Prof Rob Hyndman discusses the interesting elements of his work as editor of the Internal Journal of Forecasting, his work on forecasting COVID for the Australian government, time-series and causality.
“If you went through this pain and aggravation and suffering and you didn’t learn, well then shame on us. Shame on us”.
Hearing these words from New York Governor, Andrew Cuomo, pleading for a fundamental change to how society works in response to the pandemic gave me goose bumps.
COVID-19 has revealed some fundamental design flaws in our global economy. We have built our societies on the back of the growth imperative and therefore relentlessly pursued economic growth, and the efficiency of that growth, at all costs – not only at the expense of the environment but also at the expense of people, most evident through widening levels of inequality in our society. It is much harder to deal with the worst effects of the virus if you are poor and it is the key workers of our society who, in general, seem to be the most poorly paid.
These design flaws need to be fixed and I believe the investment industry has a role to play. Not least because we are an industry that oversees around $100 trillion of capital on behalf of billions of people and our investments have an impact on society. But also because social, environmental and financial issues are so globalised and interdependent that disruptions to these create systemic risks for capital markets and investors.
The coronavirus crisis reminds us that we need to embrace a systems framework for investing and improve our understanding of the context in which our portfolios exist.
A systems framework for investing
We can start by looking at how our investment organisations contribute to long-term value creation. Kate Raworth in her 2017 book, Doughnut economics, describes value creation by looking at humanity’s long-term goals where there is a “social foundation of wellbeing no one should fall below, and an ecological ceiling of planetary pressure we should not go beyond”.
Achieving this implies that organisations need to bring more stakeholders into their value creation boundaries – broadening definitions of value creation outwards beyond shareholders and clients, to embracing employees’ well-being, wider society and the planet.
Impact, the third dimension of investing, lies at the core of the investment industry’s societal purpose and its potential for value creation. It follows that our license to operate rests on taking responsibility for and managing this impact. And our license should only be maintained if the industry creates and communicates some value for wider society.
Now more than ever, investors need to move towards a systems framework for investing which recognises that our businesses and portfolios cannot be considered as independent from wider society or the environment. They will affect (and be affected by) both of them – for better or for worse. A systems-theory viewpoint starts with the idea that the returns we need can only come from a system that works and results in investment policies that directly incorporate ESG and foster the sustainability of investee companies and the system as a whole.
In other words, we need to move beyond the shallow mapping of sustainability factors onto investment outcomes to more holistic and reflexive policies that focus on the intentionality of the investor to produce positive real-world outcomes and therefore sustainable investment results. This is what it means to be a purposeful investor.
Universal owners: the most influential capital on the planet
Moving towards a systems framework for investing not only means that stewardship of existing assets really matters, but it also means that our provision of new capital needs to be directed towards investments that support a sustainable future. The crisis is another reminder that this reallocation of capital may be sooner than we previously thought.
Large asset owners have a unique role to play in influencing systemic issues. Universal owners are very large, long-term, leadership-minded organisations which, because of their size, hold a slice of the whole economy and market through their portfolios. These asset owners are exposed to global challenges and opportunities to influence outcomes lie in integrated management of the market exposure of the investment return.
Universal owners provide a natural base of investors who can understand and manage systemic risk through their investment strategy. But they are also well-placed to play a more influential role in safeguarding the financial system and contributing positively to big societal issues. In other words, they can “do well while doing good”. These asset owners are deliberate in aiming for impact (‘intentionality’) through their ability to produce positive system effects (‘additionality’).
Smaller asset owners can also influence the system by selectively employing universal ownership strategies within their portfolios. Often these funds are motivated by mission, values and beliefs considerations and need to exhibit the intentionality to influence and impact the system.
This can be done through collaboration with other larger asset pools or through delegating. If the latter, they need to be confident that performance metrics also address systemic issues. This can be achieved in part by asset owners shifting focus to principles-based evaluations of agents instead of the current verify and analyse model.
This starts with an evaluation of whether principles and beliefs (i) are clear, meaningful and actionable, (ii) are actually being followed (intentionality) and (iii) lead to the desired results (additionality).
Sharp investors are increasingly aware of the impact system-level issues, such as climate change and inequality, can have on their investments. And this crisis gives us the opportunity to proactively learn how to create wealth and prosperity in a world worth living in.
Marisa Hall MSc, FIA us the co-head of the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.
Credit opportunities within long-only fixed income, hedge funds and private markets are broad and likely to expand as the economic impact of COVID-19 is reflected in corporate earnings and balance sheets. This type of environment has historically led to investment opportunities for long-term investors across the credit spectrum. Investors seeking to benefit from credit dislocation should ensure that suitable portfolio allocations are in place.
