When the International Monetary Fund (IMF) and Egypt reached an agreement on a $3 billion Extended Fund Facility (EFF) in December, the market had a general sense of euphoria: Egypt Government Eurobonds had already recovered a significant portion of their 2022 losses in anticipation of the agreement, and followed through with an upswing in January. Since then, realism has taken over, wiping out all IMF-inspired gains and sending the government’s financing costs through the roof. 

Against this backdrop, can Egypt weather the storm and what should we look out for? Our editor, Samuel Yip, asked Yury Zusman, a London-based emerging market strategist and the author of a research series EM Dynamics, to shed light on the four key areas that will show us where the macro picture is heading.

Currency 

Samuel Yip: How is the Egyptian government dealing with its currency situation, and what has the IMF asked of them? 

Yury Zusman: As part of the agreement with the IMF, Egyptian authorities agreed to allow for a flexible exchange rate. This way the exchange rate could adjust and the FX market could clear without the need to spend the foreign reserves of the Central Bank of Egypt (CBE). 

Generally, in a country with a current account deficit, capital flows into the country and finances the deficit. The difference between the amount of capital flowing into the country and the deficit is added to (or subtracted from) the country's FX reserves. 

In a completely free-floating exchange rate regime, the currency market clears such that capital inflows equal current account deficit and change in reserves is zero. 

However, in a regime where the central bank intervenes, the exchange rate can be at some other level where capital flows are different from the deficit and there is a change in reserves. 

A fixed exchange rate regime is an extreme example of this: the exchange rate does not adjust to a market-clearing level and any difference between capital flows and current account is met with reserves. 

This difference can be positive (implying a reserve build) or negative (implying a reserve draw). However, while a country can theoretically build unlimited reserves, it cannot draw them down indefinitely – there comes a point when the country runs out of foreign currency. At that point, the country can no longer finance the difference between capital flows and current account deficit and is forced to devalue. 

Similarly, running out of foreign currency means the country cannot make payments on its foreign liabilities and so has to default. 

Egypt started to go down this path last year. There was a global shock, driven by geopolitics and rising rates, and capital inflows in Egypt turned into very rapid outflows. Egypt, which was maintaining a fixed exchange rate regime, started to quickly run down its reserves. This was exacerbated by the fact that the exchange rate became overvalued during the pandemic leading to a widening current account deficit and a greater need for foreign capital to finance it. Investors also viewed the exchange rate as overvalued which further discouraged foreign investment into the country.

With falling reserves, Egypt became at risk of not having enough foreign currency to pay its liabilities. Ultimately, the country was forced to let the currency adjust to a significantly weaker level. 

In order to avoid running into a similar problem down the road, the IMF demanded from the country's authorities a commitment to a flexible exchange rate in exchange for fresh funding. Such exchange rate flexibility would allow Egypt's current account deficit to narrow to a more sustainable level, attract foreign capital and rebuild the country's foreign reserves.

Having said that, while Egypt did devalue its currency, it has not fully adopted a flexible exchange rate regime – USD/EGP has been fixed at close to 31 since March, while the forward market and the local "black" market suggest the currency should be weaker.

Inflation

How does inflation affect the government’s ability to contain the financial crisis?

Egypt has been struggling to bring down its inflation, with prices going up 32.7% over the past year. Part of this is due to a global commodity price shock combined with currency devaluation and FX passthrough. However, the CBE also engages in quasi-fiscal activities, including subsidized lending to a big portion of the economy, which can be extremely inflationary. 

Apart from raising the cost of living, especially for the most vulnerable parts of society, high inflation also reduces the competitiveness of domestically produced goods and services and can lead to the need for further currency devaluation. 

As part of the agreement with the IMF, the CBE committed to winding down most of these lending schemes and transitioning all remaining such activity to the fiscal authorities. 

Over the medium-term, the CBE will need to institute a credible inflation targeting regime. A successful transition will lead to higher investment and sustainable growth. It will also increase the inflow of foreign capital which will be attracted by positive real rates of return and lower devaluation risk. In the long-run, it will also help Egypt to bring down its interest costs and allow the country to finance itself with longer maturity local currency debt, which will reduce rollover risk and increase debt sustainability.

Government Reform / State Exit

The Egyptian government – in particular its military – is heavily involved in different sectors of the economy. Does the IMF agreement require any reforms relating to that? 

Yes, an important IMF requirement is for the Egyptian state to reduce its footprint in the economy by isolating the most strategic sectors and selling down its assets in the rest of the economy. 

According to the IMF, public sector companies, excluding the military-owned ones, amounted to around 16% of the economy in 2018. This figure is likely higher now. 

There is less information about the exact size of the military involvement in the economy, but another 10-15% of the economy seems like a fair estimate. Anecdotally, military-owned enterprises are involved in almost everything under the sun: bottled water manufacturing, retail fuel stations, cement production and holiday resort properties. 

