April 14, 2021

A market in time: carbon trading and net zero

Updated on 27/04/21

Last week, Joe Biden convened a summit of 40 world leaders (albeit over Zoom) for his Leaders Summit on Climate, a keystone event in his twin bids to restore American global leadership and spur forward his own climate agenda. Biden's own pledge to cut carbon emissions in America by at least 50% won headlines and praise, as did similar commitments from Japan, Canada and the UK. Setting ambitious targets requires some political fortitude, but the real challenge is working out how to reach them. For now, the White House is placing spending at the heart of its plan to cut emissions: around half of its proposed $2tn infrastructure package is earmarked for green issues such as renewables, electric vehicles and retrofitting homes to be more energy efficient. A combination of spending and enhanced regulatory standards may help to dramatically reduce emissions.

Yet many observers, and some participants, noted a general reticence to address a proverbial black elephant in the room: the question of a carbon price. French President Emmanuel Macron was one of the notable exceptions:

“Taking action for the climate means regulating, and regulating at an international level. If we don’t set a price for carbon, there will be no transition.”


The vexed question of whether and how to price carbon has been vigorously debated for over a decade. Essentially, there are two possible methods: introducing a fixed carbon tax, or building an emissions trading system (commonly known as cap-and-trade). Each approach has plenty of benefits and drawback. The key distinction, though, is that whereas a carbon tax defines a fixed price for emissions, and hopes that this price achieves the desired reductions, a cap-and-trade system defines a maximum allowable level of emissions in a given jurisdiction, and creates a market dynamic that facilitates continuous price discovery for carbon emissions. Of course, both approaches raise similar issues. How do you know where to set the bar, whether in dollars or tons of CO2? And which method would be more effective in reducing emissions?

In 2017, a World Bank Report led by renowned economists Joseph Stiglitz and Nicholas Stern concluded that in order to reach the Paris temperature targets, the effective price of a ton of CO2 would need to be between $40-80 by 2020, and $50-100 by 2030. Although these ranges are strikingly wide, they do at least provide a ballpark sense of the likely dollar figures involved. The report also found evidence of both approaches working well in tandem: the combination of the EU cap-and-trade system and a top-up imposed by the UK government saw British coal power plants "reducing their emissions by 58% in 2016".

The EU's cap-and-trade scheme - dating from 2005, and officially known as the Emissions Trading Scheme - is one of three major active carbon trading systems; the other two are the California Cap and Trade Program, and the Regional Greenhouse Gas Initiative (RGGI), which includes ten states in Northeast America. Assuming that the schemes in place are effective, this is a good start in terms of reducing global emissions; the US and the EU were the world's second- and third-largest emitters in 2017, and that year the state of California emitted more CO2 than all but 18 countries:

By the same measure, though, many of the world's top emitters don't yet have a functional carbon trading system in place. China, which recently announced its aim to achieve carbon neutrality by 2060, only launched its cap-and-trade system at the start of February; India and Russia have no immediate plans to follow suit; and Texas - which would rank as the seventh-largest emitter if it were a country - is unlikely to introduce a trading program for carbon emissions (though it does have one for nitrogen oxide emissions in the local Houston area).

By far the most significant of the mature carbon markets, the EU's ETS has just entered its Phase 4, having been launched way back in 2005. The 3-year initial pilot covered about 40% of EU CO2 emissions, but came under some criticism for setting overly lenient limits; the second phase (2008-2013) tightened up these restrictions, but the carbon price came under heavy downward pressure due to the 2008 crash and its lengthy aftermath across Europe. Phase 3, which lasted until the end of 2020, arguably heralded the maturation of the market, with new funding mechanisms, broader inclusion in the market, and an EU-wide carbon cap, all of which buoyed prices form around €6 in 2013 to above €30 by the end of the phase.

The development of the ETS carbon price over time is displayed below. Broadly speaking, carbon prices rise with emissions (often correlated with economic activity), because there are fewer 'spare' carbon credits to be traded, and demand is higher. However, Phases 3 and 4 of the ETS also introduced a 'linear reduction factor' that reduces the overall emissions cap each year; for this new Phase, that factor has been increased from 1.74% to 2.2%. The combination of economic growth and tighter caps pushes the price of carbon up:

While carbon prices in the EU have dramatically increased since 2013, the current level of around €45 (or $55) is still at the low end of what Stiglitz and Stern suggested was the necessary price range in 2020. What's more, while the EU ETS looks to have contributed to a meaningful reduction in Greenhouse Gas emissions across the region, the EU's own climate targets (likely to be made even more ambitious over the coming years) indicate that more dramatic action is needed. The latest EU climate plan aims to achieve a 55% reduction in emissions by 2030 compared to 1990 levels - yet even the introduction of additional proposed climate measures is only expected to achieve a reduction of less than 40%:

To achieve the EU's goal of 55% reduction by 2030 - not to mention net-zero by 2050 - far more dramatic action will be needed. It stand to reason that the ETS regime will play a key part in that effort.

It's worth briefly considering the behaviour of the EU EUA, which is the commodity security of a tonne of carbon emissions. Over the past the past three years, its price has more or less tracked macroeconomic fortunes, oscillating in the €20-30 range for much of 2019 before crashing to almost €15 at the onset of COVID-19, which hugely impacted demand. Since then, it has shot back up to around €45, reflecting increased economic activity and optimism, as well as the emphasis political leaders are now placing on tackling climate change. For instance, as shown below, prices increased from €25 to €35 between Biden's election and inauguration:

The above chart also shows how, for a commodity, there's relatively little divergence between the futures contracts of varying lengths. This is shown in greater detail below; although the overall level of the carbon futures curve has been rising steadily, the steepness of the curve has remained relatively gentle:

This, of course, is the upshot of a commodities market that is based not on the vagaries of geopolitical tensions or supply-chain problems, but on relatively predictable ground rules set by the EU, the market's governing regime. Even so, investing in carbon emissions - essentially, taking a view on the likely tightening of climate regulation - used to be a complex undertaking, much like regular commodity training. Last summer, though, the first "Carbon ETF" was launched: KraneShare's Carbon ETF (KRBN), which aims to outperform the IHS Markit Global Carbon Index. That index tracks carbon futures in the three most active carbon-trading schemes (which at the end of 2020 had a combined market size of $260 billion). So far, the ETF seems to be tracking its index fairly well; it would seem to have made the world's carbon markets far more easy to invest in:

Whether the KraneShares ETF becomes a significant option for investors or not, its development would seem to indicate the maturation of the carbon emissions market. Strange as it may seem, this artificially-created commodity might yet play a significant role in saving the planet - and could make for an attractive investment along the way.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

March 24, 2021

Sunny uplands? Texas, Biden and the outlook for renewables

Renewable energy is back on the agenda in America. The election of Joe Biden, whose platform emphasised modern, sustainable power infrastructure and clean energy, had already pushed the sector back into the limelight after four years of coal-trumpeting and tough talk on drilling from Donald Trump. Then, last month, the state of Texas suffered a power catastrophe, replete with prolonged blackouts, political mudslinging and at least dozens of deaths. The crisis forced arguments over power generation back to the surface, re-igniting the debate over renewables' reliability. As always, the outlook for clean energy depends who you ask.

