The HBS Global Policy Tracker is an initiative to collect and standardise economic policies implemented around the world as a response to the COVID-19 pandemic. It focuses on fiscal policy, monetary policy, and lockdowns.
The data is updated in real-time with the efforts of several dozen students and staff at Harvard Business School and other Harvard Schools.
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. Here, we survey 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. We identify 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.
Asset allocation plays such a fundamental role to determining long-term returns that ignoring these sustainability issues – where the impacts affect economies, businesses and society over decades – just does not make sense.
Read Strategic asset allocation: the new frontier for responsible investment here.
Do infrastructure investors live dangerously?
Infrastructure businesses are usually impacted by the tail end of recessions as demand for essential services flags or public counter-party risks increase. But from the onset of the COVID-19 crisis, it was clear that infrastructure was going to be impacted before every other business.
The initial phase of this crisis was not an economic shock but a state of emergency requiring nation-wide lockdowns, effectively shutting down most key transport links. The impact of the oncoming economic recession on infrastructure investments will only come later.
Who could doubt that equity returns for unlisted infrastructure companies were lower and often negative in the first quarter of 2020? Major airports, ports and roads saw their traffic collapse often by more than half. Along with lower expected revenues and dividends, investors’ required risk premia had also increased, not only for so-called merchant assets, but also for holding any illiquid assets, including infrastructure.
The Q1 2020 release of the EDHECinfra indices captured both impacts (on revenues and risk premia). The infra300 equity index was down -6.37 per cent for the quarter (equivalent to -23 per cent on an annualised basis) and the most impacted sectors exhibited returns more than twice as negative.
While the COVID-19 lockdowns impacted performance negatively, it must be noted that the infra300 has had worse quarters, including -11.5 per cent in Q1 2009. In effect, some segments of the unlisted infrastructure universe are much less impacted due to the contracted nature of their business model. Transportation stopped but utilities kept running and data infrastructure became more useful (and surely more valuable) than ever.
There are risks in infrastructure investments, and the COVID-19 lockdowns only highlighted some of the risks that were there all along. While infrastructure is often touted as being different from the rest of the economy, it does not follow that it is uncorrelated with economic activity. Instead, infrastructure companies are the backbone of the economy, which means that they are exposed to deep-seated risks that investors should not ignore.
For a decade, investors have increasingly focused on “real assets” partly as a response to the financial crisis of 2008. The current crisis however is the reverse phenomenon as a ‘real’ crisis eventually contaminating the financial sphere.
The realisation among investors that infrastructure assets represent significant risk exposures and that these should be understood and managed will determine the coming of age of the infrastructure asset class.
For asset owners, a better understanding of the risks related to infrastructure assets will:
For asset managers, showing which systematic sources of risks (and returns) their investment strategy embodies will:
What can infrastructure investors do this year with benchmarks absolute returns benchmarks defined as the risk-free or inflation rate plus a spread or 400 or 500 basis points? Is everyone who invested in transport and probably any merchant asset going to underperform? Or is it not more relevant to ask how they are doing relative to the market given the investment choices they have made? With such bad benchmarks, it is not possible to tell who made the right choices and who didn’t.
The COVID-19 lockdowns did not change the risk profile of the infrastructure assets that investors hold today. They are the same infrastructure assets than the ones they held at the end of 2019. Their long-term value, business and financial risks are unchanged. Neither has their potential obsolescence in a lower carbon economy, or any long-term trends of the usefulness of certain types of infrastructures.
What the COVID-19 lockdowns achieved better than any stress-test or downside simulation is to reveal some of the risks that were always present in businesses that are at the core of the economy. The stability of infrastructure assets is conditional on the economy itself being stable. In the event of a large shock, even infrastructure assets become more correlated with other asset classes.
The implications are important for long-term investors who report liabilities on a fair value basis and need to understand the impact of infrastructure (which has a significant duration) on their funding ratio, including for short reporting periods.
This does not change the potential role or attractiveness of infrastructure for investors. As the EDHECinfra analytics demonstrate, these companies continue to have unique characteristics including a high cash yield and attractive risk-adjusted returns.
The current crisis is a demonstration of how valuable infrastructure assets are in normal times (when they can be used) but also that they are not risk-free. Ignoring these risks is not an option anymore for asset owners or managers alike.
Frederic Blanc-Brude is director of EDHECinfra.
The Chinese government ended the 76-day lockdown of Wuhan on April 8. Outside Wuhan, many local governments had already eased restrictions on movement and shifted their focus to reviving the economy. This letter documents several facts of the post-lockdown economic recovery in China. The main findings are summarized as follows.
(1) The official statistics suggest a quick recovery in manufacturing. The bouncing-back of manufacturing can also be seen in non-official data on city-to-city truck flows, active online job posts and air pollution emissions.
(2) Electricity consumption, retail sales and catering income suggest a much more persistent output decline in services. The business registration data also shows less firm entry in services.
(3) There is huge cross-region heterogeneity. Our data on visits to key locations and firm entry suggest a stronger recovery in the southeast region.
(4) Small businesses were hit much harder; their February sales shrank to about 35 per cent of their 2019 level, but have been slowly recovering in March 2020. April will be the key month to determine the recovery speed.
