ESG Focus | Oct 23 2020
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
In Part 1 of this series, FNArena examined the massive post-covid stimulus – the division between clean aid and dirty aid – and the broad directions of funds. In this article we examine the rise of the S in ESG, stakeholder capitalism and the acceleration of Modern Monetary Theory onto the global economic stage and its links to ESG.
ESG Focus: Covid, the aftermath – Part 2
-MMT to fund social and environmental investment – behold the rise of the State and stakeholder capitalism
-How to balance the issuance of covid stimulus against inflation, moral hazard and corruption
-Big institutional investors expect covid will accelerate ESG investing
By Sarah Mills
The new normal
Covid-19 is forcing a recalibration of the world’s investment markets.
The production of a safe vaccine is the only scenario under which the world is likely to return to any kind of normal, but even then the shock to the economy and the chain of events set in train will, combined with broader global policies, set the world on a new trajectory.
Covid-19 will strengthen forces already in play, accelerating changes in trade, technology, finance and economic policy.
Much of this article focuses on the rise of the “S” in ESG, the role of post-covid Modern Monetary Theory (MMT), and how ESG fits into this big picture. It’s a long read but it’s a broad subject. In our next article, Part 3, we will focus on the broader investment impact of these trends on the E, the S (Social) and the G, as well as the likely winners and losers.
Recession and lay-offs sharpen focus on inequality
One of the most interesting effects of covid-19 has been to propel issues of inequality and wealth distribution to the top of the political agenda as the recession and high unemployment pressure governments around the world to attend to the “S” in ESG.
Covid is expected to increase social inequality (a key ESG theme) with developing economies proving particularly vulnerable given pandemic concerns are likely to accelerate another ESG-related trend of corporate on-shoring and continue to hamper international tourism.
These economies were also more vulnerable under an ESG roll-out given the push to remove slavery from supply chains.
There are multiple reasons for the sudden focus on social issues.
Even prior to covid-19, many speculated that a massive recession was imminent. Marx’s capitalism-threatening surpluses bloomed as China industrialised.
Then there is the impending fourth industrial revolution, which is expected to further increase surpluses (of all kinds) while destroying old industries; not to mention the potential for new technologies to replace jobs (possibly before new jobs are created).
Then there is the potential for big data, extended networks and economies of scale to concentrate more power in the hands of fewer organisations (which reduces competition and employment – and hence consumption, which is necessary to mop up the surpluses).
On top of this, serious environmental concerns and the shift to a circular economy represent a further threat to business-as-usual consumer spending and the value of capital in some industries.
But it is global demographics that are proving the biggest bugbear. Ageing populations typically exhibit reduced consumption.
The combination of all of the above is resulting in a state of affairs known as secular stagnation, a situation of rising inequality and falling global growth – a recipe that could upend the status quo.
Grappling with this problem is a key preoccupation for policymakers. One of the solutions has been to propel social concerns to the top of the policy agenda.
The State is expected to take a more central role (as we have seen post-covid); universal basic income has been mooted; and more immediately evident is a dramatic transformation of monetary policy to fund new ESG-related infrastructure such as a circular economy, renewables and recycling.
New age of stakeholder capitalism
Given the ideology of the day favours a private over a public approach to solving social problems, much of the post-covid stimulus is likely to be channelled to corporations that address key gaps in social services by way of grants and loans, rather than to governments as service providers.
This is likely to result in a sharp increase in “social” corporations, or social enterprise, which we discuss in Part III of this series.
Of particular interest is that recipient corporations of government and ESG fund investment (both green and social) will be answerable to more than just shareholders, as will other non-recipients as legislation and regulation tightens in response to social concerns.
The Economist’s Schumpeter and CBNC suggest the post-covid focus on social inequality may have serious implications for investors.
In particular, they point to the sudden rise of the “growing stakeholder” approach.
This trend has been dubbed stakeholder capitalism and The Economist’s Schumpeter is scathing of the concept, arguing that it is not efficient to serve so many masters.
CNBC also notes the trend’s growing influence post-covid.
“All this goes under increased number of stakeholders,” says CNBC.
“As a function of government intervention, or just moral persuasion, shareholder value in the form of share buybacks, and dividend payments may be less prioritised …
“Some companies have already cut dividends as some of the hardest-hit struggle to stay afloat, and buybacks are also expected to slow this year. Longer term, the ‘shareholder first’ attitude may prove a thing of the past."
