Unsexy risks

Today, the annual gathering of the World Economic Forum in Davos ends, and the global leaders of politics, business, and entertainment gathered there can finally stop their virtue signaling and go home to their daily activities where they don’t give a damn about the problems of the world. As if Davos Man wasn’t discredited enough already, this year they even had to deal with the actions of one of their own, Carlos Ghosn, who has shown to the world that you can attend Davos every year and talk a big game about equality and justice, yet, when it comes to facing justice yourself, you rather use your influence and money to escape to a non-extradition country. Peter Tasker has written a great piece about the likely boost these actions will give to left-wing politicians. As I tend to say about Carlos Ghosn:

The entitlement is strong with this one.

But the WEF also publishes its annual Global Risk Report around the time of the event. In it, the participants of the WEF and experts are asked which global catastrophic risks they find most likely to happen. And every year all they can come up with are the risks that materialised in the previous one to three years. Here is the list of risks the leaders of the world thought most likely to materialise from 2007 to 2020:

In 2009 and 2010 these leaders of the world were most concerned about another financial crisis – mind you that was after the world collapsed and right at the beginning of the longest bull market in history. Inequality only became a topic of concern after the Occupy movement blocked access to office towers on Wall Street and the City of London. And climate change and extreme weather events were only cited once they became so prevalent that they were impossible to overlook.

As a tool for investors or decision-makers in politics and business to forecast future risks, the Global Risk Report isn’t worth the paper it is printed on. But as a reflection of the biases and blind spots of decision-makers, it is indispensable reading. The Global Risk Report is probably the best summary of what Karin Kuhlemann calls sexy risks

Sexy risks, as Kuhlemann defines them, are neat, quick, and techy. 

They are neat in the sense that they are easy to circumscribe and have clearly defined boundaries. The experts who can think about these risks and propose solutions to them are usually specialists in one particular field. Astronomers can help us assess the risk of a meteorite hitting Earth that will wipe out humanity similar to the meteorite that led to the extinction of dinosaurs 65 million years ago. In finance, a stock bubble in a specific market of industry like the technology bubble at the end of the 1990s is another example of such a neat risk.

Sexy risks are also sudden to materialise. They don’t creep up on us, but instead, they materialise after a tipping point is reached or a flip is switched, so to say. A classic example is the likelihood of a global thermonuclear war. If Russia and the United States start throwing nuclear missiles at each other, we can be pretty sure civilisation is going to look quite different in a few months’ time than it did in the past. Similarly, if a stock market bubble bursts, your portfolio is likely to look rather different in a few months than it did in the past. 

Finally, sexy risks involve technology. Either technology is the source of a global existential risk (e.g. the rise of deadly AI in the form of Skynet in the Terminator movies), or technology is the solution to any existential risk we may face (e.g. a vaccine to fight off the zombie apocalypse in World War Z, to stay with the movie analogy). In finance, this typically means that bubbles can be found in stocks of companies that promote a new technology like the internet or social media. The risk management tools to reduce risks are often also highly technical and use some form of financial engineering.

In short, a sexy risk is like Catherine Tramell in Basic Instinct. You know it is dangerous, but somehow you think if you are careful enough you can engage and have fun while getting away with it.

Meanwhile, unsexy risks are messy, creeping and politicised.

They are messy, because they have no clearly defined boundaries and to understand them, a number of experts from different fields of expertise have to work together. Take the deforestation of the Amazon rainforest as an example. To understand the consequences of this risk, one needs to understand not only the life cycle of trees but also how the rainforest impacts local and global weather and climate. Furthermore, one needs to understand how poverty drives small landowners and independent miners to invade the forest to make a living farming the soil and searching for gold. One also needs to understand how large landowners need grazing land for their massive cattle herds and push indigenous tribes and local villagers to sell them their land or help them burn down forests. 

