AI Unleashed and Other Platitudes

Montréal, April 17, 2023 The equity markets overcame a slew of negative macro and fundamental developments and posted positive returns in the first quarter of 2023. In effect, equity investors seemed to be looking past the appalling trend in the ISM Manufacturing PMI most recent reading[1], lower IPO and merger activity, softening profit margins and earnings growth expectations[2] to conclude that the prospect of a near-term peak in interest rates was a catalyst for improving consumer and CEO sentiment, which would ultimately be conducive for long-duration assets, including equity markets. To be fair, investors are also likely looking past the shelter component measure of the US CPI (whose pitfalls we have highlighted before[3]) and assume that inflation is already much lower than the figure being reported. To be specific, the MSCI All Countries World Index[4], S&P 500 Index and the S&P TSX Composite advanced 7.02%, 7.36% and 4.55%, respectively, during the quarter. Interestingly, excluding issuers who became takeover targets during the quarter, the best performers included a collection of ancillary cryptocurrency and artificial intelligence plays as well as some of the most significant large cap technology and consumer discretionary losers of yesteryear like Facebook (Meta), Tesla and Nvidia. The laggards, in contrast, were concentrated in the energy sector due to the decline in the price of crude oil and natural gas and, for reasons that we have already written about extensively earlier this month, the financial sector. Fixed income markets rose in sympathy with equity markets as signs that higher rates were taking their toll on economy were multiplying, thereby sending bond yields lower across the curve. Movements in interest rate curves were particularly acute in the aftermath of the Silicon Valley Bank debacle as rates dropped by a record amount over a short period and implied volatility of interest rates, as proxied by the ICE Bank of America Merrill Lynch, surged to a record. While the US policy response, in particular the Federal Reserve’s Bank Term Funding Program (“BTFP”) was well perceived from a liquidity enhancing viewpoint, consensus is that the ongoing stress in the banking sector is leading to tighter lending conditions and the market’s response was to send credit spreads higher. Nevertheless, corporate bonds generally outperformed government bonds. To this point, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate Index returned 2,66% and 2,85% respectively. However, longer maturity bonds did much better than shorter maturity ones. At the time of writing this, deposits in the US commercial banking system were still flowing out albeit at a slower pace than they did earlier in March[5]. As such, it looks like the regulators did the right thing. That said, I personally find it ironic that the venture capital industry, which was the principal recipient of the over-investment and over-lending largesse of Silicon Valley Bank and the likes, did not contribute a penny to bail-in the fragile First Republic Bank[6]. For the moment, it appears that the risk of a credit crunch has been contained as capital evaporation seems to have been largely limited to the venture capital industry, SPAC and other highly speculative sectors. It would be arguably more worrying if capital disappeared from the hands of the capital providers themselves. That would be more difficult to contain. AI UNLEASHED On November 30, 2022, artificial intelligence laboratory OpenAI^[7] officially unveiled ChatGPT, a highly evolved prototype software designed to simulate conversations with human users. Built on the Microsoft Azure’s super-computing platform and released freely to the public, ChatGPT only required 5 days to reach 1 million users, the fastest ever application to reach such a milestone, faster than Instagram (2,5 months), Spotify (5 months) or Facebook (10 months)^[8]. On January 23, 2023, Microsoft, which had already injected capital in OpenAI in two successive rounds in 2019 and 2021, made an unconfirmed additional commitment of 10 billion US$ to further its development. The announcement came less than a week after Microsoft launched an Azure service that provides access to a managed version of OpenAI’s ChatGPT^[9]. The positive reviews garnered by ChatGPT’s release and its potential to transform Microsoft’s derelict Bing search engine reportedly caused tremors in Microsoft/OpenAI’s bay area rivals’ headquarters and it turbocharged a nascent AI race as Google and Baidu respectively launched Bard and Ernie during the quarter, their own response to the Microsoft/OpenAI partnership which had already come up with ChatGPT-4, an improved version of the original. Let us take a step back to explain what ChatGPT is and why it matters. ChatGPT is a conversational software that uses large sets of text data to learn to predict the most plausible next word, or sequence of words, based on the first few words of a sentence or a context. It is also capable of applying the knowledge acquired by solving a task to a related task. This type of large language models is called generative pre-trained transformers, hence the acronym (“GPT”). The data sets on which it was trained are vast, ranging from entire digital libraries, user manuals, research papers, newspaper articles and user-generated social media content. The main advantage of ChatGPT over prior generations of conversational software is that it is extremely versatile. In effect, until recently, chatterbots were limited to provide answers to relatively narrow sets of questions. In contrast, ChatGPT is able to provide rapid, precise and coherent answers to complex questions in virtually every field. It is a revolutionary way to search the internet