Everything we do, our consumption, or work, our investments, our private, social and professional behavior, has an impact on everything else, whether we are aware of it or not. Every investor is already an impact investor, the question is whether they are consciously doing so in a responsible way or not.

The microscopic impact investment goals are well known. How much can we reduce poverty by, how many more mouths can we feed, how many people can we keep healthy, how many minds can we educate, how can we promote racial and gender equality, how can we power the world without destroying it, how can we get more people to work and consume, how do we build an equitable society, maintain and preserve our habitat, and promote collaboration amongst all peoples.

There are macroscopic impact goals as well. To see what they are we need a clearer view of what existence is and means, and the place of sentient beings within this ecosystem. The primal essence of existence is information. The whole of existence is not only information but the processing of it to achieve progress, learning, wisdom.

Each sentient being represents consciousness which can be thought of as collections of information that are self-aware, to varying degrees. Humans occupy a high position in the ordering of consciousnesses. We can store and process more information than most other living things. Yet even human beings are subject to severe limitations in intelligence and wisdom. We are the zoological analog of neurons, or transistors. We have limited knowledge of general conditions around us, limited access to information, and limited information processing power. We are not even sure as to our greater purpose in life. We have been endowed with certain abilities, limitations and impulses. We seek fulfilment and purpose to flourish yet know not our precise purpose. We resemble transistors in a microchip. If the purpose of the microchip or computer is to solve some macro problem, it is the purpose of the transistor to solve a part of the problem and transmit the result on to other transistors.

Humans therefore have a duty to receive information, in all its forms direct and indirect, process it, and transmit it, by our thoughts and actions. The collective action of humans in this endeavor serves the greater purpose, even if that purpose eludes the individual. We are therefore duty bound to behave rationally and collaboratively. This is hard because rationality is not well defined or unique.

If we accept that our role is the processing of information, certain macroscopic impact goals present themselves. To obtain information, we must both actively seek it as well as be open to its receipt. To process information, we must have learning. To transmit the information post processing, we must be responsible. To be efficient and effective, we must collaborate. To collaborate requires humility and a recognition that we are one of a multitude of transistors.

Obtaining information involves learning, obtaining and retaining facts and data. It requires curiosity. The quality of output is highly dependent on the quality of input so obtaining high quality information, ensuring it has sufficient content, is not contaminated, is relevant and unbiased, is important.

Processing information requires that we develop and constantly upgrade an efficient program. This involves a lifetime of continual learning. The output of this program is how we react to all external stimuli, the general conditions that surround us. Our actions form part of the input for others, perpetuating a chain of information processing that permeates all consciousnesses.

All this sounds theoretical and impractical, yet these concepts can inform a set of principles by which to invest.

Investors need to invest in knowledge and fact. One must always know what one is investing in. One needs sufficient and high-quality information to make sound decisions. Information which is highly concentrated and multi-collinear is less informative than diverse and independent data. Information needs to be taken in context; some information exhibits different behavior under different regimes and such artefacts need to be considered in the processing of the information. Basically, this just means that one must have as much of the facts that one can get, that the facts are not simply repetitions of the same, and that the facts are taken in context. The obtaining of information has to be circumspect. Too little data and the conclusion will be unstable. Too much information risks a false sense of security surrounding conclusions. Taking information out of context also impairs the reliability of conclusions.

The best investment is in rigorous understanding. Investors need to understand how the economy functions and how businesses and assets are priced. This has its bases in economic theory, finance, and behavioral science. In addition, common sense is an oft-overlooked ingredient in the recipe. Armed with the ability to make sense of the information before them, the investor is better able to make rational decisions on what to buy or sell.

Some industries appear contrary to the well-being of humanity; should the responsible investor fund them? Tobacco, gambling, munitions, alcohol are potentially detrimental to well-being. What about high fashion which feeds vanity, or travel which has a high carbon footprint and can hurt certain habitats and communities, or pharmaceuticals which charge exorbitantly for their drugs? Is technology a bane or boon? Will robots replace or augment?