In finance, such a messy problem is given for example by globalisation. Trade experts may have an understanding how lower tariffs create higher profits for corporations and an incentive to invest in poor countries and create jobs overseas, but it requires insights from psychology and business management to understand how the excess profits from lower tariffs and global value chains will be used in practice. Is the cash going to be handed out to investors in the form of dividends and stock buybacks, or used to invest in capital intensive projects? Or is the money used to increase compensation for existing employees? And how do these measures filter through the rest of the economy? What happens to workers in high-income countries that lose their jobs due to globalisation? How will these workers react to these developments and what kind of social and political pressures will emerge from globalisation? As we have learned in the last decade, no mainstream economist put much emphasis on rising inequality due to globalisation. And the result was a rise in populist policies and policy pressure to reduce inequality.

Unsexy risks have the additional disadvantage that they creep up on us slowly until it is too late. Climate change is a classic example of a risk that increases slowly. For decades, the consensus amongst scientists has been that climate change is real, man-made and needs to be limited in order to prevent catastrophic changes to our weather system and extreme damages to society. Yet, the risk was ignored for many years because it didn’t seem urgent enough. Today, we are in a situation where limiting global warming to 1.5˚C above pre-industrial levels is impossible because it would require reducing carbon emissions to zero by 2030 or at the latest by 2040. Even limiting global warming to the Paris goals of 2˚C seems increasingly unlikely given the non-existent progress we have made on a global scale to reduce greenhouse gas emissions since 2015. 

In finance, a similar problem is the funding of our pension system and the social safety net in developed countries. The unfunded liabilities for social security and pension plans alone typically surpass 200% of GDP in Europe. In short, most developed countries cannot afford the social welfare systems they have at the moment, but instead of doing something about it, we continue to kick the can down the road and let our children and grandchildren figure out how to deal with the mess.

Which brings us to the third element of unsexy risks: they are politicised. At the heart of the current climate crisis as well as many other social and environmental crises is one factor and one factor alone: overpopulation. The world’s population has grown too fast. And even though population growth is slowing down since the 1960s, the slowdown is too slow to prevent any of the major catastrophes driven by the need to feed and house too many people on our planet. We might be able to find solutions to our population catastrophe through technology, as Larry Siegel argues in his book Fewer, Richer, Greener. But there is a simple solution that we tend to ignore because it is politically incorrect to discuss: Reduce population growth and global population through policy action. Policies that would penalise having children or limit population growth on a macroeconomic scale are such a taboo that to propose them would make you a Hollywood supervillain. After all the baddie in Avengers: Infinity War is Thanos who tries to eradicate half of the human population. 

In finance, all our long-term challenges are highly politicised. From retirement financing to taxes to globalisation. Everything becomes a political football as soon as someone is willing to tackle the problem. And the problem is always the same: We like to protect the benefits we and our family and friends receive while we ignore the costs to people that we do not know (e.g. people living far away in another country or people who aren’t even born yet). It is this present bias and self-centred behaviour that makes solutions to unsexy economic and financial problems impossible. 

In short, unsexy risks are like Annie Wilkes in Misery. Not a looker but much more deadly than Catherine Tramell in Basic Instinct and even though you try getting away from her, she chases you down and tries to get you again and again and again.

It is definitely no fun to tackle the unsexy risks in this world, but if we don’t do it, they will eventually transform into sexy risks. Unfortunately, when they do, it is often too late to do anything about them and the end result is catastrophic. Just think of populism in the 1930s or inequality in 18th century France and early 20th century Russia.

And since you have the weekend ahead of you, I challenge you to think about some of the unsexy risks I have mentioned in this post and consider how you and your family can help reduce these risks. Let me know your answers. I am curious.

Coronavirus: How bad can it get?

The coronavirus outbreak in Wuhan, China, has gone from a niche story to a major pandemic threat in just a few days. We know little about the current coronavirus variant except that the virus likely emanated from animals. Given that about 1.2% of all bats in China are infected by coronaviruses and 3.6% of bats are infected by Paramyxoviruses (both have the potential to harm humans), it is no surprise that there are regularly cases when these viruses mutate into something that can cause severe illnesses and even death in humans. Ironically, it was only two years ago that researchers managed to pinpoint the origin of the SARS pandemic. It was a cave in Yunnan province a mere kilometre away from the nearest village which prompted the scientists to warn that another deadly outbreak could emerge at any time. Two years later, their warnings seem to have become reality. But China isn’t the only pandemic hotspot in the world. The map below shows that the Indian subcontinent and central Europe also have a high likelihood to be the centre of a new pandemic outbreak from wildlife.