While there are many other economies where the state accounts for a large share, I think the military's dominance in the private sector is quite unique to Egypt. Not surprisingly, these enterprises are not very efficient and rely heavily on subsidies, tax breaks, procurement advantages and, in the case of the military, free labour by conscripts. 

There is also a lack of transparency and accountability of public enterprises. Egypt's government statistics, in general, is actually of quite poor quality - much of it incomplete and significantly lagging. But when it comes to public enterprises, there is very little information at all. IMF also understands this problem, and improving transparency and accountability of public enterprises is, in fact, one other objective of the program.  

In the near-term, selling state assets and cutting tax breaks for public enterprises would raise the necessary revenue to service government debts. In the medium-term, retrenchment of the state from the private sector and a level playing field for private enterprises will lead to greater efficiency, higher productivity and higher long-run growth. Egypt has very high potential growth due to a lower starting base and great demographics, i.e. very young population and strong population growth. But to realize this potential, the country needs to be able to create jobs that will absorb the new labour force entrants. A dynamic private sector is a key element of this.

Debt Level

What about their government debt level? 

If successfully implemented, these reforms are designed to get Egyptian government debt back onto a sustainable path. 

When you look at the key drivers of the debt trajectory, growth, primary fiscal balance, interest expenses and currency are the key drivers of sustainability and default probabilities, both in terms of macroeconomic theory and empirical evidence. To Egypt's benefit, the government already has a primary surplus, which it achieved during the previous EFF program. It needs to maintain that and hopefully increase the surplus slightly. 

The country also historically has had very good growth, but needs to implement the aforementioned reforms to maintain it at a high level and avoid a growth shock in the near-term. 

The Egyptian government uses about 50% of its revenue to pay interest expenses, which is very high. Paying such a high proportion of revenue just to service the debt can lead to political challenges and result in the country's unwillingness to pay its debts. 

Structural reforms will help bring its interest costs down, while raising additional tax revenue will generate more revenue overall. The currency factor has two sides to it. Immediately after a devaluation, the debt level rises as FX-denominated debt becomes larger in local currency terms. However, in the long run, a flexible exchange rate will help Egypt to rebuild its foreign currency buffers, which will ultimately result in a greater capacity to service its foreign currency debts and help the economy weather future macro shocks. In totality, these reforms will reduce the risk of default and improve Egyptian credit.

Recently, there’s been a lot of focus on China’s declining population, with India overtaking as the world’s most populous country. But the bigger and perhaps more urgent issue is that populations are aging, a trend seen across the globe. Economists are trying to figure out how this will affect inflation, and the jury’s still out.

The pace of population aging is much faster than in the past. In 2020, the number of people over 60 years of age worldwide outnumbered children younger than five. Between 2015 and 2050, the proportion of the world's population over 60 will nearly double from 12% to 22%, according to the World Health Organization.

And it’s happening at varying rates. By 2050, South Korea is set to have nine seniors for every working-age person, while South Africa will have two, the World Economic Forum predicts. Among the fastest aging are Eastern European countries (Poland, Slovakia and Slovenia in particular), China and Brazil, while Japan already has the world’s oldest population with 28% over 65 years of age.

The massive labor supply from some of these countries in the past few decades has played a part in low wages and, therefore, low inflation.

“The previous trend lower in interest rates and inflation occurred because demographics lined up over the past 25 years to keep wages low and savings high,” says Bruce Liegel, former fund manager at Millennium and author of Global Macro Playbook, a monthly research series.

“These disinflationary forces allowed global central banks to run very accommodative interest rate policies without any concern that they would be causing a mistake, a.k.a. inflation.”

Some believe that as this supply of workers dwindles, the knock-on effect could be upwards pressure on both prices and already-high inflation, impacting central banks’ interest rate paths.

“This great demographic reversal will lead to a return of inflation, higher nominal interest rates, lessening inequality and higher productivity, but worsening fiscal problems, as medical, care and pension expenditures all increase in our ageing societies,” says Charles Goodhart, Emeritus Professor of Banking and Finances at the London School of Economics and co-author of a book on the combined impact of aging societies and a retreat from globalisation.

“We doubt that politicians, facing rising health and pension costs, will be prepared or able to raise taxes enough to equilibrate the economy via fiscal policy.”

This school of thought sees the days of zero interest rate policies as gone, with low interest rates unlikely again in the short to medium term, and aging populations limiting the options for central bank rate setters.

Earlier this year, as the UK faced its highest inflation for decades, prompting a series of rate hikes, Bank of England Governor Andrew Bailey warned that early retirement and the resulting shrinking workforce were contributing to pushing prices and interest rates higher.

Others point to Japan as a microcosm of the world’s aging demographics – a ‘test kitchen for “shrinkonomics”’ as the International Monetary Fund puts it – where a rapidly aging population has not notably pushed up inflation. In fact, an IMF study found substantial deflationary pressures there from aging.

