and mortgages to corporate debt. For caution, the first two preferences are obvious. The third is supported by over leverage in the corporate sector while household balance sheets remain healthy and employment and wages at least appear stable.

Along comes a pandemic: COVID19

How bad is the pandemic? We are not epidemiologists or medical professionals, although it appears even the professionals struggle to quantify and specify the human and social costs. Just observing and not extrapolating or forecasting, the contagion appears to have slowed in China, its place of origin, whereas it seems to be accelerating in the rest of the world. The US has so far been lightly impacted. Distance, relative connectivity and a federal health agency will likely allow the US to escape with relatively less damage. Europe is vulnerable and the numbers support it. No pan European health authority with executive powers, no border controls within the Schengen, tourism and strong economic ties to China have led to relatively intense contagion. The rest of Asia seems vulnerable as well just given how integrated the economies are in China’s economic network including tourism. Central Asia is another at risk region. The epidemic within Iran and the Belt and Road activities in Central Asia must lead one to consider interpolation. The near absence of the virus from Africa should also be questioned given Chinese involvement in African economic and infrastructure development.

China appears to have contained the outbreak. If so, the economy should be switched back on in a quarter, maybe a month or two more. China’s approach to containment has been intense and effective. There are grounds to erring on the side of caution and it appears China has done so. Countries or regions with poorer surveillance or stronger civil liberties may struggle to enforce similar controls.

How long will containment measures be deployed and what is the economic impact?

Factories can be shut quickly but re-starting can be more complicated. Supply chains need time to resynchronize.

China may have contained the outbreak domestically but will have to vigilant against importing the virus from abroad.

The share of China in countries’ imports of intermediate goods has doubled to trebled since 2001. In the US the number has more than doubled from less than 5% to 10%, in South Korea it has gone from less than 12% to over 25% and in Japan it has gone from 10% to 20%.

Before the pandemic, the IMF estimated GDP growth to rise from an estimated 2.9 % in 2019 to 3.3 % in 2020. Current estimates, which are quite noisy, put 2020 GDP growth at 1.5% (revised down from +2.9%).

As of Feb 21, 2020, the S&P 500 traded at 19 times 12-month forward earnings, the highest the P/E level has been since May 23, 2002, according to FactSet. Credit spreads across IG and HY are at similar levels of overvaluation.

Has the COVID 19 market correction broken the buy the dip mentality?

In the last 10 years, buying the dips in the stock market have paid off very well. Market dips resulting from US debt ceiling impasses, European sovereign debt crisis, the China slowdown of 2015, the Fed failing to roll its put in 2018, et al, were all buying opportunities. Growth while positive, limped along at times in the last 10 years, credit quality decayed, earnings fluctuated, yet staying invested with the central bank’s stimulus wind at your back always worked. Will it work this time?

I think the downside is more substantial and the risk of a more protracted downturn is real.

Growth was slowing to begin with. Japan was about to slip into recession before any pandemic was contemplated. Europe was slowing precipitously before China flagged the COVID 19 epidemic to the world. America was recovering from a mild slowdown, but it was a weak recovery. The COVID 19 pandemic front loads the slow down and exacerbates it.

What can policy do, both monetary and fiscal?

We have managed to use monetary policy to force the economy to function at an artificially high rate of growth for a long time. Unhappy to let the economy slow, we never allowed the policy levers to be reset even when the economy was stable and growing. The result is that there is little capacity left for central banks to stimulate the economy. There is some room left for the US Fed but the ECB, BoJ and PBOC are mostly close to capacity and facing diminishing marginal efficacy.

The COVID 19 pandemic will allow countries to engage in fiscal stimulation without too much political resistance. Expect budget deficits to expand in 2020 and beyond. This could steepen term structures going forward.

In summary:

• Weaker equity and credit markets still to come.
• Weaker commodity markets, specifically in industrial metals and energy.
• Steeper term structures. Could be driven by rate cuts or rising longer term bond yields.
• Continued strength in USD and gold.

• China is first in and first out.
• Europe is slow to react and over-reacts.
• US might be spared the worst.

Note. This is an incompletely developed train of thought.

The path to artificial (general) intelligence will involve the entire human race. The achievement of AGI could be as mysterious as the distinction between the brain and mind. When AGI is attained it will be the sum of all of us, participating in its evolution and action. Each human mind, each human contribution, would be like atoms in molecules in cells in neurons in a collective brain generating a collective intelligence. There will not be an evil AI which destroys us because when we achieve AGI, it will be a part of us as much as we are a part of it.

With the current focus on climate change and resource sustainability its interesting to think more deeply about the sources and uses of energy on earth.

Fossil fuels. Fossil fuels represent 85% of global energy generation. General opinion is shifting towards the view that fossil fuels are unsustainable because, a) there is a finite endowment which is being exhausted, b) alternative energy will be more economical, and c) the climatic consequences of fossil fuel consumption are too high. Whether one agrees or not with these arguments depends on one’s point of view, time horizon, and economic interests.

