2020 has until now been a good year for investment across the board, from government bonds to equities. This provides further support for the economy via low rates for financing and positive wealth effects supporting consumption and thereby the ongoing global recovery. Unfortunately, it is unlikely that the good times for both bonds and equities can continue uninterrupted. What worked in 2020 is therefore unlikely to work again in 2021. This can be seen in the bond market, where a spectacular first half of the year has been followed by 6 months of virtually no return on USD Government bonds (see Figure 1). So, while equities are likely to do well in coming decades as they have done for the last 120 years, the future is more likely, to resemble the last 20 years than the last 20 months. The Y shaped market recovery this year was based on an unusual consensus reached under unusual circumstances. The next crisis is likely to be as messy as those of previous decades.
In this context we see the nomination of Janet Yellen as a positive stabilizing factor for the US economy and we expect her to show a solid commitment to QE and the associated support programs financed by the Treasury and executed by the Fed, what we call QE+. We expect that this will lead her to support unofficial and, if needed, official yield control, so we are not arguing that bonds will sell off dramatically. We do note that it does not take much for returns to turn unattractive, as they proved to be when Yellen chaired the FOMC from 2014-18. We also note that the more leverage is built up in the system the further equities can fall when the ongoing recovery ends. With monetary and fiscal policy stretched this means that a buy and hold strategy in equities is likely to prove more painful than in recent years.
For various reasons we have not been publishing on the topic of ESG and Impact investing since we co-authored the "Allocating for Impact" report for the G8 in 2014. Based on the latest upgrades to our portfolio construction system and the application of additional data sets, we are now able to measure ESG performance on aggregate portfolio levels. As an example, we present a "Sustainable" alternative to a traditional equity portfolio with a 50%+ reduction in CO2 emission per USD 1 million in revenue and significantly higher "green revenues". This portfolio has outperformed MSCI world and S&P 500 over recent years. In coming months, we will be adding measurements of ESG and Impact and welcome feedback on our ongoing work on improving our Sustainability Matrix.
Chinese macro data continue to show improving momentum and the Chinese leadership is signalling ongoing commitment to the transition to a more sustainable economic growth model. Also, the US consumer and corporate earnings continue to recover and the first shots of Covid vaccine are being administered. We therefore expect the nascent global recovery will prove sustainable and remains overweight sub-investment grade credit and equity markets. Specifically:
➢ In our systematic allocation strategies, we remain fully invested in equities and after adding an allocation to emerging market equities, the associated ACICI SA fund is up 19% over the last 6 months. ➢ In the multi-asset mandates and funds, we maintain a full allocation to equities of respectively 50%-60%, dependent on restrictions. In these funds and mandates we also have a 30% allocation to high yield bonds. ➢ In our Global Fixed Income Opportunities Mandates we hold an unchanged allocation of 80% high yield bonds and 20% emerging market debt. In the ACCI GFO fund the allocation is now split between 90% High Yield bonds and 5% in each of EMBI and CEMBI bonds. The fund is up 7% over the recent 6 months.
Yellen, interest rates and the ongoing profit recovery:
The first half of 2020 saw great returns in high grade bonds; the recent six months have seen virtually no return at all on the US Aggregate bond index and negative return on US treasuries. In Figure 1, this is exemplified by a low-cost ETF holding a basked of medium treasuries (iShares 7-10y). This figure starts on the day Janet Yellen took office as Chairman of the FOMC. In our view she did a good job guiding and managing global market, liquidity, and various constituencies over the following 4 years. In the same way, Jerome Powell has done a good job helping to save the US and the global economy this year. Even so, it is clear from Figure 1 that US government bonds gave very limited returns in the period from when Yellen took office as Chair of the FOMC until Powell made his turnaround in late November 2018; basically, until he and the FOMC gave up on the policy he had crafted with Yellen. As seen on the draw downs in Figure 2 on the following page, the total return over those 5 years was 7%, well below the accumulated inflation during the same period. This nominal return, with drawdowns of 7%-8%, means that for several years this "risk-free asset” was under water.