Elsewhere, a Federal Reserve study predicts that real interest rates in the US will remain low in the coming decades despite shifting demographics, with the country having reached “a new normal”, while research in the euro area found that although lowered savings among the elderly put upward pressure on interest rates there were several mitigating factors to offset this.

So, one thing’s for sure, the debate looks set to continue, as central banks, governments and economists grapple with rapidly changing demographics and what they may mean for us all.

The Federal Open Market Committee may be split on future rates, but what is certain is that the financial system has already gone through a sea change, and things will be radically different from the past 20 years. 

Zero interest rates: a boon to investors

Since the peak in interest rates in the 1980s, low interest rate policies have driven markets, particularly asset prices. This accelerated after the 2008 financial crisis, as central banks around the world adopted quantitative easing and zero interest rate policies (ZIRP).

“[Declining interest rates] provide a subsidy to borrowers at the expense of lenders and savers,” says Howard Marks, chairman of Oaktree Capital Management. They reduce both the cost of capital for businesses and the prospective returns investors expect, driving up asset prices.

“By simultaneously increasing asset values and reducing borrowing costs, they produce a bonanza for those who buy assets using leverage.”

During this prolonged period of ZIRP, market participants have been incentivized to invest in low-yielding projects or assets, often taking ever more risks to find yields. This makes sense: if you can borrow at 0%, any asset or project with a positive yield will be profitable, assuming the interest rate does not go up.

Carry trade: a global, systematic phenomenon

The upshot is that the entire financial system has operated as a huge carry trade.

A popular investment strategy, the carry trade often involves borrowing in a low-interest-rate currency and investing in higher-yielding assets. But it can also be applied to virtually any asset class, with investors borrowing at a low rate and generating profits from any asset class.

“The carry trade is a global phenomenon on a systematic level, encouraged by extremely low rates for an extended period of time,” says Bruce Liegel, a former macro fund manager at Millennium Partners LP and the author of Global Macro Playbook, a monthly research series on global macroeconomics at Hedder.

“This entices investors to borrow money and invest in riskier and riskier assets, with the boom in private equity and venture capital being a prime example.”

Unwinding the carry trade

This systematic borrowing at an assumed interest rate, which has now blown up, is causing financial stress for investors and asset prices, and some are starting to close out – or “unwind” – their positions.

Warren Buffett famously compared interest rates to gravity: when the force of gravity increases (interest rates go up), the prices of assets must adjust downward.

The US banking meltdown involving Silicon Valley Bank, First Republic Bank and others, is a good illustration. The banks that got into trouble invested short-term deposits in a longer-duration asset, creating a duration mismatch. With a dramatic rise in interest rates, these banks are taking large unrealized losses on these investments. They become realized when depositors take their money out, causing a liquidity issue for the banks.

Banks aren’t the only ones

But banks are not the only players feeling the stress.

“We are also seeing it in the commercial mortgage-backed securities and real estate markets, where investors were able to borrow cheap money and invest in projects as a leveraged play,” says Liegel.

A lot of these borrowings have to be refinanced at a higher rate, and here comes the problem: investments that work in a zero-rate environment do not work in a 5% world.

A simple analogy is someone buying a vacation property with a low floating interest rate over 20 to 30 years. Now that mortgage rates have gone from under 3% to over 7%, the investment no longer makes sense and the owner may be forced to liquidate or sell, driving the asset price down in the process.

“We are starting to see a lot of this unwind from all the embedded leverages that have been put in the system over the last 15 to 20 years,” says Liegel.

A long-term trend?

But what if the rise in interest rates is just the start of a long-term trend?

In JPMorgan Chase’s CEO Letter to Shareholders, Jamie Dimon predicts that the economy will be “[heading] to higher inflation and higher interest rates than in the immediate past.”

If so, the compounding effects of the unwind could be just getting started. As central banks around the world keep interest rates high to combat inflation, the unwinding of the carry trade looks set to continue. The warning is clear: it's time to brace for impact.

With the proliferation of factor ETFs, it is now easier than ever to implement factor investing for an investment portfolio. In this article, we will explore the basics of factor investing, the range of factors to select from, and the methods to evaluate the performance of factor ETFs.

What is factor investing?

Active investment managers base their investment decisions on thorough analysis of individual companies and their respective stocks. In contrast, factor investing prioritize identifying certain characteristics that historically outperform the broader market on a risk-adjusted basis.

The idea, originated from a research study in 1992, is that if you select a group of stocks based on these characteristics and construct a portfolio around it, the portfolio can theoretically outperform the market over the long term. As an intuitive yet data-driven investment approach, factor investing is widely adopted by investors, and can be easily implemented across a wide range of portfolios.

Many ETF providers now offer factor-based strategies that actively select stocks (and this has been expanding to additional asset classes as well). To invest in any specific factor, we can simply purchase the units of some of the most liquid ETFs.