Hotspots map of emerging infectious diseases from wildlife

Source: Chmura (2017).

The social cost of such pandemics is impossible to calculate. After all, what is a life worth and what is the cost of putting an entire city into quarantine as China has done in Wuhan? However, as investors we can try to identify the likely economic costs of pandemics. And coronavirus-related pandemics like SARS, the Avian Flu (H5N1) and the Swine Flu (H1N1) all cost the global economy in excess of $30 billion.

Estimated cost of pandemics

Source: Chmura (2017).

The example of SARS is probably a good guidance for the possible economic impact of the current coronavirus outbreak. We can’t be sure but it seems as if the current coronavirus pandemic spreads faster than SARS but is less deadly (see table at the end of this post for a comparison of different coronavirus pandemics). This means that the economic impact will likely be felt not only regionally in China and neighbouring countries as was the case for SARS but also in developed countries in the West. On the other hand, the countries that are affected by the pandemic will likely suffer lower direct damages from loss of life and loss of productivity due to workers being sick.

But that is only a mild consolation. The immediate effect of the pandemic is felt by airlines and the tourism industry as flights are cancelled and tourists stay away from affected countries. Since the current outbreak happened right at the beginning of Chinese New Year, which is a peak travel season, tourism to and from China as well as intra-Chinese trips will likely take a massive hit. During the SARS pandemic, passenger volumes in China, Hong Kong and Singapore dropped by two thirds or more. The knock-on effects are felt in the tourism industry overall and in retail and food services industry more generally. An interesting case study on the impact of the MERS virus in 2015 on Korea has been published by Heesoo Joo and his colleagues who showed that although Korea is a highly developed country far from the centre of the MERS outbreak, the virus spread quickly to Korea and caused significant economic damage. Once it was known that Korea was affected, the tourism industry took a hit. In the end the cost of MERS to the Korean tourism industry was estimated to be $2.6 billion or about 0.17% of GDP.

Reductions in international passenger arrivals during the SARS pandemic

Source: Noy and Shields (2019).

The cost of MERS to the Korean economy is roughly in line with the estimated direct costs of the SARS pandemic on developed Asian economies. Direct plus indirect effects (e.g. loss of GDP due to sickness leaves of workers, reduction in educational attainment due to temporary school closures etc.) cost the Korean economy about 0.1% during the SARS pandemic. The United States economy likely suffered costs of c. 0.05% of GDP. And both countries were hardly affected by SARS and have diversified economies that do not depend heavily on tourism. Countries that were hit directly by SARS experienced losses between 0.5% and 2.5% of GDP. In a hypothetical scenario where the SARS pandemic would not be just a temporary shock but lingered on for another 10 years, the economic impact could be even higher as the chart below shows.

Estimated economic impact of SARS pandemic

Source: Lee and McKibbin (2004).

At the moment, we are far from this extreme scenario, but it seems clear that the Chinese economy will likely experience a substantial decline in output due to the current pandemic. If other countries will experience significant economic losses depends mostly on how deadly the current pandemic will be (the more people die, the bigger the impact on the tourism industry), how fast it spreads to other countries and within large countries like the United States, and if it can be contained quickly. Remember that today there is still no known treatment for SARS. All we can do is help patients with antiviral treatments to reduce inflammation of the lungs and isolate them so they cannot infect other people. And then we just have to wait and let the pandemic run its course.

The current coronavirus pandemic in perspective

Source: NPR.

Let it gush or: Let it bleed, part II

The other day I wrote about the lack of research spending by private businesses in favour of dividend payouts and share buybacks. If US businesses don’t invest in research, they risk losing the competitive advantage in the high-tech fields they currently dominate, such as IT and communication services. But, as one reader pointed out to me, a lot of R&D that used to be done in-house in the past (such as software development) is now bought off the shelf from specialist providers. Also, one could argue that private businesses don’t have to invest in research as long as they can tap into the fundamental and applied research done at universities and hire the best talents from elite institutions to work for them.