We are not saying that a bond bubble is about to pop up, and we are not claiming that yields cannot go down again. In fact, we expect yields to decline temporarily, more or less every time equities decline significantly, which we loosely define as between 10% and 15%. In addition, we expect that the Fed, as actively and as discreetly as possible, will manage the upward move in yields from now on. The reason for this is captured in the second half of the Figure. The tremendous rally in US government bonds from early in the 4th quarter of 2018 to the 30th of March 2020 was driven by a 180-degree turnaround in the Fed policy. It is difficult to know if Powell and Yellen think they overtightened a bit or a lot before this shift in policy, but what we do know from their comments and research is that they both stand by the idea that the equity market along with corporate bonds and mortgages are very important for the economy’s ability to grow. And they agree that economic growth is important for an inclusive economy that creates jobs and equal opportunities. (Yellen has published on these topics for decades).
At the same time bond yields cannot be allowed to increase very much or very aggressively. If, for example, the US 10 year was to move from below 1% to 3, or even 4%, the cost of this debt could grow to unsustainable levels. Compared to other countries, the US does have the advantage that the debt is all USD "local currency", so it can be "printed away". This makes the debt burden much more manageable but still not necessarily sustainable over the long term since the printing of money would eventually increase inflation. If inflation becomes unpredictable there will be a problem for growth, as risk premiums would increase. All of these are long term issues, but they could grow very large, and it is therefore preferable for the Administration to manage this one as gently as possible. A great balancing act is therefore needed, whereby the cyclical side of the US economy (and Chinese economy) including private demand, leads the world into a strengthening recovery.
In this scenario, the upward pressure on yields is managed with QE and promises of lower yields for a longer period of time. Should marker collide the reaction will be additionally monetary and fiscal support. In this case, a harmonious relationship between the Fed and the Treasury is necessary. To achieve and sustain this, Yellen is an obvious choice. She stands for QE+ and a willingness for Treasury spending, on new programmes for minority groups and possibly, also on investment in both infrastructure and education. The question is therefore not if she will support QE+, but how much further she is willing to go with the process of mixing monetary and fiscal policy. Our guess is that she will prefer to stay out of the business of the Fed and will encourage the Fed to do whatever it takes to keep interest low by QE+. However, should interest rates move above levels where the government can afford cheap borrowing, where jobs are plentiful and where the lower middle class also finds borrowing conditions in the housing market attractive, she will probably be a forceful supporter of interest rate control.
Assuming the balancing act succeeds, and if the US government bonds are kept under control, the rest of the yield spectrum can also be controlled through the tool of the modern QE+. As seen in Figure 3 below, this has already led to a significant decline in the borrowing costs of corporates issuing high yield and investment grade bonds.
This means that broadly speaking the corporate world is coming out of this recession in the same way as the previous two recessions i.e. with a bit more debt and much lower nominal costs for serving this debt. As the recovery is now on track and nominal demand is returning, corporate profits are rebounding strongly. Low borrowing costs will further help profits to grow into 2021 and beyond and a positive feedback loop is thus moving ahead with increasing profits justifying lower spreads. In our algorithms, corporate profits play the role as the acid test of whether an equity market rebound after a recession is going to be a one-off bounce or a sustainable upward movement. This means that if a market recovery is followed by solid profit recovery, it is more likely to be sustainable and lasting. This is what we see happening now because the profit component increasingly supports the rebound in our algorithms and thereby supports the equity allocations across our portfolios, which in turn is supporting performance across mandates and funds. This is illustrated with the Systematic Equity Allocation portfolio in Figure 4.
China and its market implications
Returning to the topic of global growth, it is worth noting that the recent Chinese data again confirmed that the recovery is broadening and firming. Aggregate growth numbers are obviously well below what we have been used to over the last 30 years, but as noted previously, the very long period of very high growth means that, in US dollar terms, the demand pull from China might be expected next year to be as important as ever. So, while the story is neither as new nor as untainted as previously, it is nevertheless very important for both the global population and the global economy. As we noted last month, both the state of the world and the environmental situation in China indicate that prioritising both green technology and green investments makes a lot of sense. Looking forward to such a centralised push for a more sustainable future, it is likely that statements like "go green or go home" and "don't short Beijing" become part of the future investor language in the same way "Don't fight the Fed" has been in recent decades. We ourselves have again made allocations from global equity exposure and into emerging market stocks. The weight of China is 35%-40% and together with Korea and Taiwan above 70% in MSCI emerging markets and in this sense the whole emerging market story is to a large extent the story of Asia, in the same way as successful investment into Emerging Markets are dependent on global liquidity and global growth.
