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What Does This Mean for the Big Picture?
By Garvin Jabusch.
A Fragmented World
The chances of a global recession are high with most major economies simultaneously experiencing a slowdown. Europe is sluggish because war is disruptive, China is decelerating because of its zero-COVID policy and trade disputes with the West, and the United States— while fairing relatively better (GDP grew 2.6% annualized in Q3)—is slowing as the Federal Reserve intentionally applies the brakes in a bid to slow inflation. Globally, inflation is contributing to recession risks, both caused by and compounding the other causal elements in each region.
Certainly, the world has faced recessions before, but this time may be a little more worrisome. Foremost, this is arguably the first time these problems have coincided with the global threats of the climate crisis, resource degradation, pandemics, and open war. Second, the world has recently become increasingly fragmented, both between and within nations. As tribalism and zero-sum thinking have become dominant ideologies, our ability to solve big problems has diminished. Fragmented groups are poor problem solvers.
Geopolitical, economic, and climate events are exacerbating one another. Presently, the world has decided to prioritize the first two at the expense of the last and is accelerating fossil fuels deployment. But is this really an either/or situation? Kristina Georgieva, Managing Director of the International Monetary Fund, in a speech at Georgetown commented (as repeated by Ian Bremmer on his podcast), “we can survive inflation, we can survive recession, we can’t survive the climate crisis.” Separately to Bremmer, she added, “you look at the emissions going up even as the economy is going down, so we have lost time. Time is not our friend.”
And she is right. On October 26th, the UN said it “finds that the international community is falling far short of the Paris goals, with no credible pathway to 1.5°C in place. Only an urgent system-wide transformation can avoid climate disaster.” We may find in time that inflation has come to be viewed as a quaint economic disruption once worried about occasionally, as the climate crisis proves far more devastating to our livelihoods and standards of living and becomes the single most damaging financial factor.
A Silver Lining?
Is there a silver lining? One might assume a global economic slowdown must mean GHG emissions are falling in tandem, much as we saw in the 2020 COVID lockdowns. Unfortunately, on the contrary, 2022 is set to be the highest year of emissions in human history. Some have celebrated that renewable energy deployments and electric vehicles mean emissions will be “only” two percent higher than the previous record, but we’re still going the wrong way. Our ongoing, destructive addiction to fossil energy continues to accelerate, despite recession, diplomatic agreements, and net zero pledges.
Even so, renewables are gaining traction. Europe is now clearly and rapidly accelerating its transition to renewable energies, mostly as a means of energy security, but also because renewables are abundant, inexpensive, and do not contribute to climate change. China is accelerating its already aggressive transition to renewables as well and is by far the world’s leading deployer of solar energy. The United States has recently passed the Inflation Reduction Act which attempts to accelerate many aspects of decarbonization. Still, all three regions are also increasing their use of fossil fuels, including coal and natural gas. Once more, geopolitics and short-term economics are driving political—and more importantly capital—allocation priorities today.
What should be done to confront this environment of recession complicated by climate chaos, pandemic, war, and divisiveness is simply to invest in a better future. This has become complicated; however, it doesn’t have to be.
Moving Forward Takes Action
Economists are fond of saying that tomorrow’s production function is an output of today’s investments, and as such, investment allocation is the single most important tool available to influence and direct the economy. What can those in asset management do about that? Nothing? ESG? There’s no shortage of talk about climate change in finance, but there is a shortage of action. Traditionally, those in asset management have thought of the time horizons of investing and climate change as very different. Today we can see that is not true. Climate change has become a present danger in the world, and therefore to portfolios with market exposures. Asset management has not caught up to this. As a result, markets are not getting the right signals—not even from ESG. ESG routinely gives high marks to the most destructive companies in the world and ignores or hands out low ratings to some pioneers and leaders of problem solving and regeneration.