The finance sector is widely recognised as an originator of periodic crises. The last 20 years have seen the bursting of the dot-com bubble, the sub-prime mortgage crisis and the eurozone debt crisis. In each of these episodes, financial markets played a central role in creating the problems that ultimately inflicted significant damage on the wider economy. What is less widely discussed is the unhelpful role that the finance sector can play in amplifying crises that emerge from entirely non-financial origins.
The global pandemic arising from the spread of COVID-19 is just such a crisis. In addition to the cost in human lives, the widespread lockdowns seem likely to give rise to a massive economic shock on a scale comparable with the Great Depression. Perhaps unsurprisingly, the initial response of financial markets was extreme. The equity market sell-off in early March was one of the fastest in history and signs of stress quickly emerged in the US Treasury market and the credit markets.
Dramatic swings in asset prices add to the first order economic effects of any crisis. The negative wealth effect of rapidly falling asset prices depresses aggregate demand. Tighter credit conditions make it more difficult for businesses to refinance loans and to raise new capital. And additional uncertainty around the solvency of financial institutions (typically leveraged to asset prices) contributes to heightened risk aversion. Markets not only reflect the changing economic landscape but also directly affect it.
A large exogenous shock that creates huge uncertainty for businesses and investors is always likely to elicit a severe reaction in financial markets. But is it possible that FTSE 100 and S&P 500 companies were by mid-March worth only two-thirds of their value one month earlier? Even allowing for the fact that some businesses will be pushed to the brink of insolvency by this crisis, and that others will see a large hit to their revenues over the coming year, it is difficult to justify such a significant devaluation, given that the vast majority of the value in any business typically lies in the expected cashflows beyond the next year or two.
Contrary to what efficient markets enthusiasts would have us believe, the scale of the market reaction reflects much more than a rational reassessment of fair value in light of new information. Many will point to behavioural explanations for the large market moves, which will undoubtedly have played a part. But arguably just as important are the procyclical dynamics embedded within financial markets.
There are two primary sources of procyclicality in markets. First, systematic strategies that embed a momentum or trend-following bias; and second, benchmark-induced performance-chasing arising from a principal-agent problem.
Strategies in the first category are procyclical by design. Their popularity derives from the historical evidence showing that momentum strategies have been profitable across regions and asset classes over long periods of time. Strategies that make use of stop-losses (widely used by hedge funds) and those that use volatility as an input (such as risk-parity) also tend to be procyclical in nature, especially when volatility spikes as markets go into freefall.
Benchmark-induced performance-chasing can take a number of different forms. At the asset owner level, the tendency to hire managers after a period of benchmark outperformance and to fire managers after a period of underperformance, creates a flow of funds away from the weakest performing assets and towards the strongest performers. A side-effect of this procyclical bias to hire and fire decisions is an asset management industry that is hyper-sensitive to benchmark-relative performance. This gives rise to “benchmark hugging”, whereby managers seek to ensure that portfolios do not stray too far from their benchmark – often formalised by the use of a tracking error target. This creates a tendency for managers to chase fast-rising stocks or sectors in which they have held an underweight position, or else expose themselves to increased career risk.
When markets are rising, these procyclical dynamics embed a generalised bias to overvaluation and create the potential for asset price bubbles. Furthermore, when investors are primarily concerned with short-term returns, corporate executives respond by prioritising earnings and share price performance in the short run. This often results in a reduced resilience to shocks, evident in rising leverage levels and over-optimised just-in-time supply chains. What in the good times is presented as efficiency, is in tough times exposed as fragility.
In benign market conditions, procyclical strategies therefore create a latent vulnerability in markets and the corporate sector. This vulnerability is then exposed when conditions deteriorate or in the event of a large and unexpected shock to the system. As markets start to fall, procyclical strategies tend to amplify market moves by withdrawing their support from assets that are no longer exhibiting positive price momentum and actively shorting those that are falling fastest. The rapid repricing of markets when faced with bad news therefore reflects a mixture of overvaluation prior to the shock and procyclical selling as markets fall.
Monetary policy has only served to reinforce the dynamics described above. Ultra-low interest rates incentivised corporates to undertake a large-scale debt for equity swap, amplifying returns on the upside while reducing their ability to withstand negative shocks. And unlimited monetary stimulation over the last decade has fuelled a number of trends, rewarding procyclical strategies and punishing certain categories of fundamental investor. In particular, this cycle has given rise to an extraordinary decade of outperformance for quality, growth and momentum styles of investing over value.
Investors implementing procyclical strategies and policymakers tacitly supporting their use have contributed to fragile markets and a corporate sector myopically focused on the short term. These social costs are increasingly recognised by commentators and the wider public. In order for the finance sector to retain its social license it needs to prioritise long-term value creation over short-term share price maximisation. This will require asset owners to review the types of strategy that they employ and to radically rethink the way that they hire, engage with and monitor their asset managers.
It is time for investors and policymakers to pay attention to the damage done by a dysfunctional finance sector. Reducing the scale of procyclicality in the system would be a good start.
Philip Edwards is a co-founder of Ricardo Research