Six weeks ago, questions of grid resiliency and load-shedding were only meaningful to energy policy analysts and sector experts; the fact that Texas' power grid existed in glorious isolation, insulated from both its neighbouring states and thereby from federal regulation, was nothing more than a curious factoid. Then, disaster. Prolonged sub-zero temperatures in the Lone Star state (in a dystopian feedback loop, themselves linked to climate change) put the Texas grid into double jeopardy: demand was spiking as shivering Texans used more energy to heat their homes and workplaces, but the freezing conditions was disrupting fuel supply and power generation across the board, from natural gas and nuclear plant failures to freezing wind turbines. A concurrent water supply crisis, due to burst pipes and frozen infrastructure, compounded the humanitarian fallout that will take some time to fully reckon with, but has already been linked to scores of deaths.

The Texas crisis pushed the bitter political argument over the direction of America's energy policy back to the forefront of public discourse. On one side, a Democratic party led by a president whose electoral platform included a promise to invest $400bn in clean energy and innovation over the coming decade, and who promised dramatic carbon emissions goals; on the other, Texan and national Republicans who blamed 'unreliable' wind and solar power for the cratering of power supplies. The actual technical details behind the catastrophic failure of the state-wide grid were quickly lost amidst the cacophony of hackneyed talking points and tropes.

Perhaps more than in any other developed economy, green energy and decarbonisation are wedge issues in American politics. The Republican party is stacked with climate-change sceptics, and its individualistic pro-entrepreneurship probably inspires a certain sympathy with the American fossil fuel industry - after all, for the first few decades of its existence, the development of oil production in the US was mainly propelled forward by risk-taking pioneers and prospectors. The Democrats' progressive wing, by contrast, contends that climate justice is an integral part of social justice in general, and ever since the days of Al Gore the mainstream of the party has also displayed more commitment to the green agenda than anyone on the other side of the aisle.

The starkness of the partisan divide over clean energy means that political events have an outsized bearing on the prospects of related stocks and securities. The chart below displays the performance since October 2019 of the S&P 500, EuroStoxx 50, and three energy-related ETFs: the SPDR Utilities Select (XLU), a general energy sector fund, and the Invesco Solar ETF (whose ticker, aptly, is 'TAN') and the iShares Global Clean Energy ETF (ICLN):

Until last summer, there was little daylight between the broad indexes, the energy sector as a whole, and the green energy ETFs (though both registered higher pre-COVID peaks than the others), yet as the presidential election in November approached, both TAN and ICLN pulled away from the S&P - especially in the last month before voting. Biden's election put rocket fuel (no doubt sustainably sourced) under both, driving the Invesco Solar to almost four times its value in October 2019, and the iShares Clean Energy to almost triple.

Then, Texas. The failure of the Texan grid, and the subsequent finger-pointing and increased political tumult around the whole topic of renewables, looks to have taken some of the wind out of the sector's sails. Between September and January, both clean energy ETFs at least doubled in price, but once the Texas crisis started to unfold, both began to sag again. Investor sentiment cooled somewhat, pegging back the ETFs to around 1.5x their levels in September - still impressive, to be sure, but hardly stellar given the seismic shift in the White House, and consequently in federal energy policy:

Advocates of clean energy will hope that any investor queasiness in the aftermath of the Texas catastrophe dissipates quickly, but either way, the overarching story for the sector remains positive. Over the past year, the solar sector in particular has performed impressively; the stock of three major solar-only companies has doubled or better since the COVID market crash in March 2020:

Reassuringly for investors, this doesn't seem to all be based on fuzzy market sentiment or green inclinations. SolarEdge and Scatec have posted healthy EBITDA figures since 2016; First Solar's fortunes have been more changeable (allowing for the massive restructuring programme that caused First Solar's huge $720 million loss in Q1 2017). Geography might be a factor here: Scatec focuses on emerging markets, and might therefore have an easier time growing at a smooth rate, whereas First Solar's (and, to a lesser extent, SolarEdge's) exposure to the vagaries and complexities of the US might have made steady growth more challenging.

Fundamentally, the renewable energy sector is in a good place. It has already eclipsed the oil majors; last year, NextEra Energy pulled ahead of ExxonMobil in terms of market capitalisation. Aside from half of the US, most of the developed world is fairly unanimous in its recognition of the threat posed by climate change, and the various ways to act - even if there is some considerable divergence on the target timetables for net-zero. Companies, investors and governments are all embracing the ESG agenda, and the 'environmental' element tends to attract the most attention. The UN Climate Change Conference, slated for November in Glasgow, Scotland, may well accelerate the pace of change in favour of renewables and green energy - and this time, the American delegation will be no less motivated than their counterparts from around the world.

Yet the Texas episode showed that it's unlikely to all be smooth sailing going forward, at least in the US; with the partisan sentiment that accompanies any discussion of renewables, and with only the slimmest of Democratic 'majorities' in the US Senate, progress in America may be stop-start at best. The flipside, of course, is that if the Biden White House nonetheless manages to drive forward the clean energy industry - and if the private sector responds with similar gusto - then the clean energy sector could be on the verge of massive growth.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

March 11, 2021

ESG 2.0: This time it’s general

In the alphabet soup of financial acronyms, there are three letters that have risen from relative obscurity to mainstream prominence in less than two decades: ESG. Today, the notion of analysing investment opportunities not only in terms of their financial attractiveness, but also on the basis of their environmental footprint, social impact and governance standards is widely understood, though not yet universally practiced. So how mainstream can ESG become before it folds back in on itself - and is that perhaps the point?

Back at the turn of the millennium, ESG investing - or sustainable investing, SRI, impact investing, and a host of other non-identical but overlapping terms, all often used interchangeably - was a hard sell. Its advocates tacitly acknowledged that in order to do any good with their money, an investor might have to accept lower returns, or place non-optimal constraints on their portfolio positions; a slightly lighter wallet was the going rate for a much lighter conscience. A simple pitch, but hardly a compelling one, particularly for institutional investors sensitive to every basis point of potential return.

Turning point

Professionals and academics started to challenge that conventional wisdom in the 2000s. A seminal 2008 paper by Alex Edmans, now Professor of Finance at London Business School, analysed the stock performances of the "100 Best Companies to Work for in America", an annual list compiled since 1998 by Fortune on the basis of employee satisfaction survey data. Edmans found that the companies in question outperformed industry benchmarks by over 2%, and concluded that employee satisfaction - a corporate governance issue - 'is positively correlated with shareholder returns', and accordingly that 'certain socially responsible investing ("SRI") screens may improve investment returns'.

