Once upon a time, there was a Thai philanthropist who funded a program in Africa which paid for the education of the poor. One of the beneficiaries of this funding program, a young physicist barely out of their teens, discovers a new physics, a new way of characterising, describing and understanding reality. From this new physics, they realise a way to achieve low cost, in more than monetary terms, energy, in the form of fusion, facilitated by coopting another fundamental force that surmounts the electrostatic resistance to fusion. The result is a power generator that is compact and cheap to fuel, and manage. Construction, though, is complicated and takes time.

The young scientist takes their invention to their benefactor, realising that what they’ve made is not so much an invention as a discovery and therefore a public resource. Together, they realise that there is significant political and expropriation risk. To mitigate this, they decide that the technology has to be housed in a company that is owned by a foundation whose governance will resist the forces of cynicism and self interest. Gravitas LLC.

Gravitas would be owned by the WC Foundation. The trustees of the foundation would be representatives from the world’s poorest nations. When a nation grew out of poverty, such representatives would have to resign and be replaced. The WC Foundation would provide governance and strategic direction to Gravitas while delegating the day to day management of the business to professional management.

Gravitas began to supply reactors to countries based first on their need and their relative poverty, with the rich developed world at the end of the queue. The complicated manufacturing process meant a considerable queue and significant waiting times. However, operational reactors were powerful enough that many clients of the first reactors were able to export power, at a price. Gravitas itself was run at modest profit margins to feed the foundation and its grant budgets, but never to enrich itself beyond modest return on equity thresholds.

Understandably, industrial espionage, lobbying and coercion, not to mention direct threats were rife. The reactor design, however, made re-engineering impossible. The reactor chamber was a vacuum with no moving parts and indeed nothing inside it. Whatever processes were at play when the reactor was operating disappeared when the reactor chamber was dismantled. Attempts to scan the reactor while at rest showed little while attempts to scan it in operation led to instantaneous reactor shutdown. Somehow, at a fundamental level, the reaction itself was shy, and evaded scrutiny.

It was important to the inventor of the reactor and the new science to distance themselves from the business and the technology for their own safety. Hence all commercial interests and intellectual property was transferred to the company and away from the inventor so that they no longer had any influence on the conduct of business of Gravitas. It was not enough that the technology might be obtained from the company but may be re-created by the inventor so the inventor lived the rest of their life in fear and under high security, a surely dreadful fate for a young and intelligent soul who had brought so much to a world that had been burning the furniture and indeed the walls and foundations of its house to fuel its energy needs.

AI, so topical in the mid 2020s, was aimed at trying to replicate this technology could only look on in wonder and return a verdict that “it’s a kind of magic.”

Each force or interaction is a topological space.

The interaction between two or more spaces produces physical properties such as charge and mass.

The observation space is a factor in how matter and interactions manifest.

Each space is induced by the physical matter it manifests.

The angular displacement between two or more spaces influences the physical properties of matter. The angular displacement of the observation space is similarly a factor.

The speed of light is an absolute limit within a space. The intersection between two spaces can manifest at speeds beyond the speed of light.

The purpose of blended finance is to attract capital to impact investing by pooling risk and then redistributing it in such a way that it addresses the financial and impact objectives of various investor types.

Philanthropic capital is relatively scarce compared with financial capital. To attract more capital, of all types, to fund impact investments, the blended finance design has to leverage the philanthropic capital so as to create investment products that appeal to the purely financial investor who may have no interest in the impact objectives.

A blended finance structure should therefore have a tranche that appeals to philanthropic investors that is junior so as to de-risk senior tranches which might appeal to purely commercial investors. Very likely, the returns of this equity or first loss tranche will not be as high as one would expect from the same tranche in a purely commercial structured finance vehicle. The risk return of this philanthropic first loss tranche would be, more return with a lot more risk.

The purely commercial tranche might be in the mezzanine tranche which would be designed to yield or return as much as an investment of similar risk. This tranche would be aimed at non-philanthropic investors who expect a market rate of return for the relevant risk.

An idea would be to have a philanthropic senior tranche aimed at philanthropists who would provide cheap (or free) funding to the structure.

Inflation has dominated investors’ attention since 2021. In 2023, core inflation cooled from 6.6% to 4.0%, a significant move yet well above the 2.0% target of the Federal Reserve. Meanwhile, the Fed raised rates 4 times from 4.50% to 5.50% and while it signaled that market expectations for rate cuts in 2024 might be premature, investors had begun to place bets on such rate cuts and bought up equities. Equities (MSCI World) are up almost 18% while bonds (Global Aggregate) are up almost 2% with a month to go to the year end.

At the end of 2022, we made some predictions as to what the economy would look like not just in 2023 but into the future. In summary, they were:

• Inflation would be structurally higher.
• Economic growth would be structurally higher.
• Such economic growth would be more inclusive and of higher quality.

See: Ten Seconds Into The Future 2023 Outlook for details.

We still hold these views. Let’s reiterate the reasons why.

• Inflation will be structurally higher:

  • China demographic dividend fading.
  • Near-shoring is less efficient than specialisation and trade.
  • Climate crisis mitigation and adaptation investment.

