We can't have nice things

Unless we are willing to pay for it

Photo by Emerson Moretto on Unsplash

Hello,

Welcome to Known Unknowns, a newsletter that is full of sin.

The virtue bubble is about to pop.

I don’t like to use the word bubble regarding financial markets, I am too much of an efficient markets believer to think that such a thing is possible. After all, all if prices reflect information, and information tells you that an asset price will go up, it is reasonable to keep buying, regardless of whether it is based on fundamentals—even if prices will someday go down. That is if you are into active trading (which I am not). However, I am tempted to use the B-word when it comes to the virtue economy.

The virtue economy is not just ESG investing; it is also choosing where you work and what you buy based on who you think is virtuous. It may have been a bubble because during good times because we told ourselves that we could make virtuous economic choices and not pay anything for it. ESG funds were even sold as outperforming regular (sin-filled) funds. And for a while that seemed to be true. When everyone was buying up ESG, it outperformed—at least until it didn’t this spring when markets fell.

The true test of any asset class is how it performs in adverse market conditions, and ESGs are under-performing now. And they should. That is not a value judgement, it is just math. If you put a constraint on your investment choices, then you should earn less than an unconstrained portfolio.

Meanwhile, in a high-inflation environment (8.6%!), only buying from virtuous vendors leaves less scope for substitution, which is your best inflation hedge. If the labor market tightens, maybe you can’t afford to be so fussy about where you work.

I think that this is a bubble that needs to pop. ESG funds are facing more scrutiny for “greenwashing” or not picking the right companies. However, this is a feature rather than a bug. What makes a company virtuous is arbitrary, and everyone has different values. Oil companies are some of the biggest investors in renewables. Does that make them good or evil? Interrogating your hamburger buns for moral virtue takes time and is terribly inefficient.

Just buy what you want, work for who pays you the most, and buy sin-filled stocks. Then, give all that extra money to charity.

When will interest rates go back down?

Not anytime time soon, I think. Like many financial macroeconomists, I always thought that long-term interest rates mean revert, which means that I have been waiting for 40 years for them to go up (well, not really that long—I was not that interested in such things in elementary school). The ten year hit 3%. Is this the start of rates reverting to the mean, and the last 40 years were just one long cycle?

Yes and no. I think that structural changes, such as the demand for dollar assets from more globalization, low inflation, regulation, and the explicit Fed put on bonds, lowered the rate’s natural level. Therefore, although we are not going back to the 1980s, rates may still rise, foreigners are less excited about US debt, and well, inflation is both high and unpredictable.

Although I am not one to make market calls, I would not take out an adjustable-rate mortgage in the hope that mortgage rates will go back down to 2.7%.

Policy risk

Now that inflation is officially out of control, there is much speculation that there will be a recession within a year. Many people think that it is already here. I think that this is a fair assessment, even if other aspects of the economy look good on paper. If you are much poorer because you can’t afford to keep up with rising prices, then it is a recession to you.

But the biggest risk to the economy is the policy choices that we make. During the 20th century, several recessions were caused by the Fed coming in too hard and slow on inflation. So far, they have been too slow, although not that hard. It’s a narrow path for them because raising rates too much could cause a recession, as would not raising them enough.  

I am even more concerned about policies that can undermine our long-term growth. We need better immigration policies, and politicians need to stop blaming greedy corporations for their policy mistakes. We can’t break up successful companies just because they are big, and we need to embrace trade rather than fight it.

Us humans are remarkable for our ability to innovate, and we have the tools for greater prosperity if we can just support the economy when we need to and then get out of the way.

We can’t have nice things

Case in point. The Chilean pension system (the best DC system in the world) is falling apart. One of the main benefits of DC plans is that they are always, by definition, fully funded. Plan sponsors and governments can’t use the money now to pay for things today, even if they are making promises for later. However, as it turns out, if the money is sitting there and the political will is gone, people will spend it. Retirement systems are so interesting to me because what happens to them is always the canary in a coal mine for the larger economy. They reflect everything about our ability to save, redistribute, plan, and deal with risk. 

For Chile, it was nice while it lasted. I recently asked a Latin America columnist why some countries, such as Chile, seem hell-bent on undermining their successful economy. She said that it is not just them—none of us can have nice things, as that is human nature. America just happens to have a better Constitution that saves us from ourselves.

In other news

I debated Adrian Wooldridge in a Munk debate about whether we should return to the office. It was very exciting for me because I have been a big fan of Adrian’s since I started reading The Economist. Moreover, not only did I get to debate him, but my writing now appears beside his at Bloomberg (with a byline!). As you know, I think that people should go back to work, even if they don’t want to. I worry that young people are seriously under-investing in their human capital.

My latest podcast with Stian Westlake is up. We discuss the intangible economy and how we need to reform our institutions. He always makes me smarter.

Until next time, Pension Geeks!

Allison