A couple of years earlier, Michael L. Barnett and Robert M. Salomon (now Vice Dean at NYU Stern), reached a broader conclusion regarding ESG. In a multi-decade analysis of dozens of SRI funds, they found that returns varied with the number of SRI "screens" used to select investments. Initially, with a small number of screens, returns were indeed dampened - but after a certain minimum number of screens, returns rebounded again, and grew with the number of further screens used. Do ESG right, and not by halves, and it seemed you could have your cake, eat it, and not feel too guilty about it.

Morals go mainstream

In the following years, increased research on the potential financial benefits of ESG dovetailed with a rising perception in the investment industry that potential investors from younger generations - particularly Millennials - would be far more interested in the morality or otherwise of their investments. The compound effects of morals and marketing saw ESG funds and strategies balloon in size; according to the US SIF, ESG AUM in the US grew from $639bn in 1995 to $12tn in 2018, and then to $17.1tn in 2020 - representing almost a third of all professionally managed assets in the US. Nor is the trend likely to abate, for two key reasons.

Start with how business sees itself in 2021. Even before the triple whammy of COVID-19, the BLM protests and the riot on Capitol Hill, there was a recognition amongst the Davos set that stakeholder capitalism was the way forward. Then the pandemic shone a light on how corporate heroes and villains treated their employees; the George Floyd protests forced many corporates to take a stand on societal issues; the events in Washington DC this January saw business leaders call for a peaceful transition of power, and suspend or investigate their political donations. Business leaders now routinely speak of their responsibilities towards society and the environment - and for some, it might be more than PR bluster.

Yet the impetus to do more is not just coming from consumers and social media, but from governmental directives. Yesterday the EU's Sustainable Finance Disclosure Regulations (SFDR) came into force, compelling asset managers to publish information on their sustainability metric and controls; in time they will also have to report on carbon footprints and exposure to arms dealers and fossil fuels. The impact won't be limited to Europe: EU-based open-ended UCITS funds are sold globally, and anyone marketing a fund to European investors will have to disclose the same information, while any business that has EU funds as investors will also need to report on their ESG metrics. What's more, the UK is likely to introduce similar legislation that is at least as demanding as the EU version, which is consistent with the UK government's intention to bring about a "green industrial revolution", and the Bank of England's commitment to divest from the debt of large corporate polluters.

Is convergence the key?

A recent attention-seeking headline blared that Vanguard, the firm that pioneered passively-managed tracker funds, was the world's largest investor in coal; to be precise, the firm 'controls holdings worth $86bn in companies that produce or burn thermal coal'. Yet Vanguard, of course, barely has a real choice in its investments; the entire point of many of its funds is to faithfully track major equity indexes as accurately as possible. So long as constituents of the S&P 500 or EuroStoxx 50 burn fossil fuels, or engage in other non-sustainable behaviours, Vanguard (and its peers Fidelity, Blackrock and the rest) will continue to be major 'investors' in those companies.

The real question is whether ESG investing ought permanently to be a subset of investing, or simply catalyse the entirety of the market, and society, to act sustainably. It is at this point that questions of methodology, and the often-competing motives of money, marketing and morals, become pertinent. How broad should the ESG tent be? And how real is the danger of 'greenwashing' - where companies or funds market themselves as ESG-friendly despite fairly modest restrictions or requirements?

A few illustrative examples may help. Consider the relative performances of the EuroStoxx 50 and its ESG-weighted equivalent, which tracks the largest 50 stocks in the EuroStoxx index that:

  • "are not involved in fossil fuels"
  • "are not compliant based on the Sustainalytics Global Standards Screening assessment, have Severe Controversy Rating (Category 5) or are involved in Controversial Weapons"
  • that are "involved in Conventional Oil & Gas, Unconventional Oil & Gas (Arctic Oil and Gas Exploration, Oil Sands and Shale Energy) or Thermal Coal"

Over the past five years, the ESG-weighted index indisputably outperformed:

The divergence, though, stems from the second half of 2018; since then, the gap has remained fairly consistent. If we instead examine two pairs of general and ESG-screened indexes (S&P 500 ESG and EuroStoxx 600 ESG) over the past three years, the gaps are even narrower:

To be sure, there is some outperformance in the US market - and no underperformance, emphasising that negative screens of broad equity indexes can give investors benchmark-like returns without exposure to the least ESG-friendly securities. Yet as options for ESG investment go, these broad equity indexes are relatively modest in their criteria. Fossil fuels, weapons, and cigarettes mean a straight red card, but beyond that, the selection criteria have few teeth - which is why the returns are so similar to the regular indexes. For investors, this is not so much taking an activist stand on ESG issues as opting out of industries that are on their way out anyway.

The overall point is that ESG investing is not a specific style, strategy or product; rather, it adds another dimension to the investor's decision-making process. A conventional buyer of tracker funds probably appreciates the option to buy the indexes she wants without the least savoury constituents; a fixed-income investor would welcome the growth of green bonds and social bonds; a seed venture capitalist can assess the impact and policies of a start-up as well as its revenue projections.

Across finance, criteria that two decades ago would have been dismissed as irrelevant, spurious or detrimental to returns are now an ever-more prevalent way to assess investment opportunities. As ever, the challenge for investors is finding the best investments to meet their goals, whether measured in percentage points of return, tonnes of carbon, societal impact, or - increasingly - all of the above.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

February 17, 2021

Far from the madding crowd? On Tesla, crypto and r/wallstreetbets

New year's resolutions are made to be broken. After the chaotic drama of 2020, fuelled by a once-in-a-century pandemic, the start of this year was supposed to herald a return to something approaching normalcy. Yet in the markets, at least, things have only grown stranger. Tesla bet big on bitcoin, a move telegraphed only by Elon Musk posting a smutty Twitter meme; a group of traders used a reddit sub to co-ordinate the mother of all short squeezes against hedge funds that had over-shorted Gamestop, an otherwise unremarkable US videogame retailer. The resultant spectacular price movements spurred many commentators to voice concerns that the market was becoming distorted, dangerous and untethered to reality.

Their argument goes something like this. On one side, you have rational actors that approach the market in a clear-headed fashion and that, on aggregate, facilitate 'price discovery': as the price of an asset is buoyed up or weighed down respectively by its bulls and bears, it converges towards its fundamental, intrinsic value. Equity prices are driven by companies' demonstrable prospects of making money for their investors in the future; commodities by a well-grounded outlook for their levels of demand and supply. Yet recently, the markets' smooth functioning has been endangered by bored day traders speculating with their federal stimulus cheques, the pernicious hyping and meme-ification of certain investments on social media, and the all-soaking money hose of monetary and fiscal stimulus. If left unchecked, these forces will make the market increasingly dysfunctional, spelling danger for unwitting private investors and large institutions alike.