Factors to select from

There are over 300 factors but we will consider the ones set out in the list below. All main ETF providers offer factor ETFs on the following:

• Value. As one of the original factors, value is very well known and studied. It refers to buying undervalued stocks and selling overvalued stocks based on some metric. The original definition of value was based on the book-to-market ratio, an indicator of companies' financial health. However, modern methodologies might consider a variety of metrics to identify the value of the underlying stocks.

• Dividend. This factor can be defined as the outperformance of those stocks paying high dividends compared with peers with lower dividends.

• Low volatility. This factor assumes that the performance of stocks with low volatility is superior to their riskier counterparts over the long term.

• Momentum. Another important, well known and studied factor is momentum. The rationale is to buy outperforming stocks and sell underperforming ones, as investors tend to select securities based on their past performance.

• Quality. This expresses the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon.

Factor Investing: Performance Analysis

How did factor ETFs perform in recent years? The following table illustrates the return of various factor ETFs between 2019 and 2022. Note that S&P 500 is also added to the table as a benchmark.

It is perhaps surprising to see that even for the same factor, different ETFs perform very differently. For example, between 2019 and 2022, State Street Value recorded a return of 57.99%, significantly outperforming iShares Value, which achieved a return of 40.44%.

We know that implementations can in practice differ, but by how much? And what is contributing to the difference in results achieved by different funds? There are a number of reasons:

• Weighting schemes. Not every ETF provider assigns weights to the factors in the same way. Some may use more complex methodologies (for example, risk parity, portfolio optimization, etc) and others may use simple schemes.

• Rebalancing period and logic. The rebalancing period and treatment can also make a difference. The frequency at which an ETF provider rebalances the fund may have an impact on its performance. There might also be special cases (e.g. when companies get into mergers or acquisitions or are delisted), and the rebalancing treatment might differ from one fund to another.

• Selection. The methodology to select stocks can also be different. Some factors do not have standard selection criteria, and this might result in very different methodologies, scores and ranking systems to select stocks.

• Long only or long-short? It is always possible to just invest in the entire universe by giving some overweight to some stocks, or construct a long-short portfolio by longing the outperforming group and shorting the underperforming group (based on any of the methodologies).

How to evaluate factor ETFs?

The evaluation of factor ETFs can only be meaningful if we can establish a framework to analyze their performance. We should not only analyze absolute returns, as this would be a poor and oversimplified method to make investment decision.

Generally speaking, there is no single performance indicator that would work alone. With a collection of indicators, we will get a sense of how ETFs differ with each other, as well as what we might prefer on the basis of risk aversion and risk tolerance. Basic indicators that investors typically consider include:

• Annualized return. The return achieved during the year, keeping in mind compounding.

• Annualized volatility. The volatility of the achieved return on an annual basis, which means how “different” the return might be on an annual basis compared with the average return.

• Sharpe Ratio. The ratio between return and volatility, providing insight into the overall risk-reward profile of an investment. A higher Sharpe Ratio indicates a greater risk-adjusted return, indicating a more favorable balance between risk and reward..

• Beta to S&P 500. This expresses the systemic risk of an investment, which means the expected percentage change for a 1% change in the index.

• Expense ratio. This reflects how much a fund pays for its expenses, including portfolio management, marketing, custody etc.

The following table is a comparison of dividend ETFs offered by iShares (HDV), State Street (SDY) and Vanguard (VYM), based on the indicators above.

Other considerations

Factor investing is a widely recognized concept in the financial industry that aims to decompose returns into identifiable factors. It is a relatively intuitive investment approach that has been supported by decades of research, and could be helpful to investors looking to boost their portfolio’s risk-adjusted performance over the long term.

However, factor investing is not without its pitfalls. First, there are plenty of factors, and uninformed investors might find it difficult to understand which factors to invest in. Second, the methodology behind each factor is sometimes unclear, and investors may be exposed to factors that are constructed in a way that is different from what they anticipated. Finally, factors can go through periods of underperformance, and it may require a long period of time before an investor can start seeing superior returns from factor investing.

Overall, we can conclude that factor investing is a useful strategy for enhancing the equity profile of a portfolio. However, rather than solely evaluating factor ETFs based on surface-level information, investors would benefit from dedicating time to comprehending the underlying factors within each fund. This diligent approach serves to mitigate potential risks and optimize the overall effectiveness of the strategy.

Key Takeaways:

1. Big spikes in the gold price are not really following moves in inflation, indicating that gold may not be the inflation hedge that many people think it is.

2. There is a compelling case for viewing gold as an anti-dollar asset, particularly in the current macro and geopolitical climate.

3. There has been a strong central bank appetite for gold, and this will sustain demand for the precious metal in the years to come.

Gold has long been regarded as a safe haven asset by investors and bankers alike. Recent surges in inflation and geopolitical uncertainties have sparked further interest in the precious metal, ultimately driving its price close to all-time highs.

At first glance, this enthusiasm for gold as an inflation hedge seems justified. As the common thesis posed, gold’s quantity is limited and, unlike fiat money, you cannot print it, making it the perfect anti-inflation safety bet.