The impact of our actions may be unpredictable, their net effects indeterminate for years to come. Many impact investors demand measurable impact in short time frames. We can only guess at some of the impact our actions will have, a year or decade or a century into the future. Decision making under such uncertainty, amplified by the long time frames is difficult and humbling. Intractability may discourage action, which is itself a negative impact. Often, life presents us with tradeoffs and asks that we balance the costs and benefits as best we can. The optimal solutions are known only far in the future. The best we can do, it to be mindful of our actions, to collect information assiduously, process it thoughtfully, and to act responsibly. If we do so, we will have as good an impact as can reasonably be expected.

Micro-goals can be pursued more specifically but even these can sometimes suffer from unintended consequences and adverse selection. Some of the UN’s 17 Sustainable Development Goals are mutually incompatible in specific contexts. The cost of carbon emission reduction may be a price too high for certain less developed countries and would result in negative social and economic outcomes. Hydroelectric renewable energy displacing communities, responsible labour practices impair household income and employment, price controls in pharmaceuticals depriving R&D budgets, are examples of the complex relationships in societies.

Another issue is that measurement has its limitations. Campbell’s Law states: “The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.” Goodhart’s Law states: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” These and the Lucas Critique are warnings that goal setting in impact investing is not easy and that sharply defined impact metrics can have unintended consequences.

These limitations and difficulties should not discourage us from investing responsibly or consciously. It means that we have to do the best we can, a vague principle but one that can guide our methods.

To invest responsibly, we should do so in an informed way, which means data collection. To collect data, we first have to know what is important to us. Investors seek to make money, so the financial rationale is the central objective. However, the investor should also determine all those other factors that are important to them. Environment, Social and Governance factors are one classification which has made responsible investing more systematic. Conceptually, the investor should consider all the impacts that their actions can have, from the environmental, social, political, physical and economic. A mental or systematic appraisal of a course of action should consider if that action has positive or negative consequences to these factors. Sometimes it will be possible to clearly define and measure this impact, and other times, it will be difficult, and a qualitative and subjective determination will have to be made. Once all these objectives are defined, the nature of the data required to make these determinations will be better understood and the investor can proceed. Understanding the priority and tractability of the objectives also puts the data in context and improves data collection advising when precision is required and when a rough sense will do. Inappropriate prioritization of data can confound analysis as much as insufficient data.

Analysis and decision making requires understanding the underlying relationships and interactions represented by the information. The analysis should always begin with an exploratory approach rather than seeking to justify preconceptions. Even so, biases are inevitable and should be recognized so that results can be understood in context. An exploratory approach can either be structured where a theory is being tested, or it can be strongly exploratory where a theory is sought. It can be parsimonious (start narrow and widen) or it can be comprehensive (start wide and focus.)

For the responsible investor, those non-financial objectives will need to be considered. The consequences of the profit optimizing solution on the environment, society, economy and on the investor themselves, needs to be considered. It will not always be possible to have a positive impact on all factors, or indeed on the majority of them. Prioritization and judgment are important. Most important of all is that the investor is behaving conscionably, diligently and honestly. That honesty is very important and regards an awareness of one’s own limitations and the limitations of the operating conditions.

 

Some principles (including some general, non-impact specific comments):

• Recognize that balance is central in decision making. Processing information under uncertainty invariably requires balance.
• Make as much money as possible, but sustainably over long horizons. Successful investors are efficient processors of information. Financial success increases capital and thus the strength of signal from such investors. If you are also a philanthropist, you can always give it away.
• Realize the trade-off between efficiency and stability.
• Have a net positive impact across environmental, social and economic goals, minimizing damage and maximizing benefit.
• Have all the relevant facts and recognize which ones are more important than others. Spurious and over-analysis reduces the informational efficiency of the system.
• Recognize that one’s actions are a source of information for all agents in the system (oneself included) and avoid actions which might reduce or impair the informational efficiency of the economy.
• It is possible to bootstrap this informational process by taking actions to send information to oneself.
• Avoid over paying for assets simply because other agents are doing so.
• Avoid hoarding liquidity when the economy may require it.
• Arbitrage reduces arbitrage opportunity and thus improves information efficiency.
• Diversity of information is a good. Introducing diversity is the basis of contrarian investing. When informational diversity already exists, the benefit of adding to it is reduced.
• Crowded trades reduce informational efficiency.
• Analysis without action impairs the informational efficiency of the system.
• Emotions are a source of information, but should be processed rationally. The emotions of others can be mined if one is not similarly emotional. One’s own emotions are more difficult to process given their self-referential nature.