There's no doubt that recent weeks have seen some hair-raising price action. Start with the Gamestop saga, which saw the reddit investment community r/wallstreetbets band together to bid up its share price, in an attempt to humble the hedge funds that had effectively shorted 140% of the company's shares. For a time, the play looked to be working; Melvin Capital, the main fund in the redditors' crosshairs, had to seek emergency financing, and toward the end of January the stock price had peaked at almost twenty times the level at which it had started the month. The subsequent week saw Gamestop hurtle back to earth almost as quickly - though at the time of writing, it's still hovering above $50, a value last reached back in 2013:

The Gamestop episode was quickly co-opted as evidence for whatever narrative people already believed. The unlikely duo of Alexandria Ocasio-Cortez and Ted Cruz were united in their anger at retail investment brokerages like Robinhood, and its Wall Street backers whom they accused of freezing out the small-time investors; fringe libertarians rejoiced at an apparently spontaneous, crowd-sourced humbling of the mighty hedge-funds; stung by such schadenfreude, tearful finance moguls appeared on the business networks to bemoan the apparently incomprehensible resentment of the masses.

Yet one of the most common reactions was to see Gamestop as merely the latest in a series of 'meme-like' trades: widespread investing in a certain security on the basis of social media fashion and mass hype, rather than any 'solid' rationale. After all, recent weeks had seen crazy price inflation from two securities that attract the most ire and handwringing - Tesla and Bitcoin.

The arguments over both are well-worn, and have been more fully addressed elsewhere (including, for the cryptocurrency, on our recent blog post). In brief, Tesla is either the future of human mobility, run by one of the greatest visionaries of our time, or a wildly-overvalued publicity machine headed by one of humanity's greatest narcissists; Bitcoin might be the successor to gold and the solution for frictionless, secure global payments, or the 21st-century equivalent of Dutch tulip mania. There's rarely an intermediate position to be found - heavy is the talking head that seeks to give a considered, nuanced opinion.

Whatever your outlook on these two, it's remarkable how their total market capitalisations have dovetailed over the past year or so (see chart below). Tesla Inc and the sum total of Bitcoins in circulation are now worth the best part of one trillion dollars each, with both having shot up almost tenfold since last year's trough; depending on the day, both would comfortably rank with the top ten most valuable companies in the world. What's more, Musk's firm announced at the start of this month that it held around $1.5bn worth of Bitcoin in its corporate treasury, and would start accepting the cryptocurrency as a form of payment for its electric vehicles.

Bawdy memes notwithstanding, Musk can't actually claim first-mover advantage on this though. That accolade goes to MicroStrategy Inc and its CEO Michael Saylor, which started ploughing corporate funds into Bitcoin last summer, and by now has almost $1bn-worth of Bitcoin on its books, with $600m more, financed by fresh debt, apparently on the way. MicroStrategy, until now a 30-year old software company focused on business analytics, now has more invested in Bitcoin than its entire asset base in 2019; as such, it's starting to function even more like an equity-shaped crypto proxy than Tesla:

Both Tesla's and MicroStrategy's Bitcoin plays are disruptive in at least two senses. Firstly, they complicate and obfuscate the significance of both companies' financial results. Sizeable movements in the cryptocurrency's price have the potential to overshadow any profits resulting from the EV and software businesses respectively, making two equities that are already mercurial even harder to 'truly' value.

Perhaps more significantly, though, both are extending themselves beyond the traditional notion of what it is that companies generally do. One of Bitcoin's most-discussed vulnerabilities is that its long-term value depends on mass uptake and usage. Yet this is also its greatest strength: past a certain critical point - which may already be receding into the distance - its place in the mind of investors and the general public may be impregnable. Tesla and MicroStrategy are forcing the issue, attempting to jump-start the cryptocurrency into mainstream life - and hoping to benefit from first-mover advantage.

Some observers see this as something between speculation, market manipulation, and snake-oil hysteria. They point to the mass democratisation of investing (commission-free equity trading, purchasing Bitcoin through Revolut, and so on), together with the outsized influence of some corners of social media (Musk's Twitter account, or some of the more colourful character on r/wallstreetbets), and see on the horizon a denaturing of the market itself. Prices will continue to decouple from 'fundamental' value; securities will surge and sag based not on carefully-compiled research pieces, but viral memes and trending hashtags. After all, the Gamestop episode proved that such forces can move markets on a previously unimaginable scale. An already-overvalued stock market will inflate further - the mother of all bubbles.

There's a couple of issues with this take, though. Start with the notion that 'equities are dangerously overvalued' - a truism you'll see parroted across much of the financial media. That's actually far from obvious; it depends which market you're talking about, what metric you use, and how much of a long view you take. For instance, here's Bloomberg's Long-Term, Inflation-Adjusted PE Ratio for four major stock indexes, rebased at the start of 1995:

There's no doubt that today's levels are relatively high, but (with the exception of the MSCI World) valuations are not off not the charts. And that's without taken account of the truly unprecedented low-yield environment of the past decade, which inevitably has pushed more money into equities. Maybe stocks are fairly expensive right now - but there's no need to cry armageddon and reach for the tinfoil hat.

More profoundly, though, the entire notion of 'fundamentals' needs to be rethought. Classically, valuing a mature company's equity involves making reasonable medium-term assumptions about revenue and growth rates, discount rates, and company strategies; it also assumes that companies will operate in a 'rational' way to maximise dividends and shareholder value. If this were ever valid, recent years should have told us that it's now outdated - or at least that companies, much like people, can't necessarily be modelled as rational actors that operate in similar ways. Before Tesla, there was Amazon, which floated in the late Nineties and didn't become profitable until the past decade. Imagine pitching the Jeff Bezos model to equity investors in 1995; you'd have been laughed out of the room.

The Amazon model of prioritising investing for growth over making profits was a paradigm shift. It won't be the last. As equities become increasingly commodity-like, with investors focusing more exclusively on price movements rather than dividend potentials, the question of what is 'fundamental' to valuing a stock will have to shift too - perhaps to include intangible inputs such as brand perception, popular appeal and the number of followers of a CEO's Twitter account. If these more qualitative factors do begin to become key determinants of price movements, then nothing makes them less 'fundamental' than last quarter's revenue growth. They may be more volatile - but then, the past year has provided a striking reminder that for companies as well as portfolios, past results aren't necessarily an indicator of future performance.

Time will tell whether Musk and Saylor are visionary pioneers or simply canny PR operators; whether Bitcoin will mature into either a usable form of payment or stable store of value; and whether the Gamestop movement was r/wallstreetbet's warning shot, or merely a flash in the pan. But decrying the underlying forces that are fuelling all three as 'irrational' is a cheap line that disguises the collective burying of heads in the sand. We have two choices: to expand and re-define our notion of what 'rational' can mean, or - if that grates too much - merely to grit our teeth and remember the wise words of John Maynard Keynes:

The market can stay irrational longer than you can stay solvent...

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

February 11, 2021

Beyond bonds (4): Giving credit its due

This is part of a series of posts that will consider various possible responses to the current environment of low or negative fixed-income yields. To read the introduction to the series, click here, and for the first piece, click here.