Unfortunately, when we look at the research spending in the United States as a whole, the picture is even direr than in the private sector alone. The Council on Foreign Relations last year published a lengthy assessment of the US investments in research and development and its implications for national security. The chart below shows the spending on research and development in the US per sector. While total research spending in private businesses has remained roughly stable since 2000 (though as I pointed out the other day, research spending on intellectual property has declined), federal spending on research has been in steady decline after the financial crisis. 

Research spending as share of GDP in the United States

Source: National Science Foundation.

However, you may notice that the chart above ends in 2016 and since then, things have become much worse on the Federal level. The Trump administration has repeatedly tried to cut federal spending on crucial research programs by up to 100%. It is only thanks to Congress that instead of massive cuts, these research programs have seen small increases in funding. Matt Stoller recently showed the striking difference between the Trump administration’s plans for the budget and the Congressionally approved budget. Here is a chart from his post.

As the Council on Foreign Relations points out, these cuts in federal research grants would create a massive national security issue over time since it would reduce the competitiveness of US companies and the US military. The risk becomes obvious if total US research spending (federal + private + other sources) is compared to research spending in other countries. The US is about to be overtaken by China and loses its advantage vs. France, the UK, and other countries.

Total research spending by country

Source: OECD.

Unfortunately, we know that spending on research and development is highly correlated with future productivity growth, future economic growth and future profitability of private businesses. By neglecting these crucial investments the United States – both on the private business and on the federal level – is risking its prosperity and its position of economic and political dominance in the world.

The Virtuous Investor: Rule 21

Life is short – Make it count for something

This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.

“Moreover, consider how full of grief and misery, how short and transitory is this present life.”

Erasmus of Rotterdam

One of the central tenets of modern finance is that money is neutral. It is supposed to be a means to an end but in itself is neither good nor bad. A corollary sometimes derived from this tenet is that investing should not be concerned about ethics. It should simply be a trade-off between risk and return, where risk is narrowly defined as risk to the portfolio.

This central tenet of modern finance is wrong and so is the corollary derived from it.

Meir Statman, who is one of the leading experts on behavioural finance recently published a free book called Behavioral Finance: The Second Generation. In it, he describes how real people want more from their investments than simple returns. They also want expressive and emotional benefits from them. To quote from the introduction to his book (emphasis mine):

According to second-generation behavioral finance, 

  1. People are normal. 

  2. People construct portfolios as described by behavioral portfolio theory, where people’s portfolio wants extend beyond high expected returns and low risk, such as wants for social responsibility and social status

  3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to save and spend in the right way. 

  4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than just differences in risk—for example, by levels of social respon­sibility and social status

  5. Markets are not efficient in the sense that price always equals value in them, but they are efficient in the sense that they are hard to beat.

You can think about ESG investing whatever you want, but you cannot argue with the fact that it satisfies an important want for many investors. More and more investors are concerned about climate change and environmental degradation. They are concerned about inequality and poverty and they are concerned about gender and racial inequality. And they want to do something about it.

The classic way to engage with these social and environmental issues is to engage in volunteering work and charitable giving. And if you are amongst the people wealthy enough to do so, you can even engage in fully structured philanthropy.

But how should you react if you are concerned about poverty and human rights abuses and then learn that one of your major holdings, e.g. Wal Mart or G4S, has been excluded by the Government Pension Fund of Norway for their human rights abuses? If you invest without ethical considerations and then use the money you earn with these investments to alleviate poverty and human rights abuses, have you really made a difference?

Modern finance does not account for cognitive dissonance. Modern finance assumes that we can compartmentalise our investments and our personal values and that one does not influence the other. But this is not true. The entire literature on cognitive dissonance shows that these internal contradictions make us feel terrible and we will do a lot to resolve this dissonance. In short, we want to be able to look ourselves in the mirror in the morning even if that means we are worse off financially.

Indeed, some people are willing to incur massive financial downside to stay true to their values. Of course, there are always going to be people who don’t care about the environment or social justice but in the 21st century, there seem to be fewer and fewer of them around. And luckily, in the 21st century, we don’t really have to compromise anymore on these things.

