Volatility Delivers Victory for Goldman Sachs -- The Capital Note

The Goldman Sachs logo in the company’s space on the floor of the New York Stock Exchange in New York, April 17, 2018
(Brendan McDermid/Reuters)

Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: Volatility boosts bank profits, ESG (again), a defense of the financial media, and why studying economics will make you rich.

Volatility Delivers Goldman a Big Win
Post-crisis regulation fundamentally altered the business model of investment banks. Firms that had minted profits with their prop-trading desks were forced to pivot after Congress instituted the Volcker Rule, which prohibits banks from trading large sums of their own capital. Since then, bank traders have for the most part been limited to “market making,” or holding securities only as inventory to sell to their clients.

Some banks, such as Morgan Stanley, responded by getting out of the trading business altogether. Under the leadership of CEO James Gorman, Morgan Stanley beefed up its wealth-management wing, which offers more reliable revenue than trading but at a lower margin. The firm went from a risk-taker to a service provider, and with great success: Morgan Stanley’s profits tripled between 2014 and 2017.

Other firms, such as Goldman Sachs, weren’t quite ready to give up the gun. Under Lloyd Blankfein, who got his chops as a commodities trader, Goldman maintained the trading operations in equities, fixed-income, commodities, and currencies that made it so much money before the crisis. Some saw it as a strategic error: A protracted period of low volatility, spurred in part by the Fed’s post-crisis interventions, diminished profits from market-making. Investment-bank traders hold securities for short periods of time, so they can only make profits when prices move frequently. Blankfein’s refusal to cut trading operations seemed to many shareholders a sign that he was stuck in the past. Indeed, the tenure of David Solomon, the firm’s new CEO, has been marked by a move into retail services.

But with the pandemic leading to a surge volatility, Blankfein, now in retirement, is looking pretty smart. Goldman saw a 17.5 return on equity in the third quarter, its highest posting in a decade. Revenue from fixed-income trading shot up 50 percent, and wealth-management added 71 percent. Its sizable trading desks took in massive volume as asset managers moved in and out of markets in the downswing and upswing of the market.

It remains to be seen how long the party will last, but for now, trading isn’t dead.

— D.T.

ESG Update
Not a day, it seems, shall pass without more news on the “socially responsible” investing (SRI) front, but, first, some curious comments from Bloomberg’s John Authers in the course of an article extolling the rise of SRI (now increasingly referred to as ESG investing, in that companies are measured against a series of environmental (E), social (S) and governance (G) standards).

Authers notes that ESG has been slower to win acceptance in the U.S. than in Europe (that is true, not least, probably, because ESG and its cousin, “stakeholder capitalism,” tie into a long line of thinking in continental Europe, stretching back more than a century), but “Even the biggest capitalists in the U.S. seem now to accept that they must take the interests of more than just their shareholders into account.”

Leaving aside the fact that in practice, most companies have (one way or another, and to a greater or lesser extent) long done just this for reasons of self-interest if nothing else, there is nothing in the slightest bit surprising that “the biggest capitalists” in the U.S. — or, more accurately, the managerial class of some of America’s biggest companies — have embraced “stakeholder capitalism” in its recent, more explicit form.

Stakeholder capitalism is, essentially, a derivative of corporatism. In an article earlier this year on this topic, I argued that:

[Corporatism] has taken different forms over the years — some more benign than others — but all of these forms are based on the belief that society should be organized by and for its principal interest groups — let’s call them “stakeholders” — intermediated by, and ultimately subordinate to, the state. The individual doesn’t get a look-in, but to the managements of large corporations (the latter would count as one of those interest groups), it is an opportunity (and thus a temptation) as well as a threat. After all, much of the power that is being taken from shareholders will end up with those to whom they unwisely entrusted their funds.

Under the circumstances it is hardly surprising that the CEOs of so many large companies have signed onto what was a stakeholder manifesto issued by the Business Roundtable in 2019.

Then, turning his attention to some (sensible) new regulations being proposed by the Department of Labor to clarify how ESG investment can be reconciled with the fiduciary obligations that come with managing ERISA-eligible funds, Authers writes that it is “odd to politicize the issue.” Not really, ESG is already a profoundly political issue. All the DoL is trying to do is establish some guardrails to make sure that ESG investments offered to future pensioners are subject to some basic financial discipline. Moreover, the DoL does not want to see prospective pensioners put into ESG funds “by default.” Choosing such funds is fine, but it should be the investor’s active decision to do so.

Meanwhile, wandering over to that unusually sanctimonious corner of the Financial Times labeled, yes really, “Moral Money,” I see yet more worrying over the failure of those wicked Americans to keep up:

[A] poll of 800 institutional asset owners, consultants and managers shows that in most parts of the world the Covid-19 crisis has left financiers with an increased faith that ESG improves returns. Apparently, 97.5 per cent of investors think this in Canada, up from 90 per cent last year, while in Europe the figure is at 96 per cent (up from 92 per cent) and in Asia it is 93 per cent (up from 78 per cent).

The outlier, though, is America: just 74 per cent of US investors think ESG improves performance, which is down from 78 per cent the previous year — and 24 per cent think it harms performance.

If I were an enthusiast for ESG (spoiler: with the exception of the ‘G’, I’m not), I’d reckon that 74 percent was a pretty good number. And if I were a client of these institutional managers—even more so in Europe—I’d be appalled: As a rule of thumb, consensus in the investment “community” is a sign of trouble to come, especially when that consensus has been fueled by higher fees (and ESG has proved a source of some rich pickings).