Yet, a close examination of gold's performance challenges this conventional wisdom, and reveals a complex picture that carries important implications for investors.

Gold as inflation hedge

Looking at the trajectory of gold relative to US dollars since 1975 and overlaying the US consumer price index, it becomes evident that significant spikes in the gold price do not consistently correspond to rising inflation.

Surprisingly, even during  the last three years when inflation exploded, gold prices traded in all directions, indicating a weak correlation between the two.

Not only does gold’s performance fail to align with actual inflation rates, but it also shows limited correlation with inflation expectations. Examining the Federal Reserve Bank of New York’s inflation expectation survey uncovers that this forward-looking metric does not strongly correlate with gold’s performance.

Additionally, the yield environment plays a crucial role in shaping gold’s appeal. Since the asset does not offer carry, dividends or interest, high yields,which typically materialize in response to rising inflation, dampen its attractiveness.

Considering these factors, it becomes clear that gold’s connection to inflation is more nuanced than previously believed. At most, it could be deduced that inflation is a lagging indicator for gold.

Gold as anti-dollar

Instead, a compelling case can be made for viewing gold as an anti-dollar asset, particularly in the current economic climate.

Gold is most often discussed in dollar terms. Though, amid geopolitical uncertainties and concerns over the future of the US dollar as the world’s reserve currency, investors are increasingly turning to gold as an alternative to holding dollars.

Today’s macro variables stand out as particularly fertile for investors to adopt such a stance. Western sanctions against Russia and the fears surrounding the dollar-dominated financial order have intensified this sentiment leaving many to equate the move as the weaponization of the greenback.

More recently, the debt ceiling dysfunction and the uncertainty around future Fed moves are pouring further fuel on the fears that surround the fate of the US dollar and its status as the world’s reserve currency, with some pointing to signs of a crumbling dollar-denominated financial order.

Against such a challenging backdrop, investors are increasingly turning to gold to avoid holding dollars.

But can’t you simply hold other currencies to avoid the US dollar? The obvious alternatives would be the Euro, Sterling or Yuan, but two of these have the same drawback in terms of weaponization and sanctions, the other has currency controls. The politics are just as problematic as the US for different reasons, and the bond markets are also much smaller and less stable.

Notable gold price surges, such as those witnessed in 2005-2011, 2019-2020 and in 2022 are just as clear if you look at the price versus EUR, GBP or CNY, which indicates that gold outperforms any other dollar alternatives.

Gold as central bank reserves

Another crucial factor shaping gold’s recent trading patterns in central bank demand.

While allocation to gold among central banks varies greatly, the World Gold Council’s data indicates  that top reserve-holding countries/regions largely have single-digit gold allocations.  

However, central banks are currently gobbling up gold at the fastest pace in decades, with 2022, the year when Russia’s foreign currency reserves were frozen, witnessing the highest increase since 1987.

The primary buyers include China, Kazakhstan, Russia and Turkey; nations often at odds with the US diplomatically are diversifying their reserves away from the US dollar, which they perceive as less secure.

This makes sense: if you are a central bank in a country which might at some stage consider not aligning with the US on matters of international policy, holding a large proportion of your reserves in US dollar doesn’t seem so safe.

But how fast can a central bank build up its gold reserves? Gold production typically amounts to 3-4 tonnes a year. Approximately 30% of the output is utilized for jewellery, leaving around 2.5 tonnes for industrial use, private investment and central bank acquisition.

Such limited supply undermines the ability of central banks to purchase gold in large quantities at high velocity.

Consequently it could take several decades for the largest buyers to reach the reserve levels seen in Germany, France, Italy, the Netherlands or the US.

Implications for investors

Despite questions surrounding gold’s efficacy as an inflation hedge, the combination of increased investor interest in diversification away from the US dollar and the strong central bank appetite for gold is expected to sustain demand for the precious metal in the years to come.

What’s more, as geopolitical tensions persist and central banks seek to secure their reserves, gold’s role as a political hedge is becoming increasingly prominent.

Credit Suisse was a systemically important bank, so the Swiss National Bank’s decision last month to intervene with a CHF50 billion lifeline loan was sound. But why make a move only days before the troubled bank’s eventual fallout, when the crisis had been years in the making?

The decision seems to have been motivated by the frenzy of the situation, and the urgency to find a solution: the hope was that this loan would regain the trust of investors and clients. The SNB aimed to silently quiet the increasing, deafening talk of a bailout.

However, it’s likely to prove a myopic exercise, as the bank’s problems run much deeper than its financials. This has been a crisis of confidence, and it all began in 2021 with the Greensill saga and the collapse of Archegos. The SNB lacked the foresight then to demand risk management changes or issue clear statements to alleviate public concerns about the bank. Quite the contrary, in its 2021 annual report, the central bank merely stated that Credit Suisse’s financials were “robust” due to an increase in capital, but no action was taken, despite FINMA, the SEC-equivalent in Switzerland, having already launched an investigation into Credit Suisse. Capital is fine, regulations look ok, let's move on. 

