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The title of this piece should not scare you off. I’ll explain in detail and make no mistake, the header should be taken with nuance. Essentially what I want to convey is that the painful adjustment across global bond and equity markets over the past 5 months has been fed by a marked adjustment in macro-economic policy. However, going forward, any adjustment (upwards or downwards) will relate more to the capacity and success of governments and corporates to internalize the negative externalities to their and society’s benefit. Though internalizing externalities is a long process, we are currently in that pivot. Portfolio success will be defined by proper bottom-up analysis across government and corporate investment instruments, separating the wheat from the chaff.
The quest to seek top-down solutions to negative externalities due to the pandemic has been dominant. Giving context, managing, and controlling the negative macro-economic fallout and effects of the pandemic such as supply disruptions, inflation and debt build-up took most of our attention over the past two years. These top-down assessments modelled the effectiveness or peril ensuing from monetary and fiscal impulses, choices, and practices. Uncertainty around the levels of intervention i.e., how macro-economic policy should be administered, maintained, or reduced shaped financial market volatility. Uncertainty levels still take their cue from lingering externalities today. However, the monetary and macro-prudential policy frameworks, that should limit the risk of persistency across negative externalities, gain in clarity. It’s about time that governments, corporates, and households start to internalize the (negative) externalities.
Externalities in economics refers to a cost or benefit incurred or received by a third party. However, the third party has no control over the creation of the private or social cost or benefit. An externality can be positive or negative and is mostly understood in the context of the production or consumption of a good or service. Moreover, the COVID 19 pandemic has also proven that the spill-overs, beyond the impact of market transactions, should be considered. These range from the behaviour of political and business leaders to the behaviour of consumers in opting to successfully internalize externalities versus those that continue to neglect negative externalities. A brief positive externality from the pandemic was a temporary reduction in GHG (Green House Gas) emissions over 2020.
Internalization is when governments, corporates and consumers take responsibility and conduct policy, run their businesses or households such that negative externalities are reduced, become manageable, and controllable from within. Detecting winners from laggards or even losers will become the name of the game. The game is won the moment quality fundamental research reveals success criteria such as sound business practice, models, and genuine resistance in generating top line results whilst keeping costs under control.
Over the past months, certain government policies have shown difficulties in successfully internalizing pandemic-related externalities. Sri Lanka’s near default springs to mind, as the population’s loss of trust in their government destabilizes the country at its core. The impact of energy and food inflation is amplifying the inequality within many societies and might lead towards increased social unrest (read social costs). The Ukraine-Russia war is hampering supply of wheat and oils across EM and DM countries, which has high negative externalities. Countries that can successfully redirect supply chains or switch to other food staples will increase resilience. Countries that lack the political acumen and responsible leadership will fragilize and see their cost of funding rise. Expect a wider dispersion across sovereign credit spreads in EM as well as in DM government bond markets.
Within the corporate sector, the scrutiny to detect companies that fail or make ill decisions when internalizing externalities is on the rise. Across sectors, we will witness greater valuation dispersion among companies. One should start weighing the ability of companies to address and roll out strategies that reduce exposure to ‘climateflation’, ‘fossilflation’ and ‘greenflation’. Indeed, the pandemic has been a catalyst that has pushed bad inflation onto the society at large. The Russian invasion is the detonator that might make energy and food inflation issues more persistent. As a scenario of persistent margin pressure across industries becomes evident, vigilance is warranted. The latest earnings season has exposed the first casualties. The steep drop in valuation across the broadly held shares of Target and Walmart is a warning. Relegating these events to an overoptimistic inventory accumulation expecting strong pent-up demand is a poor excuse to explain the margin compression.
Isabel Schnabel, member of the executive Board of the ECB, delivered a seminal speech on March 22 titled ‘A new age of energy inflation: climateflation, fossilflation and greenflation’. She describes the combined supply and terms of trade shock inflicted by climateflation through increased impact on economic activity and prices through droughts and extreme weather conditions. The fossilflation is persistent due to the oligopolistic nature of the market. Transitioning away from a still very high dependency on petroleum and natural gas products might come at a high price. Greenflation is pushed by the basic needs for metals and minerals in the production of renewable energy (offshore wind parks requiring 7 times more copper compared to building gas fired plants) or electric vehicles putting supply of lithium and cobalt under stress.
A higher investment intensity has to be accommodated by government fiscal policies. Room will be given by the EU and taken by the US. The moment governments allow companies to internalize costs this will lead to higher demand for market capital thus pushing real rates higher. Companies that close their eyes and opt for the status quo could face a harsh bill by the market. That bill will come in the shape of increased credit spreads and/or distinct lower equity valuations. Idiosyncratic risk will rise over H2 2022 and beyond.
While the market might have succumbed to most of the repricing pain over the first half of 2022, due to a discounting of the macro-economic (mainly monetary) response to the negative externalities of the pandemic, we now morph into a second phase.
Within this second phase, still prone to further market adjustment, specific government bond markets and specific companies will suffer most of the pain, as they fail to address and internalize the benefits brought forward by responsible governance, social and environmental company policies.
Fair enough, some sectors currently benefit from the short-term lift in energy prices or other volatile components of inflation. However, the longer-term winners will be characterized by sustainable strategies that do not exploit negative externalities but reduce, minimize these and maximize social benefits to all stakeholders.
Think about ‘willingness and ability’ of economic agents in achieving a competitive edge when internalizing externalities. It is already and will further become a key parameter in building robust investment portfolios.