Would you feel safer lending to a medium-sized country, or to a large corporation? If the latter, congratulations - the market (for the most part) agrees with you. Investing in highly-rated corporate bonds is widely considered safer than putting your money in exotic sovereign debt overseas, avoiding exposure to political instability and sizeable FX risks. So with mainstream government bonds yielding little, should investors pivot towards corporate credit?

Before addressing that question directly, it's worth reiterating that the corporate bond market is in an unusual state. Back in May of last year, we wrote about the bifurcating credit market: thanks to the Fed's seemingly limitless willingness to backstop the asset class, investment-grade issuers were able to tap bond markets for sizeable amounts with fairly low coupons, even as worse-rated companies - particularly in the energy, consumer and industrials sectors - had to offer more juicy returns to attract investors' interest. Back then, ratings agencies were concerned that global default rates could hit up to 18% in 2020 if lockdown-induced recessions persisted into the autumn and winter; more recent appraisals of the market have put 12% - around the peak default rate seen in the Great Recession of 2008 - as a plausible worst-case scenario. And yet, thanks to negative rates and arguably overheated equity markets, investors have been strikingly keen to pile into even the lowest-rated corporate debt, pushing down yields dramatically in the second half of this year.

Of course, this series is about finding plausible replacements for safe, sovereign, fixed-income investments - so high-yield bonds, with what S&P suggests may be a 1-in-10 chance of default, can't really be up for consideration. Yet that still leaves a plethora of investment-grade, seemingly rock-solid corporate issuers offering at least moderately more attractive yields than Gilts, T-bills or Bunds. Could this be an answer?

First, it's important to establish some sense of scale. There's a huge amount of outstanding debt in the world - $110 trillion, to be exact - but the clear majority is issued by governments, rather than corporates. (As the table below shows, the exact proportion varies between 60%-75% by region, with the notable exception of Central America.) Out of the remaining $34 trillion issued by corporates, just over half ($18 trillion) is the debt of financial companies, which is perhaps unsurprising - though it's notable that fully 73% of Western European corporate debt is issued by financials, as compared to 36% of that in North America.

The table below summarises the current state of play:

Some other interesting factoids. The total amount of corporate debt outstanding across the world is fairly close to the total market capitalisation of the S&P 500. Last year, global bond issuance came to a record $5.35 trillion, compared to the 2019 figure, $4.35 trillion, which had been the previous peak. In ballpark terms, that suggests that new issuances amount somewhere between 10%-15% of overall outstanding corporate debt in any given year.

So that gives an idea of the scale of the corporate bond asset universe, and its dispersion across sectors and regions. How about the most crucial aspect of any asset class - the returns?

For simplicity, let's stick with just investment-grade corporate bonds - to save ourselves some sleepless nights - and limit our analysis to North America. The chart below shows the relative performances of the S&P 500, a major North American corporate bond index, and a similar index for US Treasuries:

In terms of raw returns, the stock market clearly wins; over the past five years, the S&P 500 has more than doubled in value, while the corporate bond and treasury indexes returned 35% and 14% respectively. However, we're not looking for equity-like returns from either of these fixed-income asset classes - it's more a question of safeguarding the principal and receiving a moderate rate of return.

It's also clear from the above chart that both fixed-income asset classes suffered less dramatic volatility than the S&P - and this is even more apparent if we zoom into the past 12 months, rebasing the chart accordingly:

While it's true that the S&P still outperformed both bond indexes over the past year, it was a far closer affair - the equity market pulled ahead only around October, and while it's now sitting almost 17% higher than a year ago, the fixed-income indexes have posted respectable gains too.

The most striking thing about this graph, though, is the relative stability of the bonds as compared to the stock market. Treasuries, a pre-eminent safe haven for investors, actually climbed at the start of the COVID-induced sell-off, and have held relatively steady ever since. The corporate bond index, for its part, tended to move in the same direction as the equity market for the first half of 2020, but with markedly less extreme price movements. The S&P was down almost 35% at its 2020 nadir, while this corporate bond index had dipped by only 13%. So corporate bonds would appear to offer some protection against extreme market movements.

Of course, corporate bonds still carry an added layer of risk compared to sovereign debt - even a large, established company is widely considered to be more likely to default on its debts than a country (which in many cases have at least indirect control over their domestic money supply). So how can a savvy investor track that risk? Scouring the financial press for warning signs of impending financial distress would be unworkable even for a few companies - let alone the entire market.

Enter the humble Credit Default Swap - as made famous by Christian Bale playing Dr Michael Burry in The Big Short. A CDS is in essence an insurance policy against a bond defaulting; you pay a certain premium, in return for which you'll be well compensated in case the underlying credit instrument in question goes bust. The difference, of course, is that you don't actually need to own the underlying bond - so the CDS has become a way that any investor or trader can express a view on a certain reference credit instrument. In turn, that makes it the most dynamic proxy for understanding the market consensus view on default risk.

Tracking the CDS price for individual companies is doable, but - much like equity investing - it's usually more helpful to get a general, aggregated sense of where the market is, using an index. Markit compiles the most widely-used such indexes: the CDX family, covering North America, and the iTraxx one, which includes Europe and ASEAN. The chart below shows the investment-grade and high-yield CDS indexes for North America and Europe over the past five years:

Specifically, this is the five-year generic level for each index; they tend to be reconstituted every six months, or 'rolled'. Prices are quoted as spreads - meaning the proportion of the theoretically protected notional debt that would be paid annually as a premium. So whereas you might pay around 0.5% of the total notional a year for protection against the default of investment-grade bonds, the same protection for high-yield bonds could cost around 4%.

The chart shows pretty clearly that the default risk for investment-grade corporate bonds is dramatically lower than for high-yield bonds, as reflected in the far lower spread demanded for protection. Once again, the 'safer' corporate bonds also display far less volatility, while the cost of insuring against high-yield defaults spiked dramatically during the COVID-induced market crash.

That's not to say that investment-grade corporate bonds are safe as houses - though as anyone who watched The Big Short can attest, that's perhaps not much of an accolade anyway - but the above does indicate at least a relative sanctuary from the most violent market movements. It's also worth noting that, on a historical basis, investment-grade defaults are on a downward trend. The chart below shows the number of 'credit events' (defaults or restructurings) for the constituents of the CDX North America indexes, organised by the 'rolling' start date. While high-yield debt has seen plenty of defaults, the investment-grade index has seen only three in the past decade:

Credit events for CDX NA IG and HY, as of May 2020, organised by start date of each Series of the Indexes.