What makes this American “failure” even more shocking is, supposedly, this:

During the recent months of the Covid-19 shock, there have been a host of studies showing that ESG has performed as well, if not better, than non-ESG investments. That is partly due to the avoidance of fossil fuels but also because any company that tries to meet ESG standards is forced to do a full-blown audit of their supply chains and internal processes, which helps boost resilience.

On the other hand, there was this analysis prepared under the auspices of NYU Stern School of Business:

Environmental, social, and governance (“ESG”) scores have been widely touted as indicators of share price resilience during the COVID-19 humanitarian crisis. We undertake extensive analyses to investigate this claim and present robust evidence that, once the firm’s industry affiliation and accounting- and market-based measures of risk have been properly controlled for, ESG scores offer no such positive explanatory power for returns during COVID-19. Specifically, ESG is insignificant in fully specified returns regressions for the first quarter of 2020 COVID crisis period, and it is negatively associated with returns during the market’s “recovery” period in the second quarter of 2020.


And where ESG funds have done well, this may be by chance as, noted here. For example, much of the market strength since March’s sell-off has been driven by the tech sector. Tech often has a light or lightish carbon footprint, but that is not why these stocks have done so well.

There’s also this from Julian Morris, writing (admittedly, pre-COVID) in the IFC Review:

A 2016 paper from group of researchers from the European Parliament and Bournemouth Business School sought to look more deeply at the relationship, using disaggregated data from Bloomberg’s ESG Disclosure form for the S&P 500 for the period 2007 to 2011. The researchers found that the relationship between ESG and financial performance in general was indeed U-shaped. However, they found that the environmental and social components were linearly negatively related to performance. It was only the governance component that drove the U-shape relationship. This governance-dominated U-shape relationship between ESG and financial performance has since been confirmed in other studies.

In other words, if it’s financial performance you are after, focus on the “G.”

Meanwhile, in other ESG news, the FT also reports:

Hindenburg Research, the short-seller that made headlines alleging that electric truck start-up Nikola was an “intricate fraud”, is coming after another ESG company. This time it has issued a scathing report on Loop Industries, a Canadian plastics recycler, alleging that the company’s technology is “fiction.”

On its website, Loop claims to be able to recycle plastic from sources that would typically be considered garbage, including “plastic bottles and packaging, carpets and polyester textiles of any colour, transparency or condition and even ocean plastics that have been degraded by the sun and salt”.

Hindenburg, which makes money by betting against share prices, said Loop’s claims were “technically and industrially impossible”.

Loop responded that Hindenburg’s claims were “unfounded, incorrect, or based on the first iteration of Loop’s technology”.

However, the company has never reported any revenue. And despite striking numerous high-profile partnerships with companies such as Coca-Cola, it has not yet delivered the recycled plastic it said it would…


— A.S.

Around the Web
Studying economics will make you rich: “Students who barely met the GPA threshold to major in economics earned $22,000 (46%) higher annual early-career wages than they would have with their second-choice majors.”

A long battle between Boeing and Airbus comes to an end:

A 16-YEAR fight at the World Trade Organisation (WTO) between Boeing, an American planemaker, and Airbus, a European one, over illegal subsidies resembles a heavyweight boxing bout in which both sides raise their gloves to claim the round. And so it was on October 13th, when the WTO ruled that the EU can impose tariffs on $4bn-worth of American goods annually. The award is lower than last year’s decision that America is allowed to slap duties on $7.5bn in European goods. But it was much higher than the Americans once braced for. More important, both aerospace titans look knocked about.

Zoom is expanding:

Zoom is bringing apps and paid-for events to its video meetings service, in a bid to consolidate its grip on the huge new audience that flocked to its platform during the pandemic…The move marks the San Francisco-based company’s first attempt to turn the online meetings habit developed by hundreds of millions of people this year into a more central part of their lives, while laying foundations for a wider business with interactive video at its core.

Random Walk
In his acceptance speech for the Elliott V. Bell Award from the New York Financial Writers’ Association, the Wall Street Journal‘s Jason Zweig gave a stirring defense of financial journalism.

Journalists on other beats seem to look down on us — as if, while they’re exploring important ideas and lofty ideals, we’re rooting around in the septic tanks of society.

I’ve heard other reporters say, “Oh, that’s just service journalism,” as if serving our readers by helping them make better financial decisions were somehow beneath the dignity of people who cover, say, professional sports…or Congress…or the White House…

To enlighten people about money is to illuminate what is often the darkest and most anxiety-ridden part of their lives. Every time we expose a fraud or demystify a complexity, we help make someone’s future more secure. Financial journalism is beneath nobody’s dignity. Done right, it’s as noble a calling as I know of.

And it’s fascinating, because of what it tells us about human nature.

Markets are quoted in numbers, but what they trade in is emotions. Markets simply determine prices for risks and rewards over time. Among those risks are not just financial losses, but the surprise and fear and regret they bring. Among those rewards are not just monetary gains, but hope and greed and pride.

Along that axis of time, all these emotions play out as people become unimaginably rich and then go bust, turn from nobodies into geniuses and then into fools, as the goddess of fortune spins her wheel, raising the last to be first, then spinning it again and relegating the first back to last.

— D.T.

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