But Credit Suisse’s clients did move on: last year the bank saw its first net asset outflow – CHF123 billion – since the 2008 financial crisis as clients lost confidence and pulled their money out.

Was the SNB confident that Credit Suisse would use a lifeline loan for the better? Unlikely, given the bank’s track record over recent years. So the only plausible explanation is that the central bank believed this loan could send a strong signal to the market. It didn't.  

Trying Swiss investment culture’s patience

Perhaps Swiss investment culture also plays a role here. According to research on behavioural finance (sponsored by none other than Credit Suisse), the Swiss rank near the top in terms of investor patience, ahead of every region in the study except Germany and Belgium. This might explain why the SNB has been standing on the sidelines for so long, perhaps waiting too long for Credit Suisse to turn things around. 

The same study found that, despite a reputation for being conservative, Swiss investors are no more risk-averse than elsewhere when it comes to investing more money to avoid a definite loss, even if this could result in a greater loss (get-even-itis). Could this explain the eventual package that the SNB offered to UBS for its takeover of Credit Suisse?

Reputation: a bank’s ultimate asset 

Reputation is perhaps more vital for banks than for other businesses, given their responsibility for safeguarding, managing and investing clients' money. And at the core of a bank’s reputation is how it manages its risk; the string of bank failures during the past few weeks is ample evidence of that.  

The lesson from Credit Suisse is clear: the bank hasn’t been applying risk management properly. This is very similar to Silicon Valley Bank (SVB), but likely worse: while SVB might have had some technical misunderstanding of long-term bond and liquidity management, the crises of Archegos and Greensill demonstrated that if clients were important businesses, or paying well, Credit Suisse would fail to monitor risks properly. 

These issues are particularly troubling: while most banking scandals can be attributed to fraudulent activities of individuals (such as the cases with Goldman Sachs and Deutsche Bank), in the case of Credit Suisse, its crises were instead systematic errors from a compliance or risk perspective. Credit Suisse believed what they were told (in the case of Greensill), and did not strictly require reports, documents or proof of the positions held (when it came to Archegos). There was probably nothing fraudulent about Credit Suisse’s action or inaction in these cases; the bank simply exercised no control, which means it did not do its job properly.

And this had an effect on the entire business: in its wealth management division, there was no such scandal, but still the blunders from the investment banking and asset management divisions led to losses on the wealth management side. 

The rescue deal for Credit Suisse arrived earlier than one might have anticipated, and the economic environment surely proved to be an accelerating factor. But without proper risk management, the bank’s business will be doomed. It remains to be seen if UBS can fix the deep-seated problems of its new acquisition.

Factor ETFs have become increasingly popular among investors. However, investing in factor ETFs is also considered to be riskier than investing in the broader stock market. It is often suggested that factor investing requires a long-term horizon and only suitable for investors who are patient enough to ride through market cycles.

How do factor ETFs work?

Factor ETFs operate through a rule-based approach for selecting and weighting stocks. These ETFs establish specific criteria, based on their factor-based methodologies, to identify companies that align with their desired factor profile. Once identified, the ETFs assign weights to these companies

For example, a value ETF might focus on stocks that display low price-to-earnings ratios, while a low volatility ETF might focus on stocks with lower volatility relative to the broad stock market. By selecting stocks based on specific factors, factor ETFs are designed to provide investors with exposure to diverse investment styles and strategies.

Who can invest in factor ETFs?

Traditionally, factor investing is an investment approach implemented by institutional investors. With the proliferation of factor ETFs, individual investors can also incorporate factor-based strategy into their own portfolios.

Factor ETFs are more suitable for long-term investors seeking exposure to specific factors while desiring greater transparency compared to traditional actively managed funds. It is Having a long-term investment horizon is important, as research studies have shown that factors have experienced, at a minimum, a consecutive two-to-three year period of underperformance.

Timing the market is extremely difficult. It is essential to possess the patience required to remain committed to a factor-based investment strategy.

What are the main factors?

There are over 300 factors, but the most popular ones are set out below. All main ETF providers offer factor ETFs on the following:

• Value. This factor refers to buying undervalued stocks and selling overvalued stocks based on some financial metric.

• Dividend. This factor can be defined as the outperformance of those stocks paying high dividends compared with peers with lower dividends.

• Low volatility. This factor assumes that the performance of stocks with low volatility is superior to their riskier counterparts over the long term.

• Momentum. This factor focuses on buying outperforming stocks and sell underperforming ones.

• Quality. This factor assumes that high-quality stocks with more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon.

Examples of factor ETFs

Below is a table featuring factor ETFs provided by iShare, State Street and Vanguard, along with their cumulative returns in recent years. Notably, the performance of different ETFs focusing on the same factor can vary significantly:

Investors should therefore conduct thorough due diligence and comprehend the specifics of each ETF prior to making any investment decisions.