Given all the above, we're in a position to return to the criteria outlined in the introduction to this series, and assess whether investment-grade corporate bonds might offer a passable alternative to classic government-issued fixed income:

  1. Relatively low level of risk for the capital invested: Yes, in the sense that defaults are rare and considered relatively unlikely by the market (see charts above). Inevitably, corporate bonds still carry a higher level of risk than US Treasuries or equivalents - but investment-grade credit still appears relatively steady
  2. Low but positive return: Yes. Investment-grade corporate bonds still tend to offer positive coupons and yields - even if only 1 or 2 percentage points
  3. At least a partial hedge against falling equity markets: To some extent. Corporate bonds are still likely to be correlated to equity markets, but to be insulated from extreme price swings and spikes
  4. Predictability, with the security offering defined time horizons and cash flows: To some extent. Buying a single corporate bond will offer predictability in some ways. but would be logistically complicated and vulnerable to changing market conditions and company fundamentals. Buying an index or fund would probably mean slightly less visibility, but in return for the benefits of diversification and dedicated management or rebalancing

Overall, high-quality corporate bonds seem to offer at least a partial solution to the original problem. Compared to sovereign debt, they might be a little more risky, a little harder to forecast, and more correlated to the stock market - but they also tend to offer a positive and passable return. In a world growing increasingly accustomed to negative interest rates from governments and banks, that trade-off looks increasingly attractive.

To read the introduction to the Beyond Bonds series, click here.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

February 2, 2021

The SHEcession: COVID-19 and the female economy

(Guest post by GGC intern Karel Ohana)

The COVID-19 downturn has deeply and disproportionately impacted women. Compared with all previous US recessions since 1949, the current one “deviates most sharply from the historical norm in its disparate gender impact”. Whereas many previous recessions mostly affected male-dominated sectors (‘mancessions’, if you like), the Covid shock, with its sizeable impacts on both the supply and demand sides, has inevitably weighted down sectors like hospitality and retail, which are largely feminised parts of the economy.

The graph below reflects this fundamental difference between the COVID-19 recession and those that preceded it:

Whilst prior to 2020, recessions were either mancessions or equally impacted both genders, last year’s downturn broke the mould: at the pinnacle of the crisis, women’s unemployment had risen by 2.9 percentage points more than men’s unemployment. Nor is this simply the result of more women working than in the Seventies and Eighties; even during the Great Financial Crash, just over a decade ago, male employment fell by 7.5% compared with 3.1% for female employment in the US. The GFC, unlike the COVID-19 recessions, saw the most job losses in sectors such as construction and manufacturing, where women constitute just 10% and 29% of the workforce respectively. This time round, though, it was sectors like hospitality and retail, where women are heavily represented, that bore the brunt of the downturn. If 2008 was the latest in a long line of mancessions, 2020 was the first clear shecession on record.

What’s more, on an individual basis, economic crises tend to hit women harder than. Women on aggregate earn less, have fewer savings and are more often reliant on the informal economy for their income. This means that they have less access to social security and unemployment insurance. In the 2008 crash for instance, the diversion of government funds toward relief efforts took a huge toll on women due to underspending in the public sector. In the UK today, many migrant women still cannot even claim social security under the ‘No Recourse to Public Funds’ condition stamped on many non-EU visas. This is described by the Home Office as “a standard condition applied to those staying here with a temporary immigration status to protect public funds”. Whatever the merits of the policy, the current recession has seen many female migrant workers unable to rely on the state safety net, however non-temporary their stay in the UK might be.

Across the world, women face significant societal and cultural factors that exacerbate the effect of recessions. According to the global World Values Survey, more than half of people in many countries in South Asia and MENA believe that men have more of a right to a job than women when jobs are scarce; approximately one in six respondents in developed countries concurred. Women are also more likely to be burdened with unpaid care, resulting in their becoming economically inactive, sometimes indeterminately. Data from previous crises corroborates that increased unemployment impels people to revert to traditional gender roles, and that female attachment to the labour market is usually weaker to start with. Moreover, the entrenched archaisms we live with strengthen the notion of the male breadwinner, thereby reinforcing the tendency for certain sectors to be ‘gendered’. In a downturn, unemployed men are favoured more heavily in hiring processes, whilst unemployed women take on more domestic work. Because women make up the majority of single-parent households, they have less access to shared assets and household work cannot be split, thereby compounding their financial woes.

McKinsey’s model displays the intersection of female-dominated industries and those impacted by the Coronavirus-induced recession:

McKinsey's graphic summarises their findings

As the graphic highlights, the nature of work remains strikingly gender specific: women and men are concentrated in different sectors both in mature and emerging economies. Moreover, the intersectionalities of class, race, and gender mean that marginalized women will disproportionately have a higher risk of coronavirus transmission. Seventy percent of health workers and first responders worldwide are women, and a disproportionately high number are Black, Asian, and Ethnic Minority. Of course, this results in excess exposure to the virus for women - but it also means women are subject to the rampant inequity of the health sector, where the gender pay gap (28%) is higher than the overall gender pay gap (16%). Indeed, as the economic onslaught incited by Covid-19 has revealed all too transparently, inequalities too are endemic. The negative feedback loops that stem from economic insecurity will outlive this virus.

The economic phenomenon Hysteresis is a helpful framework to use in observing the how negative cycles of decline become entrenched and self-perpetuating. The unemployment hysteresis hypothesis states that in the aftermath of an economic shock, unemployment shifts from its equilibrium state, and this state is sustained in the long run. When a woman loses her job, she loses valuable social capital; the longer the period of unemployment, the lower the chances of finding fresh employment. Analysts point towards hysteresis to explain how recessions become more than cyclical phenomena. Like the pandemic, hysteresis brings to the fore latent inequities in our societies.

The Covid-induced poverty spike will probably widen the gender poverty gap: more women will be pushed into extreme poverty than men. These realities are tragic for the individual, as well as for women at large, and the economic, social and political fallout from COVID-19 detracts from the strides women had made in reaching gender parity. They also serve to further amplify the force of the economic shock; women’s loss of professional capital as productive workers increases the potential magnitude of any contraction.

In their report on gender and COVID-19, McKinsey estimate that in the highly probable gender-regressive scenario, global GDP growth could be $1 trillion lower in 2030 than it would be if women’s unemployment were to match that of men in each sector; this is without take into account factors such as “increased childcare burdens, attitudinal bias, a slower recovery, or reduced public and private spending on services such as education or childcare make women leave the labour market permanently”.

As the report concludes: “What is good for gender equality is good for the economy and society as well”. For better or worse, business is a microcosm of society - and achieving gender equality in society is contingent upon securing and normalising gender equality at work.

For all the reasons above, enacting policies that may avoid a long Shecession are both a moral and financial imperative. These could include:

  1. Urgently establishing and enacting the safety measures necessary to open schools and childcare centres, and looking to ensure access to affordable childcare, which is often a significant impediment to women’s full participation in the labour force
  2. Encouraging and accommodating flexible work, which has heretofore been lower-paid, and affiliated with higher levels of financial and physical precariousness.
  3. Shifting governmental spending priorities from physical infrastructure (short-termist by nature) to more pervasive social infrastructure. Estimates suggest that by doubling investments in the care economy, we could create 475 million jobs, of which 117 million would be new professions. This sort of investment would have the added benefit of facilitating workforce participation, thereby countering the hysteresis hypothesis
  4. In the private sector, businesses must prioritise initiatives that promote women staying in the workforce, so that they can keep moving up the managerial hierarchy

Pundits are fond of saying COVID-19 is a ‘watershed moment’ for race, inequality, and work. Let’s hope they are right.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service. Any opinions expressed in the above piece are the author's own.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

January 28, 2021

Beyond bonds (3): What’s currency got to do with it?