 

Thus the investor may invest with positive impact, always acting with mindfulness, cognizant of known unknowns and unknown unknowns, and never acting carelessly or neglecting the greater purpose. These principles may appear to be general and lack specific impact objectives, but they encourage the efficient processing and transmission of information, which is an important macroscopic impact objective. 

 

 

 

The Outlook Under The Shadow of COVID 19

7 Apr 2020

 

How is 2020 different from 2008?

2008 was a US housing crisis distributed globally by the banking system.

US housing was overvalued and over leveraged. The mortgages they supported had weak underwriting and credit standards. Banks from Europe and Asia had entered the US market and were thus exposed. The resultant housing market crash led to a banking crisis which led to a credit squeeze causing an acute recession.

2020 is a massively distributed, spontaneous economic shutdown caused by a virus pandemic.

Most assets are overvalued. Corporate assets from equities to bonds to commercial and industrial real estate are over leveraged. The exception this time is the banking system which has spent the last 12 years in rehab and are thus stronger than the non-financial corporate sector.

In 2008, the prescription was to save the banks and to restore the credit transmission system. The alternative credit conduits were the bond, loan and ABS markets. It was important, therefore, not only that interest rates were low at the short end but across the curve as well. Also, investors had to be encouraged to increase their risk appetite and move down in credit quality. Enter QE and financial repression. Once credit transmission was restored, the economy would heal itself. It did, to a point.

The 2020 recession will require different medicine. Failure to withdraw QE once the economy had recovered from 2008 has meant less capacity and efficacy of additional monetary stimulus. The nature of the problem also presents challenges to even conventionally unconventional monetary policy. Such policy was designed to address a failure in the credit distribution system. But either a) the non-bank credit infrastructure is breaking, and the old policies are useful for restoring it but no more, or b) it is not breaking and policy is in a sense wasted. The complacency of people and markets have resulted in a shockingly fast sell off that has threatened the functioning of the credit markets from treasuries to commercial paper, from corporate bonds to mortgage bonds, from loans to structured credit, and from high yield to investment grade. The Fed has stepped in to do what it can, and it has had to prioritize to minimize moral hazard. Avoiding it altogether is impractical. The result is that by early April, a month from the steepest market corrections, and albeit rather shakily, the non-bank credit system is functioning.

The 2020 COVID 19 pandemic prevents people from working and spending. Restoring some normalcy will require the invention of a cure, a vaccine or an organizational change to how we live our lives. We do not have much visibility into any of these 3 avenues. The current approach appears to be to limit the spread of the virus by reducing the opportunity for contagion. This severely limits the ability for people to work or spend. People who are unable to leave their homes and socialize cannot consume as before. This represents a large-scale reduction in demand which puts strains on business and threatens large-scale unemployment. This has already begun with jobless claims in the US reaching almost 7 million at last count. The same physical constraints on mobility limits the ability of people to go to work resulting in a significant supply shock. Absent exogenous shocks, demand and supply deficiency means recession and an uncertain inflation outlook.

Many countries have begun massive fiscal stimulus programs. These include some form of universal basic income paid directly or indirectly via businesses. On balance, this is inflationary and can lead to FX volatility.

 

Is there hope?

Human ingenuity is a powerful thing and it is likely that a solution to the COVID 19 virus will be found as well.

Even before the virus is tamed, people will find new ways to live their lives. Humans have been reminded that pandemics recur and that there will always be a new disease and challenge. People will have to find new ways to work, to consume and to interact with one another.

In 2019, there were many instances of social discord: Gilet Jaunes in France, anti-extradition protests in Hong Kong, pro-independence in Catalonia, tax protests in Lebanon and Brexit. The world was clearly divided, to a great extent due to inequality. Adversity has been known to unite people, and COVID 19 is a global blight afflicting everyone. There is an opportunity here.

China may extend aid, financial and technical, to the rest of the world given its relative success at containing the pandemic. It may take advantage of America’s isolationism and nationalism to advance an agenda of engagement with the rest of the world.

Europe. A monetary union without fiscal union was unusual. The massive fiscal stimulus programs launched at the national level will place countries balance sheets under differential stress which will manifest in sovereign spreads. This may encourage Europe to consider a fiscal union.