as instead of clicking through links for answers, ChatGPT does that exercise itself and returns the answer directly. ChatGPT is an indomitable Trivial Pursuit™ opponent. It is easy to understand why this newly available tool represents a serious threat to Alphabet’s ubiquitous search engine. But it goes well beyond that. ChatGPT remembers previous prompts given to it in a conversation and is thus able to fine-tune its responses based on prior questions. It can write long essays, summarize scientific articles, produce song lyrics, debug and create computer code and it is only a matter of time for it to be able to interact with other forms of media, like audio and video files. There’s no denying that the speed and accuracy of generative Artificial Intelligence (“AI”) could boost labor productivity in many fields. In fact, in a recent report, Goldman Sachs^[10] estimated that it could raise annual US labor productivity growth by nearly 1,5% per annum over a 10-year period following widespread adoption and boost Gross Domestic Product (“GDP”) by 7%. Goldman Sachs further estimates that 300 million jobs globally could be exposed to AI-automation. Interestingly, in contrast with the first wave of automation which displaced principally manufacturing blue-collar jobs, generative AI stands to impact white-collar jobs in multiple industries such as sales and marketing support, legal, education, accounting, design and engineering and many others. In some specific cases, generative AI is bringing the marginal value of human expertise down to nothing. From that standpoint, generative AI could be the most significant deflationary shock since China joined the World Trade Organization in 2001^[11]. The spoils derived from productivity gains are typically not evenly distributed in society. In some industries, corporations might be able to retain the lion’s share of incremental profits. In others, consumers might disproportionally benefit through reduced cost of goods and services. Nevertheless, higher growth and lower costs have historically tended to be a positive combination for financial assets. For this reason, we are already incorporating the advent of generative-AI in our medium to long-term inflation forecasts and by ricochet, our medium to long-term asset return projections. To be clear, we still think inflation could surprise on the upside over the medium-term relative to consensus expectations but not as much as we thought a few months ago. That being said, many people argue that generative-AI is not ready for prime time. They point to examples where ChatGPT failed to spot contradictions in a prompt, where it regurgitated misleading information, made defamatory claims or seemed to express certain political or cultural biases. Since ChatGPT is at its core a statistical model that makes inferences, it is normal that a small percentage of its responses will turn inaccurate. It will improve over time. Some critics are more fundamental. For instance, the iconic linguist and intellectual Noam Chomsky, in an interview with Open Culture^[12] suggested that ChatGPT was nothing more than “high-tech plagiarism” and a “way of to avoid learning.” Along the same lines, songwriter Nick Cave, after having dissected lyrics written by ChatGPT in his own style simply said that it was “a grotesque mockery of what it is to be human.”^[13] Others, alarmed by ChatGPT’s prowess go further, arguing that generative-AI has gotten close to the point where it poses a civilizational existential threat. In fact, over a thousand high-tech personalities have petitioned^[14] AI research and development firms to pause their efforts to develop something superior to ChatGPT-4. I believe a voluntary pause is not a great idea because criminal organizations would never submit themselves to a voluntary pause. On the contrary, knowing that other generative AI developers were to submit themselves to a pause, the criminal ones would do everything to use the window to their advantage, the perfect recipe for AI development to go rogue. Anyways, I do not think that a development pause can be effectively implemented based on the historical adoption curve of some noteworthy revolutionary inventions. I note for instance that once Gutenberg rolled out his movable-type printing press, there was nothing that the masses of medieval monks who were tasked copying the Bible could do to prevent being disintermediated. Similarly, Karl Benz did not wait for three-way traffic light to make its appearance^[15] or for Ralph Nader to push for the safety belt^[16] to continue manufacturing cars safety belt^[17] no more than Baltimore City authorities listened to gas lighting lobbyists after the incandescent electric lights were popularized in the 1880s, providing better quality light for one third of the cost^[18]. Generative-AI has gone viral. Rightfully so as it offers a lot of promises. Notwithstanding that, it would be wise to remember what Sam Altman, ChatGPT’s creator, said about his offspring: “ChatGPT is incredibly limited, but good enough at some things to create a misleading impression of greatness. It's a mistake to be relying on it for anything important right now. It’s a preview of progress; we have lots of work to do on robustness and truthfulness.”