Weekly Edition #55
In this edition:
As all of you know, there is a war going on between Russia and Ukraine. We wrote about it last week. The west has so far not used military force against Russia, but they have enacted a whole host of economic sanctions targeting Russia. The US Dollar is the dominant reserve currency, followed by the Euro, which together compose around 75% of worldwide currency reserves. This means that the US and European Union have a lot of power over the world economy. They can essentially prevent specific people, banks, and even countries from interacting with their currencies. This essentially shuts down trade in many specific products. For example, if Russians want to buy US goods, they need to pay in US Dollars. If they cannot exchange Rubles for USD, then they cannot but the goods they wanted to buy in the first place.
The West has also cut off several banks from the SWIFT system. SWIFT is a system used by banks to send secure messages to one and other. Being cut out of SWIFT is a strong sanction which hasn’t been used many times before (maybe ever?). The West also put sanctions on the Russian central bank (RCB). The RCB had around $640 billion in foreign exchange reserves. With this they could buy foreign goods without needing to exchange rubles first. They were relying on this money to keep on importing goods and to stabilize the Ruble in case sanctions were imposed. However, around $300 billion of these reserves were in western banks. The sanctions placed on the RCB means they don’t have access to these $300 billion in reserves, which will hamper their efforts to finance their economy, the war, and stabilize the Ruble. Russia also has around $130 billion of reserves in physical gold. The problem with this is that in order to spend this gold, they have to convert it into currency first, by selling the gold. Which is difficult since there are sanctions on banks, and non-Russian banks are afraid of dealing with Russian banks because of fear of fines imposed on them. The Russian economy is coming close to collapsing, with the Ruble falling from around 75 Rubles to USD to around 109 today. If this continues much longer Russia will probably fall into hyperinflation, with goods running scarce.
One of the biggest selling points for cryptocurrency fanatics is that the ledger that keeps track of transactions is immutable. This means that previous entries cannot be changed. We’ve always thought that this wasn’t such a great thing. How many of you have had you credit card information stolen, only to call the bank and have the transactions reversed? With Bitcoin for example, if you are sending money and you mistype the address to which it’s being sent (very probable since addresses are a combination of letters and numbers between 26 and 35 characters long); then there is no way to get your money back. You would have to send a message to the person who received the Bitcoin and ask them to send it back, if you can even figure out who you sent it to.
We’ve written before about NFTs, what they are and how they work. Many NFTs (most?) live on the Ethereum network, and they are bought and sold for Ether, and many are bought and sold through OpenSea, a popular NFT trading platform. Recently it seems that a bug on the OpenSea platform allowed some people to buy NFTs for very low amounts. A Bored Ape was recently sold for 0.01 ether (around $26) and then listed for sale for 225 (~$592,000). The previous owner of the NFT is suing OpenSea claiming the NFT was worth $1.3 million. Immutability is all good if you can guarantee that there is no bug in the code. However, immutability is a huge problem if the code has bugs or reacts in unintended ways. Immutability is just another “feature” of crypto that people are for until they have a situation in which it doesn’t work, and they want it another way. The traditional financial system has evolved in such a way that many of these problems have already been fixed. And as Matt Levine is fond of saying, crypto is facing the same problems traditional finance faced many years ago and are solving them in the same way just decades later.
We’ve written several times before about ESG investing. From a first principles perspective it would seem that companies with high ESG scores should not outperform. Investors are seeking ESG investments because they want to align their investments with their beliefs. Something that “feels good” should not, in principle, lead to higher returns. Investors should in theory be rewarded for doing uncomfortable things, this is why we earn a risk premium. Stocks earn more than bonds because they are riskier, the higher volatility in stocks feels much more uncomfortable; therefore, they offer higher returns to entice investors to invest. With ESG the same principle applies; if an investment is offering an intangible benefit (positive environmental impact), then the returns offered should be lower than investments which offer the opposite (negative environmental impact). This is because if you have to invest in something that goes against your beliefs, then it needs to offer higher expected returns for you to invest.
There’s mixed evidence with ESG investing. Some research shows that it outperforms, other research shows it doesn’t. There’s also mixed evidence as to how much of an impact ESG investing actually has. If you decide to sell your Exxon shares because they drill for oil and gas, that transaction has absolutely no impact on the company. You sell your shares on a public exchange and somebody else buys it. The company is not involved. We believe if you want to invest in an ESG way, then it’s most effective if you do it in things where the money actually goes to the companies directly. In the end we think ESG investing has a marginal impact on companies, if you want to affect change, it’s much more effective if you vote with your wallet. If you don’t like a certain companies’ policies, then stop buying their products, you don’t like Exxon drilling for oil and gas, then buy an electric car and stop buying fuel.
Expected returns for traditional asset classes (stocks and bonds) are low. Faced with this predicament, investors have started moving out the risk curve, into riskier bonds (private debt) and riskier stocks (private equity). It seems that institutional investors think that juts because they are private, their return expectations have not been reduced. Public and private market valuations are intricately linked. If the stock market falls, then why would you pay higher valuations for private companies, it doesn’t make sense. If the stock market gets cheaper, so should private companies. There is also a record amount of money invested in private markets, which again drives up valuations and drives down returns. The more you pay for something the lower the return will be, all else equal.
Pension funds in the US have high return targets (around 7%), which are pretty much impossible to reach using only traditional assets. Since lowering future payouts or raising taxes is unpopular, they have not adjusted their return expectations. This would only make the underfunding problem worse, even though we think it’s the reality we live in. Instead, pension funds have decided to back up the risk truck and load up on riskier investments. Even though it is questionable if they have historically outperformed, and we have serious doubts if they will do so in the future. What do we think you should do? Invest in assets or strategies that do not depend on traditional markets to perform.
Investment portfolio backed credit lines are interesting products that banks offer to wealthy clients. The bank uses the investment portfolio as collateral to lend out money to their clients at very attractive rates (we’ve seen credit lines priced at 0.9% interest rate). Therefore, these lines are very popular among wealthy individuals, especially to avoid having to pay taxes. Instead of having to sell an appreciated position, the investor can take out a load using the position as collateral and spend the money without having to pay taxes.
The risk here is that the portfolio falls in value and there is not enough collateral to cover the value of the loan. In this case banks typically ask the client to deposit more money in the account or sell out of their positions to repay the loan. The crisis in Russia has wreaked havoc in portfolios of some investors. UBS had clients that would take out loans using Russian bonds as collateral, they would then presumably use this cash to invest in something else. Now that Russian bonds have collapsed in price, UBS is no longer accepting them as collateral. Therefore clients which were taking on a lot of risk by taking out loans against this type of debt are in trouble.
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