At Green Alpha, we think the greatest sin in portfolio management may be wishful thinking. One can add up however many hundred ESG parameters there may be in a given rating system, but doing so does not address the fundamental question of whether or not we arrive in a future economy having survived the big problems. Wishing humanity could use high density fossil fuels forever is a wish at best; at worst, it is nihilistic cynicism enabling profit from destruction. Finance may profess to fix the problems it has helped cause, but its tortured methodologies offer little assistance, and its ESG systems are confusing people. As Michael Lewis has said in a different context, “complexity is the new opacity.”
Changing the Mindset
It is not necessary to take the institutions of society (like markets as short-term casinos rather than investing platforms, or the idea that fossil fuels are the only real source of energy) as a given. It’s possible to build better ones. By fostering a mindset that embraces the idea of change and releasing the inherited paradigm many of us were raised with, markets can be envisioned in new ways. This is not without challenge, because humans are linear thinkers by nature and because the narrative of the inherited paradigm surrounds us nearly constantly. The power of big fossil fuels companies and the big banks is co-extensive with their ability to set the narrative—and thus preserve their status quo—with the message that there really is no alternative to the way things have always been. Entrenchment is the preferred strategy of incumbents. New things are fine, unless you’re already doing extremely well with the old thing—even if the old thing is demonstrably threatening everything.
Entrenchment has always been a good way to stay rich, at least until an innovative challenger emerges, but today it has become more serious than stale status-quo thinking. Entrenchment has developed into a risk all its own. Not only are there new and multiplying risks, but the pace of change is faster today than ever, while also the slowest it’s likely to ever be again. Even if radical changes to a company’s business model are required, an executive will better understand the world and make more money if their organization is aligned with where the world is going. This is true of any business but is particularly dangerous in the industry that finances—or doesn’t—all the world’s other businesses. Most big investment firms are not asking themselves, “how am I getting the world wrong?”
What’s Most Useful in Fixing the Future?
Fortunately, there are objective truths in this world and throughout history, they have become the foundation of what is valued in the makeup of the economy today. To change asset management, we can start with first principles. What does Green Alpha believe matters most in portfolio management? Climate. Literally including everything that can be known, felt, observed, measured, and contemplated, climate is the state of the world, and enterprises eroding climate stability are degrading the world’s condition.
Since successful investing cannot be based on wishful thinking, we can use another first principle to avoid the ideology trap. Relying on the basic idea that at a minimum a company must be productive and generate free cash flow, one of the first things to research for a given business is where the return stream is going to come from. Historical data gives some insight, but in a time of rapid change, it is also essential to ask: what cause and effect arrows are discernable, and what bets can be made in response to those? The next step is to do as much research as possible to arrive at the ground truth of something, or as close as possible based on the understanding of a given subject.
Relative to current events, the question we ask is: in markets, what companies tend to recover most and fastest as conditions improve? Usually, these are the most productive companies that have also been the most oversold (the last 18 months or so have been an innovation-is-bad, convention-is-good trading environment, leading to some generational opportunities). The final question at the portfolio level is: what’s the marginal benefit of diversification compared to the marginal benefit of a smaller number of fantastic companies? Assimilating these factors, the overall goal is to position portfolios to reflect the strongest—even unstoppable—trends.
Built for the Long Term
This philosophy results in strategies built for the long term. Green Alpha develops portfolios for a long-term, multi-year time horizon, while existing inside the world of short-term markets. Because portfolio time horizons are long, we’re uncorrelated with the major index benchmarks. This is intentional due to the firm preference for seeking high active share, alpha, and impact generation. There is an aphorism that states, the best way to make a new path is simply to walk it. The way Green Alpha understands sustainability is to recognize what structures will enable the perpetual flourishing of life and consequently, the human economy. It is imperative to act now to transform economies and build resilience against future shocks, geopolitical, environmental, and economic.
Every price in the market is a discount on the future. But by selecting industries and companies growing faster, ideally much faster, than underlying GDP, we can pursue the opposite: viewing present value as a discount on far greater future intrinsic value. It is not enough to judge solely on the present; potential as revealed by observable causal arrows must also come into play. Green Alpha’s job from the decision-making perspective is to make tough decisions in a complex environment; the firm holds tightly to the philosophy that productively superior fixes have more value than less efficient causes of risks and holds sparingly to old rules like diversifying into internal combustion because it is a key global industry. Green Alpha thinks it’s better to manage a believability weighted index, as opposed to an equally weighted or market cap weighted index. We seek to manage a basket of companies that work today, and will continue to do so, in the context of the above factors, 10 years from now.