“Or, as JPMorgan sums up: ‘Covid-19 is accelerating the trend of stakeholder capitalism and challenger shareholder primacy’.”
Sceptics doubt that it will eventuate. Then again, they also doubted the oil price would plunge to US$20 a barrel. It is a new world in which nothing is certain.
But for the cautious, the early ESG catchcry of “who cares wins” is holding sway.
Grand ambitions require grand funding – enter Modern Monetary Theory
From whence will this massive social funding come? From where it has always come – the printing presses.
Covid-19 has accelerated the adoption of Modern Monetary Theory, with printing presses whirring around the world to crank out enough money to fund the new social and environmental enterprises.
“A profound shift is now taking place in economics as a result, of the sort that happens only once in a generation,” reports The Economist in one of many articles discussing the subject.
“Much as in the 1970s when clubby Keynesianism gave way to Milton Friedman’s austere monetarism, and in the 1990s when the central banks were given their independence, so the pandemic marks the start of a new era.
“Its overriding preoccupation will be exploiting the opportunities and containing the enormous risks that stem from a supersized level of state intervention in the economy and financial markets.”
The role of the State
A key policy difference between pre and post-Covid MMT will be the elevation of the State given the increasing impotence of interest rates to re-fire the economy and the moral hazards associated with free money.
Because rate rises often cause indiscriminate unemployment, supporters advocate placing more power in the hands of regulators to break up monopolies to stimulate productivity and loosen supply constraints, or to assiduously use taxes to control demand and debt obligations.
Increasing fossil fuel taxes has been mooted as just one option (noting that the global fossil fuel industry attracts global subsidies of US$400bn a year). Investors will need to keep a close eye peeled to the tax environment.
Yes, the State may be being asked to take a more central role but its intervention is likely to be more as a financial intermediary and regulator rather than as a service provider to reduce the risk of political corruption, which many observe distorts markets and hampers growth.
“Today the task for policymakers is to create a framework that allows the business cycle to be managed and financial crises to be fought without a politicised takeover of the economy,” notes The Economist.
Some use the analogy of the old Wool Floor Price Scheme to help visualise the manner of government intervention. Under the scheme, the government stabilised farmers incomes, protecting them against volatility. They are also likely to use taxation as an inflation lever and, of course, print money.
Supporters of MMT advocate mechanisms such as job guarantees, by which the government creates jobs for the unemployed, and seed funding for social projects (using models recently developed that only extend further funding if the service is widely adopted) and support for circular-economy oriented manufacturing and adoption.
Mental health and health innovation (think biotechs) are two social examples. A healthier population is a more productive population.
MMT in a nutshell
In a nutshell, the idea is that if the government prints and borrows in its own currency, it has the power to recoup that money by printing more money to pay its creditors and fund spending.
It can also use its tax base, as always, to repay debt, particularly if the money is used internally in domestic employment, (think on-shoring or industries that primarily serve the domestic market such as recycling). Another option is issuing fixed-rate bonds at low interest rates.
The story goes that by printing money and creating jobs, the government increases consumer spending, which then absorbs some of those pesky capital surpluses.
“The main constraint on government spending is not the mood of the bond market, but the availability of underused resources, like jobless workers,” notes The Economist.
And taxes are likely to be the go-to tool, along with interest rates, to manage inflation.
“Spending is the accelerator, taxation the brakes.”
The theory is that, so long as supply exceeds demand, inflation can be kept in check.
Given 4IR, an ageing population, the shift to a circular economy, corporate onshoring, and the covid-triggered demand collapse, this does not appear to be an imminent problem.
The risks are high – grand experiment
Critics deride MMT as a reckless experiment, describing it as “voodoo economics”.
Some of the world’s greatest minds, including Nobel prize-winners note the mathematics supporting the theory are weak and claim the theory is ideologically driven – an extension of Milton Friedman’s monetarism.
They also cite modern macroeconomists' tendency to dismiss facts to support their theories, a case in point being that unemployment during recessions is said to be caused by choice, rather than overwhelming evidence that most are fired.
On the other hand, many monetarist theories have proved correct, such as the power of interest rates to affect inflation.
Inflation, moral hazard and corruption
The key risks are inflation, moral hazard and corruption.