This is part of a series of posts that will consider various possible responses to the current environment of low or negative fixed-income yields. To read the introduction to the series, click here, and for the first piece, click here.

Yields might be low to non-existent in Europe, Japan and the US - but there's a whole world out there, so surely someone's paying a decent interest rate on their sovereign debt? The trouble is, investing in non-traditional bonds brings its own considerable set of risks - not least of which is currency exposure...

In Europe, Japan and North America, investing in domestic sovereign fixed income has rarely been less exciting. Even fairly far along the yield curve, you'd be lucky to find a yield of even 1% - and most major European countries have 10-Year yields firmly below zero.

Still - perhaps having read our previous pieces on why equity investing can't simply take over from fixed-income positions - you're still pretty attached to the idea of investing in government bonds. They feel much safer than corporate credit (an asset space going through some fundamental shifts, thanks to COVID-19); after all, countries rarely if ever go bust, and sovereign bonds are likely to be more liquid than those of single companies.

Going global

So what if you expanded our investment horizons geographically, and considered worldwide sovereign debt as your potential investment universe? Even a cursory glance would show the potential both for high yields and considerable risk:

It's clear from the above selection that there's a fairly strong correlation between yields, credit rating and central bank interest rates in each country. Unsurprisingly, Germany and Switzerland lead the way, with each offering a negative yield of about -0.5% on their 10-Year bonds; most other European countries, and some Asian ones, are arrayed between that baseline and the 1% offered by US and Australian bonds. Bringing up the rear are Argentina, Venezuela and Ukraine, three countries whose economic and political instability would dissuade all but the most adventurous of investors (some of whom have already been burnt by Argentina's sovereign debt crisis). Hungary and Romania seem to offer notably high yields for EU member states, but given that neither are in the Eurozone (using the forint and leu respectively), currency risk is something of a concern.

In fact, currency risk is perhaps the most important elephant in the room. Many countries issue the vast majority of their sovereign debt in their domestic currency, which stands to reason. If that currency differs from the investor's, the source of currency risk is clear: you'll have to convert your principal to the target currency at today's rate, invest in the foreign currency, and hope that FX movements don't wipe out any additional yield you might capture - or, worse, cause an actual loss. In a sense, this resembles the famous carry trade: borrow in a low-interest rate currency, convert to and invest in a higher-rate currency, and then convert back. Everything else being equal, you'd earn the spread between the interest rates offered in the original and alternate currency.

Of course, everything else is almost never equal. Carry trades like this are exposed to the three-headed risk monster of interest rates, inflation and FX fluctuations, which are closely connected despite not always moving in lockstep. One spectacular unravelling of this play came in 2008, when the massive Yen-Dollar carry trade was punctured by the crisis and the sudden lowering of US central bank rates. On a smaller scale, that sort of thing could happen all the time in a carry trade; what's more, it's usually counter-productive to try and hedge the risk, as the premiums would negate any potential gains from the strategy. So a carry trade is a perfectly legitimate trading strategy - but it necessarily implies a certain view on the FX outlook for the currency pair in question, and so is the opposite of a no-brainer.

It's worth noting that some countries issue a significant amount of sovereign debt in foreign currencies. Mexico issues around 20% of its debt in foreign currency, India around 60%, Russia 65%, and Brazil 30%. Much of that debt is in US dollars, so assuming that's your preferred investment currency, you might think yourself insulated from FX risk. In truth, though, the risk is just reconstituted. You might not have to deal with the FX markets yourself, but if the local currency depreciates - say due to runaway inflation, which is more common in developing markets - you might be faced with an even larger problem: the issuing government being unable to service its dollar-denominated debt. Sometimes - as with the recent Argentinian crisis - that will mean a full-on default or restructure. In fact, a recent working paper by the IMF showed that most countries going through debt crises had issued the vast majority of their debt in foreign currencies. But it doesn't need to get that far; any political or economic news that bring that eventuality closer will probably push yields on the debt you're holding higher. That can start to eat into your principal - the very thing you're trying to safeguard by investing in sovereign debt.

FX risk can change rapidly and unexpectedly. Below is a chart of 90-day volatility for seven currencies versus the US Dollar, over the past 10 years:

Broadly speaking, the Euro, Swiss Franc and Yen were the least volatile over the past decade - though the Franc experienced some manic trading at the start of 2015 thanks to the SNB's decision to remove its currency's dollar cap. The pound's volatility spiked in the immediate aftermath of the Brexit vote in mid-2016, while the Brazilian, Chinese and Mexican currencies in general experienced greater volatility, as befits developing markets.

However...here's exactly the same chart, including the Russian Ruble, Ukrainian Hryvnia and Argentine Peso:

These three currencies experienced such high volatility over the past decade that they completely distort the original chart. Ruble and Hryvnia volatility soared to dramatic levels (that latter far more than the former) in the wake of Russia's occupying of Crimea, and the subsequent outbreak of war in Eastern Ukraine. The Argentinian Peso (already undermined by the prevalence of dollar transactions and grey-market money-changers) experienced even greater and more sustained volatility, especially in the past five years, as its governments struggled to keep a handle on the country's economy and debt burden.

All this illustrates a simple but undeniable point: FX markets, especially beyond the most widely-held currencies, are subject to sudden, extreme changes caused by geopolitical events or economic crises. So any investing strategy that implies FX exposure is certainly not for the faint of heart - and is hardly an apt substitute for standard domestic sovereign bonds.

Currency Agnosticism

The bottom line? Investing in higher-yielding foreign bonds might be more hassle - and risk - than it's worth. There is one case, though, where adopting this approach could be interesting: if the investor in question has a use for both currencies.

This isn't necessarily as unlikely as it sounds. In an era of globalised business and dual nationalities, there could be both private investors and corporate treasuries that have some sort of presence in jurisdictions with different currencies. The increased prevalence of multi-currency bank account and trading brokerages suggests that there's a growing demographic who have use for more than one currency. The limiting factor here, of course, is that the investor should be happy either to hold the 'other' currency or to convert it back to the 'original', depending on how exchange rates evolve over the course of the investment. It's unlikely that a sizeable chunk of any given portfolio could be treated this flexibly.

Ultimately, investing in 'foreign' fixed-income only really makes sense in two situations. You either have to be committed to a considered view of the foreign exchange outlook for the currency in question, and be prepared to take on the concomitant level of risk - or you need to be happy to collect your additional yield in the other currency, without any urgency to convert it back. As always, for investors chasing yield, there's no free lunch - so they'd be wise to proceed with caution.