The latest developments in programming and data science offer unprecedented opportunities for bringing quantifiable measures to the debate about Sustainable Investments and Environmental, Social and Corporate Governance factors across entire investment portfolios. We have integrated such measures into our investment process, allowing us to build sustainable investment portfolios directly on our cloud-based portfolio construction platform. Our professional interest in this area dates from 2014, when we co-authored the Allocating for Impact report2 . At that time, we had to include a warning that across the spectrum of Sustainable Investments, the availability of products for implementation in portfolios was very limited. Since then, the availability of liquid market products capable of absorbing larger investments has increased to such an extent that both active and passive funds can now be found to build well-diversified, global investment portfolios. To calculate the aggregate measures across the various Environmental (E), Social (S) and Governance (G) factors and create quantifiable comparisons across portfolios we have therefore started the process of expanding our investment platform with a Sustainability Matrix.
This tool allows us to aggregate measures across both ETFs and active funds from different providers and thereby calculate, for example, the portfolio's average CO2 emission per $1M revenue, proportions of Green Revenue, Board Independence and Diversity, as well as other recognised Responsible Investment and Impact Measurement parameters, which allow us to work with both minimisations of negative effects, maximisations of positive effects and minimum standards for aggregate ratings and specific key areas of interest. With this tool we aim to provide some basic quantitative insights and, hopefully, to help in this way to focus the debate, in addition to investment management efforts, not only on what is important but also on areas where there is an impact to be had. An example of this approach is provided in Figure 4 where we look at two globally diversified USD based equity portfolios, both with a similar US bias. The first portfolio consists of traditional ETFs covering global equity markets and has a carbon intensity of 136 tonnes per $1M of sales, well within the range of 130-160 tonnes per $1M that we typically see in global equity portfolios (MSCI World is at approximately 145 tonnes per $1M revenue). The second portfolio is a "Sustainable" global equity alternative and consists of four well-diversified ETFs each with their own specific profile and all with low carbon intensity.
As you can see, the carbon footprint is reduced by more than 50% to 60 tonnes per $1M of sales. At the same time, the green revenue is increased from 4% to 7.8% of total sales. This data has a direct link to ESG measures, but we hope they can also be used to frame and measure the positive contribution on a specific measure achieved by intentionally seeking a positive impact, an area we will return to in future updates.
In Figure 5, above, we show the return of the Sustainable global equity portfolio, here represented by the black Benchmark line, versus the return of S&P 500. The outperformance grows substantially from early 2018, meaning that it started well in advance of the pandemic. The main reason for this outperformance appears to be that many of the sectors one avoids in Responsible Investing are also the sectors which have lost out to new technology and have a high discount factor on future cash flows. At the same time Pharma and Technology, in a broad sense, are heavily represented in low emission indices. To us, this offers the important take-away that one can and should look at Sustainable Investing both from the perspective of the positive effects it can have on the world and from the point of risk management and alpha creation potential there is in the investment thesis (i.e. companies which do not appropriately consider their external and internal responsibilities often run too high a risk to be worth the return potential). Investing in a new and better world, or just in a Sustainable Future, most often also entails investing in future cash flows. This means that when market stress or a recession hits and risk premiums go up, there is exposure to a particularly large decline in the value of these future cash flows (i.e. to the collapse of the equity price).
For those who, like ourselves, have some level of recognised risk aversion, we therefore recommend combining equity investments with a systematic risk management process.
In Figure 6, the Sustainable SEA portfolio, managed with such a process, is shown as the blue line. The grey bars in Figure 3 indicate when we have moved to 60% and 0% equity weights, respectively. The main purpose of this process is to limit drawdowns and allow the investor to have a more comfortable journey to sustainable returns and their target ESG impact.