Benefits and risks of factor ETFs

There are several benefits of factor ETFs, although they are not without pitfalls either. Let’s first look at the benefits:

• Intuition: Investing in factor ETFs is generally more intuitive for investors compared to traditional stock picking, as the concepts behind each factor are relatively easy to grasp.

• Potential for higher returns: Factor ETFs are structured to outperform traditional index funds by employing alternative weighting schemes based on factors that have demonstrated by research studies to generate excess returns over the long term.

• Diversification: Factor ETFs offer investors the opportunity to diversify their portfolio by investing in a broad range of securities that represent a particular factor.

But factor ETFs are also risky in many ways:

• Complexity: There are plenty of factors, and uninformed investors might find it difficult to understand which factors to investor in.

• Timing: it is extremely difficult to time your market entry, and research studies have shown that factors have gone through years of underperformance. It is therefore only suitable for investors who have the patience for long term investing.

• Methodology: the methodology behind each factor is sometimes unclear, and investors may be exposed to factors that are constructed in a way that is different from what they anticipated.

Overall, we can conclude that factor investing is a useful strategy for enhancing the equity profile of a portfolio. However, rather than solely evaluating factor ETFs based on surface-level information, investors would benefit from dedicating time to comprehending the underlying factors within each fund. This diligent approach serves to mitigate potential risks and optimize the overall effectiveness of the strategy.

Further reading

Foundations of Factor Investing (MSCI Research Insight)

An Overview of Factor Investing (Nasdaq)

How smart is factor investing and smart beta? (Think at London Business School)

Factor Investing: A Deep Dive (Quant Evolution)

As climate impacts become ever more evident around the world, global investment in funds with holdings that prioritise environmental, social and governance issues continues to expand.

Asset managers globally are expected to increase their ESG-related assets under management (AUM) to $33.9 trillion by 2026, according to research from PwC. This compares with $18.4 trillion in 2021.

At this pace of growth, ESG assets could make up more than 20% of total global AUM in less than five years, representing a dramatic and continuing shift in the assets and wealth management industry, the group said.

The group’s survey of 250 institutional investors, with combined global assets of $60 trillion, found that nine out of ten asset managers believed that integrating ESG into their investment strategy will improve overall returns.

Asia-Pacific has the fastest percentage growth in ESG AUM. Those in Europe rose 172% in 2021 and could increase by 53% to $19.6 trillion by 2026, PwC said, while those in the US are seen more than doubling to $10.5 trillion.

As investment expands, regulators are increasingly acting to improve sometimes complex and inconsistent regulation and meet the need for more trusted, transparent data on ESG products.

“Regulators around the world are upping the ante on everything from greenwashed fund names to stricter climate target disclosures,,” MSCI said in a recent report. 

Investors are increasingly showing themselves willing to challenge board directors on their companies’ climate performance, including scrutinizing climate risk management disclosures or emissions-reduction plans in some markets, MSCI said.

Consumer spending and personal income rose more than expected in January in the US, leaving investors wondering whether the Federal Reserve could raise interest rates for longer than expected.

 At their most recent meeting, in late January, Federal Reserve officials approved a 0.25 percentage point rate increase, smaller than expected and the smallest hike since this tightening cycle began in March last year.

This took the federal funds rate to a target range of 4.5%-4.75%.

The Fed said that while there were signs inflation was coming down, officials believed “ongoing” rate hikes would be necessary. The key rate remained “well above” the Fed’s 2% target, the minutes of the meeting said.

Since then, the Department of Commerce Friday released stronger-than-expected inflation data for January.

Core personal consumption expenditure, the Fed’s preferred measurement of inflation, was up 4.7% on the year. Consumers’ spending rose 1.8% on the month, the largest increase in nearly two years.

US stocks fell sharply after the data were published, with the major indices posting their biggest weekly losses so far this year. The S&P 500 was down 2.7%, its worst week since early December.

US Treasury Secretary Janet Yellen has acknowledged that inflation is a problem but has also expressed confidence in a "soft landing" for the economy.

 The Fed holds eight scheduled meetings a year, with its next set for March 21-22.

As of February 23, the gains haven’t brought the share price back up to their peak though, when Tesla’s market cap briefly outgrew all the major traditional carmakers combined. 

Renewed confidence in the stock comes as the company posted a strong financial performance from the fourth quarter. Tesla produced 1.37 million vehicles during the year and delivered 1.31 million vehicles, up 47% and 40% on the year, respectively. 

Tesla also has the highest profit margins among electric vehicle makers. The company earned $9,574 in net profit per vehicle in the third quarter of 2022, four times as much as its closest rival GM, according to Reuters.

In addition, Tesla has been able to slash the selling price of its cars to try to further boost demand. The company announced in January that it would be cutting global prices on all its car lines by as much as 20%.

