The Capital Note

The Capital Note: Yield Curve, Corporations & Climate

A security guard walks in front of an image of the Federal Reserve in Washington, D.C., March 16, 2016. (Kevin Lamarque/Reuters)

Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: investors betting on a strong recovery, ESG everywhere, and Big Tech antitrust.

Yield Curve Steepening
U.S. Treasury yields have hit their highest levels since June, a sign that investors are optimistic about the economic recovery. While many thought the pandemic would put a protracted drag on economic growth, recent data suggest otherwise. Commercial-bankruptcy filings reported by the American Bankruptcy Institute have fallen below their pre-pandemic trend, and most business closures have proven temporary, according to Goldman Sachs Research. Meanwhile, the labor market has recovered more quickly this year than after previous recessions.

And while Trump and congressional Democrats have not yet come to an agreement on another fiscal package, the elections will likely pave the way for more stimulus. Expectations of an increase in federal spending have raised inflation expectations, moving bond yields up, while also increasing expected debt issuance by the federal government.

The combination of heightened risk appetite and a growing supply of Treasuries is responsible for a modest increase in bond yields. While a good sign for the economy, a sustained elevation of Treasury yields would likely slow the rally in stocks, which has been driven by growth stocks that benefit the most from a falling discount rate.

The big question mark is how the Fed will proceed with quantitative easing. If central bankers see rising long-term interest rates as an unwelcome tightening of monetary policy, they could engage in “yield curve control,” buying longer-dated bonds in order to decrease rate expectations. In a research note this week, TD Securities analysts said they “believe a selloff in 10y rates above 1 percent would prompt the Fed to step in” and extend the duration of QE.

An announcement would come after the election. Until then, fund managers may see falling bond prices as an opportunity to hedge against election uncertainty.

— D.T.

Corporations & Climate
In yesterday’s Capital Note, I discussed how increasing climate activism by the likes of JPMorgan Chase (and not only JPMorgan Chase) represented a threat not only to shareholder value but, at least to a degree, to the democratic political order.

As I noted, two principles appear to being consigned to the scrapheap:

  1. A company’s duty is to its shareholders.
  2. Environmental policy should be the responsibility of democratically elected governments, not a cabal of corporations, activists, NGOs, representatives of the “international community” and politicians too arrogant to go through the usual legislative channels to pursue their agenda.

My own view? This isn’t a good thing.

But the ambitions of those interested in, as a first — and essential — stage, separating the power of capital from the ownership of capital (which is what “stakeholder capitalism” is all about) and then, as a second stage, using that power to pursue an activist agenda (climate-related or otherwise) are not limited to pushing around companies.

From the Financial Times two days ago: “BlackRock has launched a sovereign bond ETF designed to weight countries on their level of risk from climate change, thrusting the debate over sustainable investment into the political sphere.”

Note to the FT: It’s already there; it just needs to be louder, in the open, and expressed democratically.

The FT: “Government debt from Germany, Spain, the Netherlands, Belgium and Ireland will be underweighted in the new ETF because of their higher greenhouse gas emissions or greater exposure to climate change risks.”

BlackRock is of course reinventing itself as leader in the field of “socially responsible” investing (we can talk about its involvement in China another time.)

But back to the FT:

“Climate change could significantly impact government finances. We have argued that there is a link between climate change and creditworthiness,” said Scott Harman, head of fixed income product management at FTSE Russell, which designed the index behind the fund. He added that it was the world’s first climate ETF to track sovereign bonds.

To date, the investment industry has largely focused on climate risk at the corporate level, with companies perceived as being particularly exposed to global warming seeing their equities and bonds shunned by those investing on the basis of environmental, social and governance (ESG) factors.

The activist strategy has been to increase the cost of capital for companies that are seen not to measure up to certain conveniently ill-defined ESG criteria (and, no, the fact that E, S and G are bundled together makes little sense: focusing on G can improve performance, E and S not so much) and thus press them to change their supposedly socially irresponsible ways.

This new fund is designed to be a step in the same direction, but with the pressure now being applied to countries, not companies.

The FT:

The iShares € Govt Bond Climate Ucits ETF (SECD), which began trading on Frankfurt’s Xetra bourse on Monday, is designed to help fill the void.

Each country’s benchmark weighting in the new index is calculated using three climate-risk “pillars”.

Transition risk reflects the work needed to be done by a country to meet the goal of limiting global temperature rise to 2 degrees Centigrade; physical risk represents a country’s economic exposure to the physical effects of climate change; while resilience encapsulates a country’s preparedness and the actions it is taking to cope with its climate-related risk exposure.

FTSE Russell claims the index is 26 per cent better aligned to a 2 degrees Centigrade pathway than its equivalent plain vanilla eurozone government bond index, in which countries’ weights are based on the size of their sovereign bond market. A portfolio built with the climate index would have 7 per cent lower greenhouse gas emissions than the traditional one, it added.