The reason why I write about ESG investing every Monday in my blog and about things like the virtuous investor every Wednesday is because it is my way of promoting the values that I find important. You may disagree with them and that is fine, but through my blog and my personal investments, I can express my values. Also, I can switch from traditional investment funds to funds with an ESG overlay. I can invest money in impact investments that not only create a financial return for me but also actively improve the situation in poor countries. And I can hire people with a diverse background to work for me (at least, once I am in the position of hiring people to work for me again).

And so can you and your clients. As an investor, your choice is to invest traditionally and use the money to express your values or to simultaneously express your values with your investments and the returns you get from them. And if the returns are a little bit lower than with a traditional investment, my guess is that many will still be willing to invest in line with their values. In fact, it is not a guess. Morningstar tested a representative sample of US retail investors on their investment preferences by giving them the choice to split their investments between two stocks, one of which had a higher sustainability score than the other. They checked for different combinations of risk, return and sustainability and categorised investors based on the weight they gave to sustainability criteria relative to traditional risk and return considerations. The chart below shows that 44% (almost half) of respondents gave a weight of at least 60% to sustainability criteria and 72% gave a weight of at least 40% to these criteria. The share of investors who did not care about expressive values like sustainability was about one in four or less.

Importance of sustainability criteria for US investors

Source: Morningstar.

Cynics may say that once markets experience a downturn, these preferences will change again and investors will abandon ESG investments, but there are studies that show that investors stick with sustainable investments for longer than with traditional investments and hence may generate higher returns in the long run, as I have explained here.

What this means is that life is short, and we should all make sure we make it count for something. This can be charitable work, advocacy, and education (as I do with this blog and the books I write), but increasingly it can also be expressed with our investments.

And this creates a win-win because it will make us feel better (I must know; I get so much satisfaction and happiness from the responses of my readers and the discussions I have with them) but it will hopefully make the world a better place as well. 

Let it bleed

One thing that bothers me is that businesses today aren’t investing in the future anymore. I have written in the past how investments in research and development have declined so much that we are putting future productivity growth at risk. While researching for another project, I came across a development for US businesses that I wasn’t aware of in all its awfulness. So, I thought, I share it with you.

The chart below is taken from the Bureau of Economic Analysis’ NIPA tables and it shows the cost of equipment and intellectual property products for private businesses. This is essentially the cost of what makes businesses hum and the good news is that since the mid-1990s the cost of equipment has declined dramatically and is now 28% lower than 25 years ago. The cost for intellectual property products is 14% higher than 25 years ago but has basically stalled over the last decade. The average annual inflation rate for intellectual property products (e.g. software) has been just 0.5% per year over the last decade.

Cost of equipment and intellectual property products

Source: BEA.

Given the lower cost for the vital parts of most businesses, one would imagine that businesses are taking advantage of these price declines and invest heavily in equipment and intellectual property products. Yet, except for a brief investment boom in the 1990s, the trend is clearly downward. Net investment in equipment and intellectual property products as a share of GDP is falling steadily. In the 1990s, the average annual net investment was about 2.2% of GDP, in the 2000s, a period that included the Global Financial Crisis (GFC), it was 1.9%. One would imagine that in the booming 2010s investments would have risen significantly to catch up with missed investments during the GFC. But no, the average of the 2010s was even lower than in the decade before and a mere 1.8% of GDP per year.

Net investments in equipment and intellectual property products

Source: BEA.

In the name of shareholder value maximization, businesses are slowly bleeding themselves to death. Because it is not like businesses don’t have the money to invest. On average, they are highly profitable, but instead of investing these profits into their businesses, they keep it in cash and spend it on dividends and share buybacks (and the occasional overpriced merger). This way, short-term shareholder value is maximized but long-term shareholder value declines steadily because as every investor knows the value of a business is driven by the value of its assets, its growth and its profitability. But without investments in equipment and intellectual property products, the assets depreciate more and more, growth slows down and productivity declines. In short, the company slowly becomes worth less and less. 

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