Starting with inflation, printing money is not, in and of itself, the issue, nor is it new.
Modern Monetary Theory appears to be an extension of new Keynesian ideas.
Ever since the abandonment of the gold standard as a monetary system in 1971, and even before, it has been recognised that a country’s wealth is largely a function of the productivity of its people (which can be affected by technology and the availability and distribution of resources, etc).
An economy is, essentially, a function of human existence, driven by human dynamics, and printing money has often been used to regulate economies with some success.
But on very notable occasions, such as in post-WWI Weimar Republic, Zimbabwe, Brazil, Argentina, Venezuela and Chile, printing money has triggered hyperinflation, raising nightmarish visions of wheelbarrows full of money being exchanged for a loaf of bread, the collapse of society and values, and in some instances, war.
MMTers, however, note that the massive quantitative easing in recent decades (in both Japan and the West) has not resulted in an increase in inflation.
Rather, inflation has fallen as the deflationary effects of ageing populations outweigh the effects of quantitative easing, triggering a state of secular stagnation.
This is a situation wherein demand is below capacity even when the economy appears to be booming, and new technologies are boosting efficiency.
This partly explains The Conversation’s observation that: “It is a major paradox that labour productivity, the most important source of long-run economic growth is actually rising much slower today than for decades, even though technological progress has seemingly accelerated.”
MMTers also point to key differences between functioning modern economies and those that have suffered hyperinflation such as the WWI-damaged Weimar Republic, and those that lend money offshore, and countries that don’t print their own currency. In the above cases, demand exceeded supply.
As noted above, MMTers argue that printing money is acceptable so long as supply exceeds demand.
Not everyone agrees – too many moving parts
MMTers argue that covid will trigger a long-term slump in demand (although detractors argue that demand could bounce with a vengeance, particularly given the size of the stimulus provided).
Detractors also point out the main differences between previous successful money-printing ventures in the past 70 years and quantitative-easing have been the relatively low debt levels of the past and the fact that the baby boomer generation was in its natural phase of rising productivity.
Analysts note that human productivity peaks at about age 47 and declines thereafter. The baby boomers, who triggered the biggest spending wave relative to GDP in history, are now in the thereafter.
Immigration (of persons aged roughly 18-30) is one way to increase productivity but very few developed countries have an appetite for increased immigration given the global economic malaise (except perhaps Australia and New Zealand), covid persistent infection concerns and the recent flood of immigrants into Europe from Syria.
Many MMT and ESG proponents point to the fourth industrial revolution as a key input in their favour.
Industrial revolutions typically seed long periods of economic growth, but the transition can be ugly.
But MMTers theorise that extending finance during the “ugly period” is affordable because the productivity gains to come will finance the endeavour.
ESG proponents argue that combining 4IR with a circular economy with improved sustainability will further productivity during this period, and provide greater resilience to potential environmental crises.
Both sides of the argument generally concede that growing social inequality and monopolies also hamper growth, as funds are monopolised by a few.
Hence we come full circle to the “S” in ESG, as a potential demand lever – a policy shift that heralds new risks and opportunities for investors.
Debt, debt, D-d-d-debt and moral hazard
Let’s first return to the second risk of moral hazard, and detractors’ arguments that printing money is a recipe for disaster given the proliferation of debt in the past two decades.
Quantitative easing and massive post-covid stimulus has raised concerns about debt dynamics and creditworthiness.
In the US, Britain, the Eurozone and Japan, central banks have created new reserves of money worth roughly 4trn in 2020, much of which has been used to buy government debt, and corporate debt, raising concern about debt dynamics and creditworthiness.
At the end of 2019, world debt reached US$253trn, equivalent to 322% of global GDP (a ratio exacerbated by the lockdown-induced recession).
By the first quarter of 2020 it was US$258trn (331% of GDP). It increased another US$12.5trn in the second quarter, well above the quarterly average of US$5.5trn, notes the Institute of International Finance.
The International Monetary Fund (IMF) forecasts that rich countries will borrow 17% of their combined GDP this year to fund US$4.2trn in spending and tax cuts designed to keep the economy going. More is likely to come.
The IMF predicts the gross public-debt-to-GDP ratio of advanced economies will rise from 10% in 2019 to 132% by 2021.
Central banks have become the market makers of last resort and deficits and money printing may well become the standard tools of policymaking for decades if inflation stays low.