• Economic growth will be structurally higher and more inclusive.

  • Constrained monetary policy and increasing expansionary fiscal policy.
  • Net transfers from rich to poor, from capital to labour, from corporates to households.
  • Less inequality leads to lower savings rates and more consumption.

These are long term dynamics. In the shorter term the picture is complicated.

Recession

In 2023/2024, we may already be experiencing recession. However, as investment in near-shoring and climate crisis mitigation accelerates, national income accounts are flattered even as some segments, such as manufacturing, fall into recession. Europe is most vulnerable to tight monetary policy and is already in recession. The US is also in a manufacturing recession with non-manufacturing just hanging on to expansion. China’s economy is suffering from a property bust which threatens financial contagion and has already substantially dampened consumer and business sentiment. India is a bright spot among the larger economies and continues to show expansion in services and manufacturing.

Interest Rates

Going purely on the economics, we expect interest rates to rise.

• Inflation to settle at a higher equilibrium level.
• Fiscal policy to remain expansionary.
• Increased demand for capital from investment from supply chain near-shoring and climate crisis mitigation.

However, one has to consider the consequences of simply holding rates where they are.

• Recession already underway.
• Cost of debt has yet to increase as corporates have termed out liabilities.

Regionally.

• Europe. The ECB is likely to have to begin cutting rates sooner than the US Federal Reserve. Financial conditions are already tight, inflation is falling due to recession and the economy is less robust and able to withstand higher debt costs.
• The US economy is more robust against higher debt costs with less reliance on bank funding.

Bottom Line.

There are a couple of moving parts to this, inflation and the term premium. Currently, yield curves are still inverted albeit less than they were a year ago.  2 year UST rates are 4.60% with CPI at 3.20% for a real rate of 1.40%. Assuming inflation is sticky at 3.20% and a reasonable real 2Y UST rate of 1.00%, this suggests the nominal 2Y could trade to 4.20%.

If the 10 year UST trades 0.50% higher than the 2 year, that implies a nominal 10 year rate of 4.70%. (It trades at 4.25% today).

2 year bund rates are 2.70% with Euro CPI at 2.90% for a real rate of -0.20%. The market has surely moved ahead of the ECB and brought real rates back into negative territory. This could stay the hand of the ECB from any rate cut expectations in 2024. Assuming inflation settles into the 2.20% range (job done for the ECB), and a reasonable real 2Y bund rate of -0.60%, this suggests the nominal 2Y bund could trade at 1.60%. Assuming a 2-10 spread of 0.25% puts the 10 year bund at 1.85%. (It trades at 2.36% today).

Equities

The S&P500 has returned 10.8% per annum since 1970, 11.6% since 1980, 10.2% since 1990, 7.1% since 2000, 13.2% since 2010. US equity valuations are high relative to history. It is reasonable to expect that returns will be lower from here on for the next 10 years; we expect 5%-7% is a reasonable range, all things being equal. Much depends on the path of interest rates discussed above. If rates play out as above, equity returns while modest can be sustained. If rates rise beyond the above then expect equity returns to be lower and more volatile. If, however, rates moderate further, then equity returns could be higher.

Credit

Credit spreads are thin and do not appear to be pricing economic fundamentals. This can change quickly as markets tend to overreact to noise as much as signal. There is a persistent complexity premium to be earned in markets like structured credit and securitisation, and strategies like solution capital and distress. It’s also an interesting landscape for investors who can trade the evolution of relative value between credit sub-markets. The long only buy and hold, or more accurately buy and hope strategy is going to be fraught.

Duration is another area of macro risk exposure that is sometimes ignored as investors hug benchmarks for comfort. Duration will be a tricky bet this year for a number of reasons. One, while inflation may be receding, central banks are unsure if this is durable or transitory. The focus on duration in the last two years have led markets to second guess central banks leading to overreactions to central bank signals. Central banks are increasingly high frequency data dependent which in turn leads to confusing signalling to the market. And finally, the complexity of the economy and financial plumbing make modelling and policy highly uncertain.

Blended finance is an efficient mechanism for intermediating capital in impact investing. There is scope for further development. 

An important innovation would be to establish a correspondence between impact (shortfall) risk and credit risk. This would require a generally accepted standard and framework for measuring and analysing impact metrics with a view to translating such data into commercial or financial risk, namely the risk of outcome payers not funding. 

Better understanding of credit risk in a portfolio of impact investments allows us to design richer capital structures to better satisfy investor risk appetites. In particular, the ability to obtain credit ratings on mezzanine and senior tranches would increase accessibility to larger pools of investor capital. 

Credit ratings would widen the market for blended finance. Adding improved liquidity would go further in attracting more capital. 

The role of government in blended finance represents a significant opportunity. In the US the mortgage agencies encourage private capital to fund what is regarded as a public good, namely, shelter for the masses. 

As climate crisis mitigation and social equality are public goods, there is a case for supporting them with policy and public capital. 

A Government Sponsored Sustainability Agency suitably capitalised could, securitise impact investments, make markets in certain liabilities and retain such risks as are considered important to the social agenda.