Environmental and social factors may be prioritized in development and investment. Unrestricted development can be risky with unforeseen consequences. The destruction of natural habitats leads to closer interaction with new species often allowing a pathogen to migrate to human hosts. This is the likely path of COVID 19. Perhaps the pandemic may encourage more thoughtful development strategy.

President Trump’s clumsy management of the COVID 19 pandemic in America may see him replaced by a more thoughtful and moderate President who can turn the considerable resources of the US to more constructive engagement of the rest of the world.

 

What are the risks and challenges?

Adversity presents humans with two choices, unite to overcome that adversity, or pursue a selfish, isolationist policy.

In all major upheavals there are winners and losers. Millions of jobs have been lost around the world and many of these will not come back. Millions will have to adapt, and not all successfully. The cost of welfare will rise substantially straining public finances. The social implications could be serious and could lead to political turmoil.

America faces a Presidential election in November. There is a chance that the incumbent Trump may try to delay or disrupt the election on account of the COVID 19 pandemic.

Europe’s fiscal stimulus may encourage some member states to seek a fiscal union which other members may be reluctant to fund.

The existing competitive tensions between China and the US are a risky backdrop to geopolitics. America may use COVID 19 as an excuse for confrontation by seeking to pin the blame on China. This scenario may spawn other difficult scenarios.

Many developing nations are ill-equipped to deal with the economic fallout from the COVID 19 pandemic. Sovereign defaults and devaluations could destabilize economies and regimes.

Economic support programs are dealing with a problem which is hard to measure. The initial programs dealt with liquidity and cash flow needs. They are also reacting to the human cost of the pandemic and extrapolating to the economic cost. Subsequent stimulus will need to be calibrated to deal with the recession. Macro data is too low frequency to be an effective guide.

Massive monetary and fiscal stimuli to support demand while supply constraints persist could lead to high inflation while having limited impact on demand.

Crises that involve massive fiscal and monetary stimuli often precipitate rethinking of currency systems, such as the Bretton Woods system in the aftermath of WWII.

 

What are the opportunities and threats?

The scale of the economic crisis could encourage a rethink about how people live, how production is organized and the nature of constructs such as money, or companies, or economic systems.

We might already live in a post scarcity world. Here we define post scarcity to mean that we have the means to satisfy all human needs, not wants. Nothing can satisfy all human wants except a radical change in mindsets. The problem could lie in that we do not yet live in a post monetary world. We have all we need but the claims on these things have been poorly distributed leading to poverty and surfeit. How do we get from current conditions to those post scarcity conditions?

The massive printing of money may render the stuff worthless. Yet we do not know how to organize an economy without money. When major currencies begin to lose value alternatives may be sought. A currency that discourages hoarding might be useful. This might be effected by issuing a digital currency with a maturity limit on legal tender, for example.

Humans are adaptable and will find workarounds to live through the COVID 19 pandemic. Some of these workarounds will become a normal part of life as we emerge from the pandemic. Humans require food, shelter, interaction, entertainment and work. Essential supply chains will need to be made more robust through redundancy and compartmentalization.

Technology and automation can help. On the demand side, online shopping has already made serious inroads in replacing brick and mortar retail. Some goods and services do not lend themselves to online transactions. Travel, F&B and other experiential services are examples. Technological solutions such as augmented and virtual reality may present alternatives. Delivery will evolve as well from manned to unmanned drones. Manned delivery might well become a luxury.

Manufacturing will be increasingly automated with the displacement of labour. Smarter AI and more generally applicable automata will make factories even more automated with less and less human intervention.

There will be significant changes in real estate. Already, people are discovering that they can be effective working at home. The demand for commercial real estate will likely not recovery pre pandemic levels. Residential real estate will be priced not as much for proximity to cities and work, but to recreation and natural features like rivers, parks and hills. Population density will become a factor. Industrial and logistics real estate will also see change as manufacturing and distribution dynamics change.

 

What are the practical implications for investing?

We now know how quickly the virus can spread and how dangerous it is. In that knowledge we have reacted by shutting down swathes of the economy on a global scale. This suppression is working at slowing the spread of the virus and case numbers are already beginning to slow. Some countries are even considering relaxing physical distancing measures. However, we do not know at what level we can operate the economy without allowing the virus to resume its spread. We do not know how quickly we can restart the economy.

