October 10, 2021

Kennox suggests that there might be other ways to view ESG and inflation than the accepted narrative currently in the markets. Maybe it makes sense to consider the idea that wishful narratives are crashing into the inevitability of hard realities.

Perhaps the situation with natural gas in Europe is a good example for ESG. A widely-accepted narrative recently has been that natural gas has no redeeming features, therefore no one can invest in the supply of gas (witness the dramatic drop off in capex across the industry in the last few years – almost a trillion $ at peak down to $450bn pre covid and an estimate of $350bn in covid). That looks like wishful thinking – there is currently no scale affordable alternative to fossil fuels. Obviously, but inconveniently. Does it not look like many investors are assuming that buying a highly-rated ESG fund will solve this prickly little dilemma? The real ESG question is how much pain we want to take as a society, and who should bear that – questions along the lines of can we consume 20% (or 40%) less energy? Should our energy be 20% (or 40%) more expensive? How do our hospitals, ambulances, and fridges deal with intermittent power? Etc. This has enormous societal implications, so let’s at least talk about the real issues – not the distraction of how the rating companies have come up with Telsa as ESG-brilliant and Shell as ESG-uninvestible. It is just a distraction from the bigger question.

On inflation, we at Kennox have neither economists’ nor academics’ biases, so let’s go back to the very basics. What if inflation is too much money hitting too few goods? And what if this money comes from the enormous leveraging that the world has undertaken in the last few decades (the Institute of International Finance global debt data is not a bad place to look here, especially the bounce in the pandemic)? This would explain why all asset prices look expensive, with bonds especially inexplicable in our minds. If this money is all an illusion (or a wishful narrative as per above), then the only two ways back to reality are inflation or asset prices falling – these are the only two ways to realign the financial system and the real world, ie the narrative to the hard realities. So to the key question: is this much global leverage sustainable? That is what the market needs to consider on inflation – and worry a lot less about “transitory” or not, 2% or 4% yoy, CPI or RPI? No one can know the answer, whatever they say, but having all your eggs in the “it’s all fine” basket looks a bit less than comfortable (to us certainly).

What is interesting is that it is possible to position in such a way that can benefit from these situations. In a market that looks very pricey, we can find investments that look very inexpensive. In a world of eye-wateringly high leverage, our portfolio has dramatically less leverage than the market, and very low absolutely, with, for example, half the companies having net cash on the balance sheet or negligible levels of net debt. If there is inflation, some of our companies do well, not simply avoiding being hurt, with energy or gold mining holdings being examples. It is this type of non-consensus thinking, and the stomach to take and hold positions in the face of market pressure and fashion, that affords this type of opportunity (for a bit more colour, please refer to the 3Q21 Quarterly commentary).

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