Monday digest

Posted 20 December 2021

Overview: Christmas tidings of comfort, if not joy
The Omicron wave feels like a real setback to the trajectory towards normalisation of our everyday lives. Christmas plans are once again being altered radically, disappointing those expecting a return to their pre-pandemic travel habits. This is not just bad news in respect of our festive activities, but will undoubtedly dent seasonal revenues for retailers and the hospitality sectors. Yet, last week, the December messages from central banks were distinctly forward-looking, confirming their belief in the path towards normalisation. As the policymakers and their economists tell it, the current Omicron episode will prove short-lived and unlikely to have a material impact on the general upwards direction of economies around the world. The hit to consumer and business confidence will be the key follow through for next year. If this strain of the virus is more contagious and less dangerous for most individuals (for whatever reason), it will be important for businesses that they can see the politicians acknowledging the evolution, and adapting accordingly.

Even without full-scale lockdowns, should COVID concerns worsen, people’s behaviour over the Christmas period will inevitably be different from before the pandemic. The travel and leisure industries are once again most at risk – especially if they are unable to tap into emergency support as before. Some have suggested Omicron could be a long-term boon for the global economy if reports of lower severity prove true. That may be, but decreased mobility or confidence over the next few months would still be bad for short-term growth.

The Fed puts its faith in the US economy
Kudos to the US Federal Reserve (Fed) for a seamless change of direction. Historically low interest rates and emergency support measures have helped to keep the global economy above water for the last two years, making the onset of their removal a troubling thought. The inevitable finally came last week, when  Fed officials announced a doubling of bond-buying reductions (tapering) starting in January, and the expectation of three interest rate rises to come in 2022. And yet, investors were not alarmed. Far from it, markets fizzed on the news – with the S&P 500 rising 1.6% and the tech-heavy Nasdaq jumping 2.2% – even if the rally subsequently fizzled out, as some short-covering price squeezes of those who had bet against the Fed faded.

Fed Chair Jay Powell and co have spent the whole of 2021 preparing markets for the taper and, when inflation expectations rose, Fed officials gradually but consistently fed in the notion that the pace of tapering could accelerate. We have noted before that the Fed’s hardest job is convincing markets that removing emergency support was not a sign of outright hawkishness, and it seems the central bank is doing this well. Officials could perhaps have made the case for liquidity management a little clearer, but chose to focus more on inflation targeting in justifying its faster taper – arguably because that is far more straightforward to communicate than how and why excess liquidity has manifested itself and become an issue.

There are, of course, the usual anxieties that come from stopping emergency treatment. As Powell would point out though, stopping treatment is a necessary part of recovery. We all knew that extraordinary support would have to end sometime – and a normal functioning economy should have the depth and dynamism to survive without it. In this respect, the Fed’s hawkish turn is a reflection of its positive economic assessment. Whether businesses and individuals have enough underlying confidence in the real economy is a different matter, and will be the crucial theme for the next few quarters. Data continues to be positive, but the rapid rise of the Omicron variant poses risks and uncertainties to the global outlook. We have already seen tighter restrictions introduced in Germany, and other countries could follow suit over the winter.

Regardless, the Fed clearly sees enough of an upside in growth, employment and inflation to change its tune. The removal of emergency support means it is now up to the real economy to repay the central bank’s fate. Also, a faster pace of tightening means strong and self-sustained growth will have to come faster too. On that front, private sector credit growth will be a key indicator to watch over the coming months. If private lenders can fill the hole left by fiscal and monetary support, the world economy will be in good shape. Pressure now is on other central banks to communicate their plans. The European Central Bank (ECB), meanwhile, is still pushing the “transitory” rhetoric on inflation. How long that can last remains to be seen. But the market’s response to Fed tightening gives the ECB – and ourselves – confidence for the road ahead.

Does the Bank of England have a credibility problem?
The decision by the Bank of England (BoE) to raise rates last Thursday was a surprise (just as surprising as the decision to not raise rates in November). Yes, the increase was only 15 basis points (bps), taking the base rate from 0.1% to 0.25%, and we should take heart that the Monetary Policy Committee (MPC) too sees the Omicron episode as a temporary influence. One could also point out that the BoE’s bond-buying quantitative easing operation ended only very recently and it needed to see if there was any impact before taking any further policy steps. Yet the BoE’s briefing of the underlying situation for December differed very little from that in November and, subsequently, Governor Andrew Bailey seemed to indicate that the path to higher rates was still in the future. Right now, UK markets are behaving as if there is no sign of a problem brewing. Sterling is stable and the equity market has kept up. If anything, it may have started to outperform.

Inconsistency of ESG ratings highlights the importance of looking behind the label

Index provider MSCI is one of the biggest providers of environmental, social and governance (ESG) ratings, and its scores are used to market ESG funds and portfolios by the world’s largest investment companies. When companies speak of ESG investments, MSCI’s ratings are often what they mean. But the neat presentation of these scores hides a great deal of controversy. For starters, MSCI does not rate the environmental part of ESG as one might expect (Bloomberg recently found that environmental factors were cited in only 26% of the reports they analysed). More importantly, it is not clear that MSCI’s ratings reflect the outcomes important to many ESG investors at all.

Bloomberg’s recent investigation found many companies were given an upgraded rating for social and governance reasons, despite making little change other than codifying existing processes – including bans on bribery or other criminal behaviour. MSCI’s environmental ratings are even more controversial: Bloomberg also claimed it that a company’s environmental score has almost nothing to do with its practices, but instead measures how much profit incentive the company has to engage in polluting behaviour.

The problem here is not whether MSCI’s methodologies are justifiable, but that they risk giving a false sense of security. Even if you think this is a good way to scrutinise a company’s ESG credentials, many others might not, and it cannot be simply taken as a given, especially when transparency is lacking. Investors might benefit from a broader variety of ratings – giving individuals the chance to choose one that aligns with their own values. There is a deep tension here, though. Investment managers act on their clients’ behalf to maximise value. For the most part, we all agree on what is valuable in an investment – its financial return. When it comes to ethical or environmental considerations, there is no universal agreement. This means that the measures themselves must be evaluated, not just the assets being measured. Active investors might be used to this kind of detective work (indeed, many use a combination of ESG providers and their own work on the underlying data), but passive investors not as much. ESG scores cannot simply be taken as given, and analysis needs to be done at each level of decision making.

These challenges are made more difficult by the lack of available data. There are proposals (such as those floated at COP26) for making ESG reporting mandatory for companies, but there is still some way to go before these analyses can be taken as reliable. Worse still, we know companies are already finding ways of tweaking the data in their favour – the so-called ‘greenwashing’ problem. These issues can be helped if there is consistent regulation. In the vacuum of ESG rules and definitions, private providers have stepped in to give their own measurements and eye-catching infographics. But these are often opaque and lack the popular backing governments can (sometimes) provide. Things are improving, but policymakers still need to do their bit so that we can do ours.

 

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