Financial markets reacted to the initial shock by selling off acutely, at a pace comparable to 1929 and 1987. Fortunately, governments responded with massive stimulus and relief programs worth trillions of dollars. This has restored some order to the markets and even prompted a sharp recovery in certain more liquid, retail accessible and sentiment sensitive markets like public equities and bonds.

Less liquid and more leveraged structured credit markets such as CLOs and ABS have seen prices fall more acutely to levels which suggest they might offer value.

It has only been less than 2 months since markets began to take the COVID 19 pandemic seriously. The future of the global economy remains very clouded and there is much we do not know. It is likely that emergency financial aid continues for the foreseeable future, until either the economy stabilizes, or a sovereign balance sheet breaks. It is likely that unemployment will be persistently higher as some industries fail to fully recover. It is likely that the economy is already in recession and that such recession will persist for another 2 to 3 quarters. It is possible that such recession lasts longer than that. It is likely that growth will not regain pre pandemic levels for some length of time.

The outlook for earnings growth is therefore negative and uncertain. The ability to forecast cash flows for any length into the future is poor. Therefore, for long duration assets or equities, valuations need to be significantly discounted. Shorter maturity assets less reliant on long horizon forecasting are preferred.

 

Summary:

Equities are probably cheap, except that visibility of earnings is very poor, and its hard to discount cash flows that are unpredictable into the distant future. That said, equities have the most volatility when it comes to recovery. Then its probably prudent to await clearer signs of recovery and miss the first days of recovery, which are more of speculative than investment.

IG bonds are probably cheap, and visibility or cash flows is average to poor. The duration that comes with IG bonds may not be an effective hedge if inflation flares up.

HY bonds are fair on a default and recovery adjusted basis. Cash flow visibility is very poor and the defaults have yet to even begin.

Mortgage Backed Securities. This is not a single market but a spectrum of them from agency to non-agency, from IG to HY. The price declines generally across all submarkets of ABS suggests that there is some real value here. Automatic, systematic selling due to deleveraging or ratings limitations have led to indiscriminate selling and assets trading below fairly draconian economic assumptions. Investors need to calibrate their allocations to their convictions.

Syndicated loans. Loans are probably cheap with fairly good visibility to cash flows. There will be downgrades and defaults but market pricing is assuming very severe default and recovery assumptions relative to historical experience and underlying economic prognoses.

CLOs are an interesting structure over syndicated loans. These have also been the subject of automatic, systematic, rules based selling which has led to dislocated prices. Current pricing also implies very draconian default and recovery assumptions. IG CLOs have fairly predictable cash flows and are attractively priced. HY CLOs and CLO equity are also very attractively priced but are subject to very uncertain cash flows and are likely an opportunity for later in the cycle of this crisis.

Distressed opportunities such as traditional corporate distressed investing, chapter 7 and 11 solutions, are probably an opportunity for later. The proliferation of covenant lite debt will delay actual default until non-payment which is likely to come 2 to 3 quarters later. This has the potential to be a multi-year opportunity to rescue some fine, viable operating business which had over leveraged themselves in the decade of cheap debt.

Private market opportunities will be dealt with separately in another post.

 

Even assuming one had lots of cash to invest, its not easy. Liquid markets like equities and bonds are volatile and sentiment driven. There may be a quick recovery or another leg to the crisis. A more tractable approach is to seek structural instabilities. We seek opportunities in the shadow banking system, especially those parts which may be over-levered. Private credit is one area of opportunity where more recent vintages were levered and vulnerable to unwinding. Weak structures can provide a supply of cheap assets and weak LPs a source of cheap secondaries. Structured credit (CLOs, MBS, BDCs and mREITs) is another area where lack of liquidity, over-optimistic pricing, and ratings driven investors conspire to cheapen these asset classes well beyond their fair value even under draconian economic assumptions. It is tempting to trade the more liquid and volatile equities markets for recovery but the speed and uncertainty of price discovery makes this very risky. A longer term investment strategy should look for a more sustainable supply of cheap assets which can be tapped for months and years and this would target the private markets.

 

Contagion

At the time of writing, the COVID 19 pandemic is well underway. At the end of January, there were almost 12 thousand cases, mostly in China. Now, just two months later, there are over 150 thousand cases, with the highest growth rates outside China.