To read the introduction to the Beyond Bonds series, click here.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

January 18, 2021

Beyond Bonds (2): Indexes and flash crashes

This is part of a series of posts that will consider various possible responses to the current environment of low or negative fixed-income yields. To read the introduction to the series, click here, and for the first piece, click here.

Dramatic market crashes pose considerable challenges for equity investors. In this piece, we examine two related questions: how common are they, and what does the road to recovery look like?

Investing in equities means exposure to market crashes - sudden, large drops in the value of stocks or stock indexes. Crashes are dangerous for two reasons: they take a large bite out of the value of your portfolio, and they inspire panic. Arguably, the latter is even worse than the former: panicked selling exacerbates market corrections, and also means realising your loss at what might be the worst possible moment.

In the previous piece, we conducted an historical thought experiment: what if you were to invest in stock indexes in a fixed-income style? To answer, we examined the dispersion of returns generated by stock indexes over defined holding periods. Of course, this approach would be difficult to advocate in reality. For one thing, directing your fixed-income allocation to stocks would concentrate your risk in equities, severely limiting the portfolio's diversification. Just as significantly, straight equity investing does not come with a defined maturity - making decisions about buying, selling or holding more susceptible to emotional reactions to the vagaries of the market.

What if, though, we employed an emotionless android to run our stock portfolios? How often would we have to suffer through dramatic market turmoil? Below, we'll analyse the dispersion of one-day movements of major stock indexes since 1988, and look into some of the more dramatic sell-offs.

Black Monday and the circuit-breaker

We chose the start date of January 1988 for this analysis because of the after-effects of one of the most famous market crashes: October 19th, 1987 - better known as Black Monday. That day, all 23 major stock indexes around the world suffered double-digit declines. This prompted numerous central banks to loosen monetary policy, trying to insulate the 'real' economy from the turmoil of the stock market. 

One of the most remarkable things about Black Monday was the lack of an obvious cause or trigger for the panicked sell-off. Perhaps the stock market was overvalued;. Even so, a correction of over 20% in a day for the S&P 500 and Dow Jones seemed impossible to explain rationally. Clearly, though, financial infrastructure buckled: bid prices exceeded asks, exchanges in New York and elsewhere encountered delays and malfunctions. Of course, this only added to the panic. In response to Black Monday, regulators across many markets introduced a 'circuit breaker', stipulating that whenever the market declined beyond a certain threshold, trading would automatically be suspended for a brief 'cooling-off' period. These circuits were tripped more than once last March during the COVID-19 sell-off.   

Analysing movements since 1988

Starting from 1988, then, we analyse 1-day price changes for nine major indexes: 3 from the US (S&P 500, Dow Jones Industrial Average, Nasdaq 100), 4 from Europe (FTSE 100, CAC 40, DAX, EuroStoxx 50), the Nikkei and the MSCI All-Country World Index. Below is the resultant KDE-plot, representing almost 8500 trading days:

The graph above reflects what anyone who's briefly tuned into Bloomberg will know: the vast majority of the time, major markets don't move by that much, day-to-day. The high,  narrow peaks that centre around 0 are a testament to one of stock indexes' greatest strengths: their boringness (to use a technical term).

However infrequently, though, there are fairly large day-to-day movements in either direction. To gain a better sense of how often these happen, the table below breaks displays the frequency of various 1-day % changes since 1988 (if reading on mobile, you'll find it easier to read the tables below in landscape mode):

It's immediately clear that movements of less than 1% in either direction are the most common outcome. Also notable: the Nasdaq has the greatest dispersion, and the MSCI World the lowest; and movements of greater than 10% in either direction are extremely uncommon (and of over 15%, almost unheard of).

For greater, clarity here's the same table in percentage terms:


How often do these large movements coincide, and what can we say about their dispersion across time since 1988? Although a full dive into these questions is beyond the scope of this piece, it's interesting to have a surface-level look. Below, we display the 15 days since 1988 when at least one of these eight indexes moved by 9.5% or greater in either direction. We excluded the Nasdaq to keep the dataset manageable:

Immediately, two clumps jump out. One, of course, is October 2008: the dramatic apex of financial panic and contagion that characterised the crash, and lead to the Great Recession. The second, last March, represents the COVID-19 sell-off, as markets around the world suddenly realised the extent of the human and economic threat that coronavirus posed. These two periods account for 10 out of the 15 days - and it's also notable that both include at least one day of dramatic recovery buying: October 13th 2008 was almost as positive as March 12 2020 was negative. October 28th and November 24th, 2008 were also dramatic rebound days,  with the longer-term economic damage of the crash still unclear. 

Other notable datapoints on the viz above include 16th October 1989,  the Monday Demonstrations in East Germany that saw the DAX slump by 12.81%, and May 10, 2010, when European markets rose significantly in response to a $1 trillion plan from the EU and IMF to stave off the impending European debt crisis

Overall, it's clear that most of the time, stock indexes don't do anything in a hurry. When they do - in either direction - it usually means that something major is afoot: the unravelling of the global financial system, a once-in-a-century pandemic, or perhaps major geopolitical upheaval. Moreover, positive sizeable movements are almost as common as negative ones, and dramatic bounce-back days after a sell-off are also seen fairly often. 

The upshot? Most of the time, investing in indexes is pretty sedate - but when something major happened, you'd best be prepared for a rollercoaster ride. 

To read the introduction to the Beyond Bonds series, click here.

The above does not constitute investment research, and should not be considered as either advice or an inducement to invest in any particular product or service

Underlying data used for analysis from Bloomberg; analysis and graphs by GGC Insights.

All text and graphics Copyright © Gold Grain Capital Ltd 2021

December 21, 2020

Beyond Bonds (1): Could stock indexes be the answer?

To kick off our series on alternatives to sovereign fixed-income, we'll ask a knowingly naïve question: what if we just doubled down on stocks? In what follows, we present the results of an historical thought experiment, and investigate what happens when you try to invest in stock indexes in a fixed-income style...

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December 18, 2020

Beyond Bonds: Introduction

How long does it take for an anomaly to become normality? For investors hoping to ride out the weird new world of negative rates, it might be time to admit that they're here to stay. Central bank rates in the Eurozone, Japan and Switzerland have been below zero for the past five years; the UK yield curve only gets out of negative territory at a ten-year tenor; and even US treasury bills (with a maturity of one year or less) are only yielding a measly 8 basis points above nothing. However fast the post-coronavirus economic recovery might turn out to be, it's hard to construct a compelling argument that yields will recover as quickly - especially in Switzerland and the Eurozone, where anemic yields have become a fact of life.

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Gold Grain Capital Limited (FCA reference number: 734736) is an Appointed Representative of Sapia Partners LLP,  which is authorised and regulated by the Financial Conduct Authority (reference number: 550103).


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