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Good morning. Are stocks finally taking the Federal Reserve seriously? Yesterday’s exceptionally strong ISM services reading sent shares sliding and two-year returns up 12 basis points. Perhaps next week will be a pattern full of Fed speakers and a new inflation report. Still shaking with anticipation? Email us at: email@example.com and firstname.lastname@example.org.
A note of caution about China
As quarantine and testing rules ease, markets are eager to end China’s suffocating zero-Covid cycle. They’re not waiting to buy: The MSCI China index rose 10 percent last week and is up 30 percent since its October bottom.
Influential voices on Wall Street are buying into the hype. Morgan Stanley upgraded China stocks to overweight on Monday, while Goldman Sachs, JPMorgan and Bank of America all issued positive ratings recently. In a note yesterday, Thomas Gatley of Gavecal Research argues for a rallying cry:
First, and most importantly, it is clear that the government has abandoned its Covid containment strategy and the trajectory will be towards more reopening in the coming months. . .
Second, the past few weeks have also seen a significant turnaround in property policy. . . Recent measures, including the central bank’s lending program and the removal of longstanding restrictions on stock market and shadow fundraising, should shift to more direct state support and be more effective. . .
Even after the November rally, valuations are low by historical standards. . .
Reduced consumption over the past three years also means households have plenty of spare cash. . . So far, neither margin financing nor mutual fund launches have shown a significant lift in onshore retail sentiment. If local investors join in, the rally could have real legs.
Gatley, at least, is doing a good job of making sense of the rally so far. The Chinese authorities’ search for a way out of the Covid-19 dilemma is a material change. At least it reopens on the table. This is definitely a good thing.
Still, as Morgan Stanley’s chief Asia economist put it, “the key issue remains whether the market will witness a full reopening in the spring.” Maybe, but unlocking has been very difficult everywhere, and China seems unlikely to be an exception. How few elderly Chinese have gained full vaccination and how little China has invested in hospital beds are big problems that cannot be solved quickly. An unexpected policy shake-up between the partial reopening and the lockdown cannot be ruled out.
Given this risk, Chinese equity valuations do not look very attractive:
Yes, the p/e has come down significantly since 2021 and is cheap especially by Hong Kong’s recently raised standards. But is it enough to justify the risks? Look at it this way: Would you rather own the MSCI China with a forward p/e of 11.7 or the Taiwan stock index of 12.4? How about the UK at 10? There are many cheap exchanges in the world. China’s outlook has improved, but it still strikes us as a tough sell.
ESG is still mixed
I often complain that ESG investment pitches and research are bombarded with vague, inconsistent and contradictory claims. Recently, more and more people have come forward with similar complaints. However, the message doesn’t seem to be getting through to the sell-side. Bank of America’s latest report focusing on ESG-marked bonds in Europe contains a lot of the usual static (along with a few assumptions).
The report is titled “ESG and the cost of capital: go for green-ium” and focuses on the cost of capital. If ESG is going to make the world a better place, it will do so by making socially beneficial projects cheaper to finance and socially harmful ones more expensive. The authors calculate the premium paid for ESG-labeled bonds by comparing European senior unsecured ESG-labeled bonds with similar conventional bonds from the same issuers. The green is quite volatile and currently sits at about 10 key points:
Would a 10 basis point difference in the cost of debt capital make a difference in which projects a company chooses to pursue? I don’t think so, because 10 basis points would be within the margin of error for a company’s revenue estimates on any given project. And as rates rise, 10 basis points becomes less and less important. Still, one tenth of a percent of projects that comply with ESG rules is good for the company, I think.
But from an investor’s point of view, surely a little greenback is good because the company’s equity value is the investors’ expected return. Perhaps the gist of the report should have been: “Yay, you can buy bonds that match your values while giving up just a chunk of expected return.” But that’s not the issue here or in any other report I’ve seen so far. Instead, we get sentences like this:
Ignore ESG at your peril. We show how ESG is reflected in traditional bond spreads for sectors such as oil and gas, utilities and tobacco. In short, long-term emissions from oil, gas and tobacco have decreased and become more expensive. Increasingly, sectors viewed as “dirty” or troubled face higher risks, lower ratings and steeper yield curves.
The suggestion here is that higher debt costs are somehow bad for investors, but in reality, all things being equal, they are good for investors. Investors care about compensation for risk, not risk. Lower emissions, higher yields, lower ratings and steeper curves may be most appealing to investors in oil or tobacco bonds, depending on who gets paid what.
Perhaps the authors have something else in mind: that companies with higher debt costs will perform poorly on equity. In this general sense they note that
According to data from MSCI (whose ESG scores are among the most widely used by investors), valuation multiples (previous price-to-earnings ratios) for companies with the highest quintile of ESG scores have historically risen from as low as 20% discount. to a 27% premium today to lower quintile peers, implying a lower cost of capital.
Here is their timeline:
But the problem with this analysis is that it doesn’t control for the sector, and the recent performance of green companies coincides with a wild growth/tech rally, and growth/tech companies tend to score high on ESG.
When the report discussed the overall performance of ESG-labeled bond indices versus unlabeled bonds, it found that labeled bonds outperformed in down markets, but not in up markets:
This is partly because marginal buyers such as central banks and treasuries (important buyers of covered bonds) tend to buy and invest more. They are also less likely to be forced sellers during a downturn. Labeled bonds are more limited in volume, so there is less incentive to sell given the uncertain ability to replace them.
Surprisingly, the authors point out that this conventional wisdom has not held true recently: the spread of conventional bonds over Treasuries is tighter than ESG bonds (although the ESG index is rated slightly lower on average). But given the slightly lower yields on ESG-labeled bonds, it should come as no surprise is expected returns, i.e. low returns at the time of issue.
Ultimately, the only economic reason to “go green” is if you think it’s going to expand from here. The authors suggest two reasons for this. First, “the ECB has updated markets on its plan to gradually decarbonize its corporate bond portfolio” and will buy more ESG and less “dirty” bonds in the future. Getting ahead of central bank buying is a logical strategy. But this is probably an example of the government providing a capital subsidy rather than a market solution to social problems.
A second reason to expect more widespread greening, according to the authors, is that over time, as the meaning of ESG labels becomes clearer, investors will make formative distinctions: “As investors agree on what constitutes ‘good ESG’ and ‘bad ESG,’ along with good and bad progress, we we see even bigger differences in costs.” I have seen no evidence that this has happened, and no reason to expect it to, since environmental, social and governance performance is often based on subjective assessments of contested values.
The idea that ESG investing will change the world by changing the value of capital remains questionable; The idea that companies with low ESG scores are riskier than companies with high ESG scores is hopelessly ambiguous in the absence of valuations; Whether ESG labeling will significantly change the market’s response to these risks is up in the air; The conceptual confusions of the ESG industrial complex aren’t going anywhere; and none of this is getting better.
A good read
How do you lose almost half of a country’s population?
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