 While that move had a temporary dampening effect on the share price as investors worried about the impact on margins, the stock has since continued to rise, perhaps on the possibility of more sales and enhanced competitiveness from the cuts.

On February 23, Tesla’s market cap was $633 billion. Towards the end of December 2022, it was around $435 billion, down 65% from a peak on January 3 of that year when it was valued at more than $1.2 trillion.

Sometimes the artificial intelligence bot will offer to sift through the internet and come up with definitive answers to your questions, rather than the stream of clickable options we’ve become used to with search engines.  

Other times you’ll find that Chat GPT “is at capacity right now.” That’s because, since launching in November, the technology has been the focus of global attention as the possible new frontier for AI.

Just two months after launch, the chatbot is estimated to have had 100 million monthly active users in January. This makes it the fastest-growing consumer application in history, according to investment bank UBS.

And as the focus has moved on to chatbots from other innovations that had been capturing the headlines recently -- like non-fungible tokens and the metaverse -- the fallout for technology shares has been swift.

Shares of Microsoft, which backs private company OpenAI which has developed ChatGPT, rose 12% year to date. Google, in contrast, saw $100 billion wiped off its market cap after its own AI chatbot made an error during a demo. 

Meanwhile, shares of smaller AI companies have soared this year, to the extent that some analysts are warning of a possible speculative bubble.

Shares of SoundHound AI, listed on Nasdaq, rose 199% year to date. The company develops speech recognition, natural language understanding, sound recognition and search technologies.

And those of BigBear.ai, which delivers AI-powered analytics and cyber engineering solutions, rose a whopping 481% on the New York Stock Exchange during the same period.

With food prices soaring, several little-known agriculture exchange-traded funds have outperformed the S&P500 during the last twelve months, including VanEck Agribusiness (MOO), Invesco DB Agriculture (DBA) and iShares MSCI Agriculture (VEGI), as investors are pouring record money into such ETFs amid fears over global food crisis and as an inflation hedge.

Prices are expected to fall slightly in 2023 before stabilizing in 2024, according to the World Bank, although most food prices will remain high by historical norms. 

The ten countries experiencing the strongest food inflation recently, according to the bank, are: Zimbabwe, Lebanon, Venezuela, Türkiye, Iran, Sri Lanka, Argentina, Moldova, Rwanda and Ghana. In particular, Turkey’s inflation problem is looking to run out of control.

The situation has prompted the United Nations to call for urgent action to protect the most vulnerable children in the countries hardest hit by the unprecedented food and nutrition crisis.

Of the G7 countries, Germany has seen the strongest food inflation, followed by the U.K. and Canada. France, the U.S., China and Italy follow while Japan brings up the rear.

“The global food crisis has been partially made worse by the growing number of food trade restrictions put in place by countries with a goal of increasing domestic supply and reducing prices,” the World Bank says.

Even before Russia’s invasion of Ukraine, food prices and global hunger were on the rise.

Climate shocks, loss of biodiversity and marine and coastal ecosystems, and the global water crisis have all contributed to an increasingly food-insecure world. The Covid-19 pandemic then further disrupted global supply chains, driving prices upward.

As a result, governments have been exploring ways to ensure food security for their populations, with some resorting to protectionism by stopping the export of certain crops. For example, India last year halted exports of wheat.

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source: IMF

Emerging market and developing economies are set to outpace the vast majority of advanced economies in 2023, according to the International Monetary Fund, as the world reels from the pandemic, inflation and geopolitical shocks.

Global economic activity is experiencing a broad-based and sharper-than-expected slowdown, with inflation higher than seen in several decades, the IMF said in its latest World Economic Outlook, forecasting global growth to slow to 2.7% in 2023 from 3.2% in 2022.

The cost-of-living crisis, tightening financial conditions in most regions, Russia’s invasion of Ukraine, and the lingering Covid-19 pandemic all weigh heavily on the outlook, the Fund said.

GDP growth across emerging market and developing countries, however, is seen at 3.7% -- higher than all the G7 economies and only outpaced by a handful of advanced economies including India and China. And the pattern is forecast to continue through 2025.

The world’s biggest economy, the U.S., grew in the third quarter of 2022 after a six-month slump. But Paul Krugman, Nobel prize-winning economist, downplayed the rebound and expects a housing-market slump and weaker exports to shrink the economy down the line.

Nouriel Roubini, Professor Emeritus of Economics at New York University’s Stern School of Business, goes further, predicting the ‘mother of all economic crises’ looming for the world economy after years of propping up unsustainable debt with low interest rates.

From individuals to corporations and governments, borrowing costs are surging as inflation – itself the result of ultra-loose fiscal, monetary and credit policies along with geopolitical shocks like Russia’s invasion of Ukraine – prompts rate hikes, he said last month.

The IMF classifies 39 economies as advanced based on factors including high per capita income and exports, with all other economies considered emerging market or developing. Many economists believe the classifications should be more nuanced.