The US Federal Reserve has been buying securities in exchange-traded bond funds to keep corporate interest rates low, but concerns are abound about the quality of the credit.
The Fed can buy bonds of investment grade credit rating, and more than 92% of government debt is investment grade, although it is worth noting this can be as low as one notch above junk.
Meanwhile, cash is also pouring in from all corners into the junk bond market, and the covid-induced oil-price crash has hit the high-yield bond market hard, a topic we will discuss in an article on fossil fuels to come.
Commentators everywhere are warning of the moral hazard.
As risk is removed from the equation, a surge in corporate borrowing generally accompanies a steady deterioration in the quality of the credit and corporate stability.
If money is free, why not keep failing companies afloat, bail out investors, and protect obsolete industries and jobs – all sure-fire ways to hamper growth and demand, creating a downward spiral.
The answer, say some, lies in increased regulation, greater market intervention and the checks and balances provided by ESG.
Rise of the zombies
To date, detractors have reason to be cynical. Where are these checks and balances?
Detractors are particularly concerned about the growing rise of “zombie” companies, which are kept alive because interest rates are (essentially) "free" – as in: without a tangible cost.
The Bank for International Settlements reports the share of listed firms in advanced economies with low market capitalisations-to-book value, and whose profits were insufficient to cover their interest payments, rose from roughly 4% in the mid-1980s to 15% in 2017.
It is estimated the proportion of zombie companies is now approaching 20% – although how many of those bounce back after covid lockdowns are lifted is yet to be seen.
Morgan Stanley estimates zombie banks and zombie firms comprise 16% of all publicly traded companies in the US, and more than 10% in Europe.
The problem with zombie firms is not just the threat of collapse (which is a direct issue for investors in individual shares) but their drag on economies (which is an issue for the broader market, economy and society).
Investors that do their homework have a chance of avoiding the zombies, but they cannot so easily sidestep a recession and a broad-based long-term loss of capital.
The Organisation for Economic Development and Co-operation (OECD) estimates Italian and Spanish productivity levels would be more than 1% higher were it not for the growth of zombie firms, which are alleged to have crowded out more productive, competitive rivals.
The global outstanding stock of non-financial corporate bonds in advanced economies amounted to US$13.5trn; twice the level of December 2008 in real terms.
To be or not to be – who decides which zombies live?
Since the pandemic, governments have intervened in the economy on an enormous scale in order to keep firms alive, including zombie firms.
But intervention is taking other forms.
A Delaware judge recently approved Hertz’s plan to raise up to US$1bn while in bankruptcy, despite the New York Stock Exchange planning to delist the company.
This precedent may herald a trend for non-market arbitrators to more directly determine the fate of companies – another key issue for investors to be abreast of.
The Economist says greater market intervention may be needed to ensure that firms can fail quickly and efficiently so that they can either be recapitalised and assets and staff redeployed.
“Bankruptcy courts must be able to revive firms with reasonable prospects, or liquidate assets that can find new productive uses in other hands,” says The Economist.
“Making the process faster and clearer will reduce the incentive of creditors to seek scorched-earth liquidations, especially for small businesses.”
This raises the thorny question of who survives such bankruptcies and why? The prospect of cronyism raises its ugly head, taking us to the third risk: corruption.
Corruption – the stuff of fairytales?
Even if inflation stays low, the new monetary machinery remains vulnerable to capture by corporate lobbyists and cronies – another path to stagnation, argue detractors
MMT is all very well in theory, but not everyone is honourable. Critics also point out the real danger free money and corruption poses to hyperinflation, and to values.
They argue evidence suggests the breakdown in simple value relationships such as money to the price of goods leaks to other value systems related to social cohesion.
And, as noted above, where are these so-called checks on government corruption? Morningstar notes sovereign ESG credit ratings are not yet being enforced.
And one only has to look at the cosy relationship between the Australian governments and shadow government and the resources industry to see that democracy and individual votes are hardly likely to hold elected representatives accountable.
Debt, corruption and coercion are also familiar bedfellows.
One only has to think of the self-interested war recovery loans, or the debilitating loans to South Africa after Apartheid fell. Debt has been used as a tool throughout modern history to rape and shackle countries (and individuals), and impede their progress.
In other instances, it has provided great leverage.
We suspect the proof will be in the MMTer’s “magic pudding”. Norman Lindsay’s 1918 children’s fairy tale of the same name may well be instructive.