It will take a long time to exhaust the current endowment of fossil fuels. The practical supply is much dependent on the costs of extraction and processing and the willingness and ability to pay these costs. Given sufficiently high energy prices, the feasible reserves increase and move the point of depletion further and further away. However, the question is one of time horizons. Given a sufficiently long horizon, we will exhaust the resource. The time it takes to produce fossil fuels is too long, much longer than the time it takes to extract, process and burn it. Since reserves are finite, however large they may be, and we are net destroyers of that resource over time, in fact at any given time, the resource must eventually be exhausted, not in the limit but at some finite time horizon. The impact of extraction alone, needs to be considered, not just the waste products of consumption. What does a planet denuded of fossil fuels look like, what is its geology, geography and ecology? One possibility which may not have been given much consideration, and perhaps with good reason, is to find ways to replace the fossil fuels more quickly than they are depleted. Is this cost effective? Is it possible or practical? Are there better alternatives?

What are the viable alternatives to fossil fuels? Wind, solar, hydro and nuclear power are the main alternative sources of energy. Wind and solar power suffer from inconsistent supply. Apart from generation costs, they are also dependent on storage costs. Batteries, capacitors, flywheels and weights can be used to store energy depending on how long it needs to be stored. Wind power is a sustainable and renewable energy which is a viable alternative to fossil fuels. It currently represents about 5% of global power usage achieving grid parity in Europe in 2010 and in the US in the near future. That said, grid parity is of limited use as a measure of comparison. Even then, the impact of wind power is not fully understood. What happens to the frictional properties of the earth’s surface under the proliferation of wind turbines? Solar power, another sustainable power source currently provides some 2.8% of global energy usage. The International Energy Agency predicts that by 2050, solar power would be the dominant source of energy. In a way, solar power has parallels to the energy transformation process in the production of fossil fuels. Fossil fuels are organic stores of chemical energy stored in the ground which trace their energy source to photosynthetic capture of solar energy millennia in the past. Hydroelectric power is still small scale and largely dictated by the physical geography of the earth.

In the end, there are only so many sources of energy. Nuclear energy powers the sun. Light energy brings that energy to the earth where photosynthetic plants convert the energy into chemical energy which is then stored in the earth’s crust until it is extracted in the form of fossil fuels. Heat energy from the sun also powers convection resulting in winds that power turbines. Weather pulls water from oceans to high ground where they accumulate. On their return to the sea, the gravitational potential energy is converted into kinetic energy which is harvested by turbines and generators into electrical energy. In large scale, there is but one single energy source: the nuclear energy of the sun. All this planet can do, is harvest it and recycle it. Failure to harvest sufficient energy will lead to an eventual catastrophic deficit. Recycling helps mitigate short term deficits.

Harvesting of sunlight can take several forms. The oldest is photosynthesis. Plants form a part of our solar panel array. The chemical energy they accumulate has to be processed to form combustible compounds such as biodiesel, ethanol or methane which can be burnt for fuel. There are practical, engineering reasons why currently, biofuels may not be efficient alternatives to fossil fuels, but theoretically, they can be. Photovoltaic cells, and concentrated solar thermal power is another way of harnessing the sun’s energy. How they differ from fossil fuels, is time. Fossil fuels are millennia of inventory, inventory that we are now drawing down. As we do so, we also release the carbon captured when the energy was stored.

An alternative to harnessing the power of the sun, is to replicate that power source on earth. This is nuclear power, which currently represents 10% of total energy production. Nuclear power is potentially inexhaustible since as long as there is matter available for conversion, there is power. The issues around nuclear power are safety and cost. On the basis of cost, nuclear power ranks well, on a total basis including capital costs and operating and maintenance costs with the capital costs being the greater share by far. Nuclear power is almost as cheap as coal and far cheaper offshore wind and solar, both photovoltaic and thermal. The consistency of supply is not even in question. The main issue with nuclear power, is safety. The memory of Three Mile Island, Chernobyl and Fukushima remain with us. Despite a low death toll, these nuclear accidents generated a disproportionate public reaction. There are good reasons to suspect that the long-term effects of these accidents, beyond the immediate death toll, are not yet fully understood. However, the low cost and energy efficiency of nuclear power makes it a viable source to pursue. What is needed is to improve safety with a view to large scale deployment. Reactors based on alternative fuels to uranium which can be dangerous and weaponized could be found such as thorium.

Yet another alternative solution to our energy problems is to either produce the energy off-planet and send it back, something called space-based solar power (SBSP), or to relocate energy intensive industry off-planet.

I had discussed ESG in this previous article entitled: ESG: Externalities Unpriced, in an attempt to encourage a more rigorous analysis of ESG, arguing that ESG leads to better investment results due to a more comprehensive understanding of the factors surrounding a business so that these factors can be integrated into both risk mitigation as well as a business origination. This provides a more comprehensive picture for management in terms of control, and for shareholder in terms of allocation and governance.

Even with these ideals in mind, ESG is more complicated than I’d thought. And here we are not even talking about greenwashing but assuming good faith efforts in the pursuit of more sustainable business practices.