Market impact
In recent years we have noted increasing risks in corporate credit markets, from both a quality and liquidity perspective.
In particular, we have highlighted a considerable rise in lower quality debt issuance across the ratings spectrum, a decline in creditor protection mechanisms and regulation-forced reduction in market making.
Additionally, as investors’ search for yield expanded, assets flowed into riskier corporate debt securities, leading to tighter spreads and a lower premium for moving down in quality.
These risks came to light as fears surrounding the economic impact of COVID-19 began to rattle global markets. Initial selloffs were widespread. The riskiest credits fared worse, with high-yield bonds effectively losing four years of gains in the first three weeks of March. Many securities were quickly propelled into “distressed” status – defined as trading above a 1,000-basis-point spread over US Treasuries – surpassing 2015-2016 [1] levels in a matter of weeks. However, the subsequent assortment of central bank measures and the start of government fiscal stimulus packages buoyed credit markets.
Although the initial sell-off was broadly based, sectors like energy, travel, leisure and retail were hit particularly hard.
The partial recovery in the general level of bond prices masks some dispersion between sectors. Although the market has begun to further discriminate between those firms that are at greater risk of impact, and price in unprecedented support from governments and central banks, we expect elevated volatility and market dislocations.
Continued stress on corporate profits could usher in a sharp increase in downgrades, and we expect default rates to increase as economic conditions worsen. In public credit markets, bouts of volatility and individual borrower distress should provide opportunities for flexible and nimble investors in the months to come.
In private markets, there has been an immediate scarcity of new deal flow in the middle market, where smaller companies are typically not able to access capital markets.
The uncertainty surrounding the shape and speed of the economic recovery from the current crisis and its ultimate impact on business models has stalled the underwriting of directly originated transactions. However, there is likely to be a large increase in opportunities to provide directly negotiated rescue financing to “good” companies with short-term balance-sheet problems or other opportunities to enable and benefit from a full turnaround or restructuring of a company.
Options for investors to take advantage of credit market dislocation
Although volatility in credit markets can represent opportunities for asset allocation more generally – high-yield bonds may represent better value and core private-debt transactions are likely to resume with higher spread levels and better deal terms – there are a number of types of strategy that are specifically designed to capture credit market opportunities during periods of dislocation.
These will differ according to their risk and return objectives, as well as their liquidity terms and time horizon. At a high level, these are often labelled distinctly as multi-asset credit, hedge funds, or private markets strategies. However, in practice, there can be a lot of flexibility and overlap between them.
Long-biased multi-asset credit strategies can allocate opportunistically between different areas of the credit market, including high-yield bonds, leveraged loans, securitized credit (such as asset-backed securities and collateralized loan obligations), emerging market debt, convertibles, and opportunistic/distressed debt.
We view multi-asset credit strategies as the best positioned to achieve a favorable outcome within traditional fixed income options, given their flexibility. They are also often able to provide market-like returns, with less downside risk and lower volatility than single-sleeve credit options.
Although multi-asset credit strategies can provide quicker exposure to credit markets, they are long-biased and are likely to underperform when credit markets weaken.
Opportunistic credit hedge funds may impose more restrictive liquidity terms on fund vehicles, but can offer flexibility along the credit spectrum. They can also provide access to other drivers of return, such as the selective shorting of credits and a more active approach to distressed debt investing.
Distressed/event-driven hedge funds can target stressed credits in a more focused manner, but generally impose more stringent liquidity terms.
Private markets special situations strategies also seek to capitalize on market volatility, pricing dislocations and periods of stress, either on a primary (directly negotiated transactions) or secondary basis.
Strategies can range in terms of breadth and flexibility, potentially incorporating shorter-term secondary trades, as well as directly negotiated transactions in situations of complexity or distress, and generally carry the least liquid investment terms.
Generally, longer-dated and more complex opportunities carry a commensurate increase in both risk and return. Those strategies focused on generating a higher proportion of returns through equity ownership, such as “distressed-for-control” strategies, will rely more on long-term capital appreciation.
The range of outcomes for strategies incorporating a higher degree of equity ownership is likely to be more variable than those with a higher element of contractual margins from spread or up-front arrangement fees.
The range of strategies here is not a perfect continuum, in terms of liquidity profile or risk and return, and there are opportunities that are not represented specifically above.
More generally, consistent providers of capital in complex situations – be it non-performing loans (“NPLs”) or bank credit risk transfer (“CRT”) – are likely to command higher premiums on a forward-looking basis, given the greater demand for liquidity and capital.
It is important for investors to understand the opportunity set, liquidity and likely speed of deployment, and the way in which returns are likely to be generated, when assessing the potential fit for their portfolio.