After China, Europe has become the new focus of contagion. This is probably because they were complacent, and also because of poor detection in Africa and Central Asia where COVID 19 is likely to have already taken root and may be more widespread than Europe. That said, containment measures in Europe should slow the virus in the next month, perhaps less.

The situation in the US is less predictable. There is remarkable complacency and data is noisy.

The infection rate has been about 60 in a million in China with similar numbers in Europe. In China the number has stabilized but in Europe it continues to grow. Given the differences in containment, the number in Europe is likely to rise faster than in China. Infection rates in both countries will rise over time. In the US the number is 8 in a million.

COVID 19 is different from the flu. It is deadlier, as data attest, killing between 1% to 4% of the infected. It may be more contagious given that it is infectious 2 to 3 weeks before symptoms show.

 

Economic consequences

Our response to COVID 19 is also different from our response to the flu. China was in lockdown for several weeks and is only just restarting its economy, and only gingerly. Europe has begun to undertake serious measures at containment. The US will soon accelerate efforts to prevent the spread of the virus. These containment measures have an economic cost.

More countries will impose travel restrictions, more people will avoid travel. Events such as cinema, theatre, concerts, spectator sports, conventions, et al have been postponed or cancelled. Lockdowns and restrictions on movements will impair retail, food and beverage industries. Manufacturing supply chains will be impaired as workers are quarantined, isolated or their mobility curtailed.

Industry is not a perfectly frictionless process. Shutting down production may not be instantaneous but require safety checks and phased shut downs. Re starting is even more difficult and may require longer periods to achieve capacity. Complex supply chains will require coordination further delaying full capacity.

The economic impact of COVID 19 has become evident. Recession risk has risen substantially and financial markets have begun to attempt to price this risk. The current volatility in markets is indicative of the uncertainty surrounding this pricing.

 

Policy responses

Central banks have begun monetary stimulus. The People’s Bank of China has cut reserve requirements and interest rates while providing loans to the economy. The Fed has made 2 inter FOMC meeting rate cuts of 50 and 100 basis points and has resumed bond buying to the tune of 700 billion dollars as well as making loans to the economy. Central banks across the globe will be resuming the stimulus policies of a decade ago to fight the economic slowdown.

Fiscal policy will be engaged to shore up demand. China and Britain have already announced large spending programs to boost the economy.

 

What happens now?

The hopeful scenario is that the virus becomes contained and burns itself out, or we find a vaccine or a cure.

At the same time countries reopen their borders and restart their economies. There is a sharp recovery in activity and the world reverts to the condition it was in before COVID 19.

Even under this scenario, some things will be different. The economy and industry will no longer be run purely for efficiency but for robustness as well, for stability. This means more redundancy and in supply chains, more slack in the system, a greater consideration for safety. ESG factors will become more important. The result will be a slightly less efficient world, but one more resilient against unexpected set backs.

The bad scenario is that no lasting solution to the virus is found and our lives become permanently disrupted. Life will adjust to the new reality but we end up losing some of the conveniences and freedoms we took for granted.

The policies we deploy such as monetary easing may be ineffective. They either pump up asset prices once again without material impact on the real economy, on employment or incomes, or, they don’t even shore up asset prices.

In our pivot from efficiency to robustness, the long term equilibrium levels of investment and consumption are lower and growth settles at a lower rate. At the same time inflation rises as supply chains lose efficiency.

 

Risks

QE exacerbates inequality. In 2019 there were over 20 instances of civil unrest, potentially driven directly or tangentially by inequality, of wealth, income, access, influence or power. The application of more QE could be a tipping point.

Inequality also manifests as a healthcare apartheid. The rich have access to quality healthcare, the poor do not.

Debt levels in the world are high. The leverage has built up in the corporate and sovereign sectors. A contraction in demand could lead to serious deterioration of corporate balance sheets. Even if policies to help alleviate corporate stress are deployed, businesses may decide to reduce debt which would mean slower investment and employment growth.

In a crisis, the strong are co-opted to aid the weak. The banking system, the private commercial banks were strengthened by force of regulation over the last decade. While the risk of financial contagion is now low, a de facto nationalisation could be effected to co-opt the banks into rescuing the economy.