Purpose. The purpose of business is profit. It is practically intractable to maximize two measures at the same time unless we establish a strong dependence between the two. For a business to maximize profits and social or environmental impact is simply too difficult to do. A business should profit maximise. The reason ESG is important to a profit maximiser is that it increases the information available to management in their strategic planning. The objective horizon is important. Short term gains can be made through irresponsible behaviour which has long term costs. It is therefore important that management is incentivised to maximize value over sufficiently long time frames. Attempts to maximize measures other than or in addition to profit, present management with confusing mandates which risk management failure. This is an unnecessary risk and should be avoided. Businesses are expected to make money, and to avoid irresponsible practices while they go about it.

Identifying and prioritizing ESG factors. As ESG is a relatively new concept, the availability and quality of data is an issue. Business managers need to identify all factors which can impact financial performance and to determine the importance and priority of such factors to the business. The importance of a factor can vary over time and can correlate with other factors. For example, the climate impact of a firm can vary over time as its product line evolves. An fashion business that pivots from leather shoes to canvas trainers may need to address its water consumption or its use of recycled plastics. The social profile of a firm also varies with the evolution of its client base. As European fashion courted Chinese demand, witness Dolce and Gabanna’s epic fail in respecting the cultural sensitivities of its target audience in late 2018. Managers need to understand the risks and opportunities to their business more holistically, and ESG provides such a completion to the traditional financial metrics. Similarly, investors need to understand the scope and priority of the ESG measures managers focus on both to understand the business better, and to benchmark the performance of management.

The ESG label implies a systematic focus which sometimes obscures the bigger picture. ESG appraisals often focus on internal processes and appraises the firm in isolation rather than its role as a part of an ecosystem. A firm’s impact on society and environment begins before it acquires raw materials and persists long after it sells its product. The sustainability and financial fate of a firm is impacted by its sourcing decisions and its legacy. Using electric vehicles as an example, the non financial impact of battery manufacture often includes the consumption of massive quantities of water, in countries where water is inefficiently priced, and the use of exploitative labour practices to further under-state the true cost. The cost of recycling, decommissioning and otherwise disposing of lithium based batteries can potentially be put back to manufacturers someday, directly, or indirectly if buyers are charged decommissioning costs. Firms are best appraised within their ecosystem, and not just within their competitors and their immediate supply chain. Impact investing, which is distinct from ESG investing, has tools for measuring the impact of a business within its ecosystem, tools which it may be useful for ESG investors to borrow.

ESG heightens the trade-off between subjectivity and objectivity. In any form of decision making, such as in the field of investments, there is always a trade-off between a subjective versus an objective approach. The ESG investing industry is thus bifurcated. One camp prefers a systematic and transparent approach which is rooted in exclusions and inclusions based on objective ESG metrics. The other approach integrates ESG factors into traditional discretionary securities analysis.

The systematic approach is decisive, auditable and transparent. However, it is susceptible to type I errors, i.e. rejecting acceptable candidates. The integrated approach is less susceptible to type I errors, is not more susceptible to type II errors, that is, accepting an unacceptable firm, but is less transparent, less systematic and less decisive, often leading to more indeterminate classifications, that is, neither accepting nor rejecting a candidate. On the one hand, a systematic approach makes the investment problem more tractable while on the other the discretionary approach makes it more purposeful. Some investors take the view that their capital should animate social, environmental and corporate governance improvement and so favour the integrated approach. This necessitates the use of some impact metrics to validate the thesis. For most investors, some combination of the systematic and the discretionary approaches is useful. There will be type I and II errors but there are sufficient investment opportunities that some level of waste is acceptable. 

Measuring impact is hard to do. If one is borrowing impact metric measurement to augment their ESG program, it is important to be able to measure this impact. This is doubly important since our interest is ultimately not the impact itself, but its information content as regards the financial outcome. How do we know that the impact metric we are interested in has real impact on financial outcome, whether as a driver or a risk mitigant? This requires good econometrics. It also brings to the fore the problem of gestation. The investment community is focused on measurement, which is understandable, but often is unaware of the gestation periods between decision and result. In public markets, the availability of daily prices encourages very short-term expectations. Private markets dearth of pricing data encourages longer term expectations. In the area of non-financial impact, the lag between action and result can be considerable. In climate change for example, the consequences of current behaviour can manifest over decades. The desire for better and higher frequency data can encourage short termism. Also, the complex relationships in non-financial metrics require careful model specification, a problem compounded by the financial industry having a patchy track record in theoretical rigour. Impact measurement is an area ripe for further research. 

Common sense is not so common. There is sometimes a lack of common sense in investment management. The narrow focus on profit can lead to tunnel vision. Complexity replaces simplicity. Conventions which may be irrational persist due to investor inertia. Many ESG factors and considerations are a matter of common sense and not some specialized analytical lens. Many impact goals would evidently reward an investor seeking to address them since they address a present need. If there are persistent gaps and adverse outcomes, they are often due to market failures. Solving these market failures is more efficient than addressing the gaps and adverse outcomes. In fact, such gaps and micro failures can be outright profit opportunities to private capital willing to provide a solution. This raises the question faced by many a for-profit organization. Fix the problem once and for all, or provide analgesics for ever, bringing us back to the question of purpose.