Many of these ideas sound ridiculous in the halls of traditional asset management and in the ESG arena. Most funds are built as either an exact replica or as a subset of a benchmark index. This is done to replicate benchmark performance, thus shielding managers from accusations of being too risky. Measuring the extent to which a portfolio is or isn’t performing like the benchmark has become the standard way to measure risk. In asset management, deviating from the index’s returns is considered a greater risk than the climate crisis. But this system has terrible flaws.
As a rule, coming up with a way of measuring something where other items depend on that measure, creates the incentive to optimize for that thing. In this system, all divergence between the measure and whatever it is quantified against disappears (see Goodhart’s Law, “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”). In the case of asset management, that measure is correlation with major indexes. There is no ability or incentive to discriminate between companies causing real economic risk and those solving it, because the standard assessment of risk does not contemplate real-world risks, but merely statistical volatility. It’s akin to teaching a student how to take a test, but not the material within it. The idea of both index funds and active managers correlating with the benchmark is just that: teaching to the test. It is no way to excel or learn anything new. Another way to think of indexing is that it is akin to intellectual monocropping: it’s efficient, and doesn’t make you work as hard, but it concentrates too many assets into too few resources, and it slows adoption of new and potentially better alternatives.
First Principles
In terms of portfolio construction, Green Alpha believes it is better to be a high active share manager, indifferent to the benchmark, who asks the question that follows from the first principle. Climate literally includes everything; will this business allow humanity to thrive on the planet without disrupting the systems we rely on?
That’s how the firm thinks about long-term alpha generation. But what about impact? At the level of the economy, a first principle is that today’s investment is tomorrow’s production function. Tomorrow’s means of production will either cause or reduce risk. Green Alpha believes companies that reduce risk while simultaneously performing more efficiently than their competitors will gain market share, and value will accrue to them accordingly. Enough competitive yet risk-lowering enterprises already exist that it is not a stretch to say saving the planet is now both cheaper and more economically productive than ruining it. More investment in remedies will accelerate this flywheel.
What about the idea that degrowth is the only path to sustainability? Degrowth arguments seem to rest on the presupposition that any economic growth from here forward will have to be based on high carbon energy. However, that doesn’t have to be the case because economic growth and climate risks can now be decoupled. Degrowth isn’t the goal; the goal is reorienting the economy to achieve growth while concurrently removing risk. This means degrowth in destructive sectors, and rapid growth in regenerative sectors for a net of growth (economic growth is measured on a cumulative basis).
Pushing the Same Way
Maybe someday the world economy will run without the need for capitalism and markets, but that day is too far in the future to help solve the climate crisis in time. The issue can’t be solved in the existing world without harnessing the power of capital markets. Uniquely among our institutions, capital markets have truly global agency; more money flows through markets in a day than is processed through governments in a year. To really fix things, ESG and impact managers must join us in thinking differently about investing. With more of asset management pushing the same way, no old system, no matter how entrenched, can withstand the velocity and direction of solutions-oriented capital. We will eventually emerge from recession, but we won’t solve the clear and present risks threatening collapse until we get asset management on board. And we can start here: climate literally includes everything; today’s investment is tomorrow’s production function.
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Green Alpha is a registered trademark of Green Alpha Advisors, LLC. Green Alpha Investments is a registered trade name of Green Alpha Advisors, LLC. Green Alpha Advisors, LLC is an investment advisor registered with the U.S. SEC. Registration as an investment advisor does not imply any certain level of skill or training. Nothing in this post should be construed to be individual investment, tax, or other personalized financial advice. Nothing in this post should be construed to be individual investment, tax, or other personalized financial advice. Please see additional important disclosures here: https://greenalphaadvisors.com/about-us/legal-disclaimers/