The existence of a magic pudding didn’t progress as well as one might have hoped – the book proving an indictment of human greed, corruption and avarice: a running testimony to the nature of the beast. But it did have a modestly happy ending for a few.
Managing the MMT risks: The great balancing act
As noted above, inflation is a key risk of MMT given the proliferation in debt. If inflation gets away, it’s all over red rover.
The task is to balance stimulus with inflation.
Post-covid, the Federal Reserve has changed policy direction and raised its inflation target to an average 2%: an acknowledgment the economy may need room to reheat. It’s a tightrope.
Also noted above, one tactic to manage inflation and limit government corruption appears to be to channel stimulus largely to corporations and individuals through government rather than to government, as in previous eras when stimulus was in vogue.
This is one of main difference between Modern Monetary Theory and previous concepts and in this sense appears to be an ideological experiment.
It is yet to be seen as to whether the mobilisation of social capital through the private sector will be more efficient than through governments.
The general agreement would be that the proven power and benefit of government distribution is less risky than the untried model.
Monetarists point to the threat of government cronyism and say corporations are by nature efficient mobilisers and distributors of capital (until they are not, as in the case of monopolies and corporate capitalism – enter the G in governance).
Considerable scepticism abounds as to the suitability of corporations as social guardians given the conflict of interest posed by the profit motive.
Certainly in most areas in which corporations have been given unfettered reach in the social sector, the outcomes have been poor.
The United States health system, for example, is considered by most as a failure from an affordability, accessibility and outcomes perspective, the country ranking poorly in most studies of western medical systems.
Others argue that stimulus is acceptable, depending on the direction of funds.
Even MMT critics favour increased government spending, arguing it might be prudent – especially if the money is spent on infrastructure, education and research and development.
ESG proponents argue reducing risks to the environment and improving biodiversity, and investing in the infrastructure for a circular economy, is a good start.
But how is this judicious allocation of funding and prospective risk managed? As noted in the Hertz precedent, greater market intervention and regulation is one option.
And then there’s ESG.
Enter ESG and greater regulation
Enter the UN Sustainability Goals, ESG, disclosure and regulation.
Readers of previous columns will be well aware of the growing disclosure net facing corporations through tighter reporting standards.
This is a trend being aided by big data – another post-covid ESG winner for investors.
The argument is that greater transparency and regulation will stave off the worst abuses of corporate social capitalism.
This is a sustainability and risk issue for investors; and the ESG investing fraternity is on board.
Analysts note that, from an investment perspective, one of the major effects of covid is a “refocusing” of decision-making on the sustainability of investment opportunities and on building more resilient portfolios to guard against future crises.
JPMorgan analysts expect that in the long run, and in hindsight, covid may prove to be a major turning point for ESG investing and for the application of ESG metrics alongside traditional financial metrics.
“As action and awareness of long-term sustainability risks are likely to increase in the longer run in the aftermath of the covid crisis, this should be a positive catalyst for ESG,” say the analysts.
Institutional investors agree
JP Morgan polled 50 global institutions managing US$12.9trn in funds and found this view is shared by a majority of investors.
About 70% of respondents said it was “rather likely, likely or very likely" that covid (a low probability risk) would increase awareness and actions globally to address high impact/high probability risks.
A majority (55%) expected covid to be a positive catalyst in the next three years; 27% expected a negative impact; while 18% believed it would be neutral.
The most immediate problem with ESG as a moderating influence on corporate excess is that stimulus has accelerated post-covid, but the ESG policing infrastructure is not yet fully operational.
ESG disclosure nets are not fully in place, nor are governments yet being subjected to ESG sovereign ratings. Big data and its applications in this space are nascent.
ESG ratings are only just beginning to make their presence felt in corporate equity and bond markets.
Meanwhile, ESG disclosure demands and regulations are expected to translate to increased costs for companies, hence the fear of lower dividends and shareholder returns.
However, it is worth considering that, as long as interest rates remain low, the corporations and banks in question are receiving free money from the taxpayer.
In Part 3 of this series, we examine covid's impact on the broader investment market and on the individual environment, social and governance arenas, and examine the winners and losers.
Part 1 of this series can be accessed via: https://www.fnarena.com/index.php/2020/10/01/esg-focus-covid-the-aftermath-part-1/
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