It would take a heart of stone not to laugh at the downgrading of Germany, home of yet another of Angela Merkel’s failures, her catastrophic and ruinously expensive ‘transformation’ (the Energiewende) of the country’s energy supply, a transformation, set to be increasingly propped up by (checks notes) Russian gas and inspired by overlapping, but, in some cases, contradictory, layers of panic.

The purportedly unflappable Merkel, panicked by the political consequences of popular panic over nuclear power after the Fukushima accident, has been overseeing the phasing out nuclear power stations ever since. However increased nuclear power would have been the low CO2 emission way of dealing with another German panic, the panic over climate. Trying to fill some of the gap with renewables is proving hugely expensive—and is taking time. How lucky Merkel is that Putin is there to help her out. And how lucky she is that Germany also has (checks notes again) plenty of coal, much of it low grade, to ensure that the lights are kept on, something, sadly, that has partly been at the expense of old-growth forest. Destroying the planet to save it, or something.

Meanwhile (reports the FT): “The Netherlands’ share falls from 4.8 per cent to just 0.22 per cent, reflecting the low-lying country’s vulnerability to rising sea levels and the small size of its renewable energy sector.”

If there’s a country that has (for centuries) known how to deal with being located at low sea level, it is the Netherlands (Dutch engineers were, incidentally, draining the equally low-lying part of England I’m from in the 17th century), but history, it seems, counts for little.

On the other hand, “France, with the continent’s largest nuclear industry, sees its weight rise from 25.8 per cent in the underlying index to 34.9 per cent, while that of Finland, heavily reliant on nuclear and hydropower, almost triples to 4.2 per cent.”

It’s a handy thing, nuclear power.

Italy, meanwhile, enjoys a substantial increase in its weighting when compared with a more conventional index. That’s the same Italy that is looking at a debt/GDP ratio at end of the year of somewhere above 150 percent, about twice Germany’s level.

Once again, it would take a heart of stone not to laugh.

And it would take a brain of stone to invest this way.

 — A.S.

Around the Web
Should Sam Peltzman win the Nobel Prize?

Peltzman found that the added approval standard substantially increased drug development costs, which caused a serious drop-off in new drugs developed and multiyear delays in the introduction of approved drugs. Peltzman and other economists following his lead have found that the added development costs caused hundreds of thousands of deaths from drugs never making it to market or being introduced after long delays. A Nobel for Peltzman is long overdue.

Peltzman’s impact can be heard today from a variety of sources, including the Trump Administration, calling for a speed-up in the FDA’s approval of Covid-19 vaccines. Delays in approval can only increase Covid cases and deaths. Peltzman’s findings remain applicable, critics insist.

Reddit day-traders will have a field day with this one. Vatican gambling on derivatives:

The Vatican invested some donations for the poor and needy in derivatives that bet on the creditworthiness of Hertz, the US car rental company that defaulted on its debts earlier this year, according to documents seen by the Financial Times…

But three years earlier, part of a €528m Vatican portfolio “derived from donations” bought structured notes containing CDS as part of a bet that Hertz would not default on its debts by April 2020, the documents show. The company filed for bankruptcy the following month, giving the Holy See a narrow escape on the investment, which paid out in full.

The spill-over effects of the shale bust:

Wisconsin doesn’t produce a drop of oil or gas, but there has been a bust there, too, as there has been along the entire industrial ecosystem that supported fracking. Dozens of idled open-pit sand mines dot the farmland near where Wisconsin, Minnesota, Iowa and Illinois meet along the Mississippi River. Hundreds of mine workers in the sparsely populated region have lost jobs. Many others, like Mr. Brush, are suffering alongside them.

Companies that supplied trucks, lubricants and drilling tools have been bankrupted. Steelworkers in Youngstown, Ohio, have lost jobs providing pipe to the oil patch. Apartments and hotels hastily built to house roustabouts in North Dakota and remote parts of Texas have emptied.

Random Walk

Enthusiasts for anti-trust action against big tech (I’m not one of them) might want to think through the implications for their 401ks, as this argument contained within a recent article by Bloomberg’s John Authers suggests.

The performance of the NYSE Fang+ index continues to be barely believable. It has outperformed the equal-weighted version of the S&P 500 by almost exactly 100% over the last 12 months.

Now that the biggest five stocks in the S&P account for 22% of its market cap, a problem for them could also mean a problem for the S&P itself. But it goes beyond that. A fascinating report from Gaurav Saroliya of Oxford Economics shows that U.S. companies are far more profitable than their counterparts in the rest of the world, as judged by return on equity, in almost all sectors. Energy is the only significant exception.

He suggests that this is because of industrial concentration. American companies enjoy pricing power in their home markets that businesses in the rest of the world, in more competitive environments, do not. This helps to explain why U.S. stocks have become so much more expensive than the rest of the world over the last decade, in terms of price-earnings ratios. That valuation imbalance in turn implies American underperformance ahead…

Getting serious about antitrust requires a shift in political attitudes. A Democratic clean sweep might lead to a new wave of antitrust enforcement, which could be good for the economy if executed well, and would be awful for stock markets in the short term.

Spoiler: It wouldn’t be executed well.

— A.S.

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