Despite the uncertainty and volatility, we believe the opportunities created by the pandemic for investors able to benefit from credit-market dislocation are considerable.
Although there appears to have been a broad-based resetting of valuations at more attractive levels, not all of the apparent opportunities for investment will turn out favorably.
We believe the most effective way to benefit from this unprecedented period is through the use of skilled managers and strategies that are highly selective in the securities or deals in which they invest.
Less liquid hedge funds and private markets special situations and distressed debt funds are likely to have the greatest returns, given the timeframe required to harness opportunities and their illiquid nature. Within this space, engaging managers with restructuring expertise could prove beneficial in enhancing process-driven outcomes, such as negotiated settlements.
Prospective investors must be comfortable with lower levels of liquidity and, for private markets, the governance burden in respect of capital calls. However, we believe that some of the closed-end vehicles that are launching offer some of the most compelling return opportunities over a multi-year horizon.
Each of the different types of strategies discussed above have risks attached to them, and as always there is no guarantee that any specific strategy will prove successful.
With this in mind, Mercer advocates building a diversified portfolio consisting of differentiated strategies to mitigate exposure to the risks attached to any single strategy.
Under this approach investors can also gain exposure to different strategies which benefit from different aspects of a dislocated market.
For example, a mix of short-term opportunities to benefit from price gains as a result of indiscriminate selling pressure, medium-term opportunities to provide finance to companies with temporary and complex liquidity challenges, and long-term opportunities to benefit from the full restructure of balance sheets and turnaround of companies operationally. Although it can be challenging to understand the nuances between these strategies, the effort in doing so can be particularly rewarding when planning an optimal portfolio allocation.
[1] The 2015/2016 downturn was comparatively mild and driven by concerns about a slowdown in Chinese economic growth and a collapse in commodity prices, especially energy. Within credit, it was therefore the energy sector, which is predominantly high yield that was the most affected. Other sectors were largely insulated.
Joe Abrams is a private debt specialist, Daniel Natale is a fixed income specialist, and Scott Zipfel is a diversifying alternatives specialist at Mercer.
Fantastic conversation with Igor Halperin around the application of reinforcement learning into forecasting problem, and the limits to data and understanding the world.
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For the economic recovery from the COVID-19 crisis to be durable and resilient, a return to ‘business as usual’ and environmentally destructive investment patterns and activities must be avoided.
Unchecked, global environmental emergencies such as climate change and biodiversity loss could cause social and economic damages far larger than those caused by COVID-19.
To avoid this, economic recovery packages should be designed to “build back better”. This means doing more than getting economies and livelihoods quickly back on their feet.
Recovery policies also need to trigger investment and behavioural changes that will reduce the likelihood of future shocks and increase society’s resilience to them when they do occur.
Central to this approach is a focus on well-being and inclusiveness.
Other key dimensions for assessing whether recovery packages can “build back better” include alignment with long-term emission reduction goals, factoring in resilience to climate impacts, slowing biodiversity loss and increasing circularity of supply chains.
In practice, well-designed recovery policies can cover several of these dimensions at once, such as catalysing the shift towards accessibility-based mobility systems, and investing in low-carbon and decentralised electricity systems.
To access the paper, Building back better: a resilient recovery after COVID-19, click here
The COVID-19 crisis is likely to have dramatic consequences for progress on climate change. Imminent fiscal recovery packages could entrench or partly displace the current fossil-fuel-intensive economic system. This paper, by academics at the Oxford Smith School of Enterprise and the Environment, surveys 231 central bank officials, finance ministry officials, and other economic experts from G20 countries on the relative performance of 25 major fiscal recovery archetypes across four dimensions: speed of implementation, economic multiplier, climate impact potential, and overall desirability.
It identifies five policies with high potential on both economic multiplier and climate impact metrics: clean physical infrastructure, building efficiency retrofits, investment in education and training, natural capital investment, and clean R&D. In lower- and middle- income countries (LMICs) rural support spending is of particular value while clean R&D is less important. These recommendations are contextualised through analysis of the short-run impacts of COVID-19 on greenhouse gas curtailment and plausible medium-run shifts in the habits and behaviours of humans and institutions.
As we move from the rescue to the recovery phase of the COVID-19 response, policy-makers have an opportunity to invest in productive assets for the long-term. Such investments can make the most of shifts in human habits and behaviour already under way. In the lead up to COP26, recovery packages are likely to be examined on their climate impact and contributions to the Paris Agreement (UNFCCC, 2015). For many countries, this will be a matter of building on existing NDCs, already framed to facilitate fast-acting investment. Recovery packages that seek synergies between climate and economic goals have better prospects for increasing national wealth, enhancing productive human, social, physical, intangible, and natural capital.