^[19] With that in mind, it is unlikely that I will delegate to ChatGPT the task of writing future newsletters. PROBLEMS FOR ZOMBIE AND VAMPIRE COMPANIES Most of you have heard the term zombie bank or zombie company. It is used to describe companies that are generating cash and that are able to cover basic running and fixed costs, including the interest on its debt, but that would be structurally unable to repay the principal on their debt without bailouts, subsidies or dilutive equity financing rounds. The term zombie was borrowed from Haitian folklore and refers to a man who is under the effect of a filter or a charm that takes away his personality. Zombies are often portrayed as slowly decaying, mindless, soulless thralls without real purpose. The concept was first applied to many recipients of the support from Japanese banks after the bursting of the country real estate bubble in the late 1980s but was later applied to US financials in the aftermath of the Global Financial Crisis (“GFC”) of 2008 and to Chinese state-owned steel, aluminum and cement, and paper producers around 2015. Corporate zombies have always been present in the public equity markets. From an economic standpoint, zombies have a negative influence because they inevitably consume more resources than they produce. If there are only a few, the negative economic effects remain manageable. But in a scenario where growth decelerates while debt servicing cost increase, zombies can quickly multiply and become a destructive force in the economy. At that point, the dilemma between maintaining zombies alive, by perpetually feeding them or letting them perish, is more easily resolved than when their number is a mere nuisance. To be clear, we do not think that a zombie apocalypse is imminent, but we believe that public policy towards zombie companies could become less complacent and their operating conditions might deteriorate rapidly. As such, existing and prospective zombie companies should rethink the long-term viability of their stupor. Beyond zombies, there is another type of company has taken its name from a dreaded mythological creature. This type of company appeared more recently and is less common than the zombie company: the vampire company. The term was first introduced a few years ago by Professor Michael Wade^[20] of the International Institute for Management Development (“IMD”) in Lausanne to describe companies that are able to offer their products and services more cheaply than the incumbents and offer unparalleled customer experience on a global scale. Like the vampire of the late romantic literary period, these companies are seductive and are relentless in the pursuit of their mission. This is the opposite to zombie companies. According to Professor Wade, vampire company examples include Uber (taxi and ride hailing industry), Amazon (bookstores), Netflix (movie rental) and Alphabet (internet search). Vampire companies operate by diverting revenues and profits away from industry leaders to themselves. To employ a vampiric analogy, they are taking over the blood pool. The problem for vampires is that the blood pool ultimately runs out. For instance, the market share of Ford’s Model T went from 8% the year it was introduced in 1908 to 61% in 1921^[21]. Although revenues continued to increase afterwards, growth decelerated because the pool was becoming empty and there were no more incumbents to displace. As it happens, the growth of vampire companies start to converge towards that of the broader economy. In the case of Alphabet and Facebook, the size of the blood pool is determined largely by the advertising budget of corporations who are paying to show up in internet searches. So, in order to survive, vampire companies need to tap into more blood pools, branch out into adjacent industries and categories. Some vampire companies have been incredibly successful at tapping into other blood pools. Amazon, who alone generates nearly 50% of all US e-commerce sales, is the vampire company overlord, in my opinion. Others have been less successful. In the past year, the top line growth of some of the better known vampire companies highlighted above disappointed and their stock price underperformed^[22]. It is still too early to tell if this was just a blip or if the decline in the vampire companies’ stock price is a market’s call on the primary blood pool of these vampires running dry or worse, on their ability to find new blood pools, like the metaverse project for Facebook, the iCar for Apple or live-stream events for Netflix… What could get interesting is if two or more vampire companies were to set their eyes on the same blood pool. I wonder if a particularly fierce battle could cause a margin erosion to the point of turning both into zombies… GöTTERDäMMERUNG^[23] ? At the Davos Word Economic Forum in January, Mohammed al-Jadaan, Saudi Arabia’s Finance Minister, mentioned that the kingdom was open to settling trade for oil and natural gas in currencies other than the US dollar and the Euro. This statement drew a lot of attention, so I decided to investigate a little further to see if this indirectly signaled that the world reserve currency status that the US dollar has enjoyed since the Bretton Woods accord in 1944 was undermined. If so, it could lead to structural US dollar weakness for years to come and upend the Greenback’s role as a portfolio hedging tool for non-US domiciled investors. Let us put a few things in perspective. First, consider that the US dollar’s share of the world’s central banks foreign currency reserves stood at roughly 56% in the third quarter of 2022[24]. It was approximately 70% at the turn of the century. The US dollar representation has been declining but the lost market share has been redistributed across a number of currencies, including non-traditional ones^[25]. Second, consider that about half of the goods and service trade globally are invoiced in US dollars while the United States represents just 10% of the volume, both relatively constant figures over the last few years. Third, consider that according to the Bank of International Settlements, the US dollar is used in roughly 90% of foreign currency transactions (out of 200% as there are two currencies involved in a foreign exchange transaction). Also, a relatively constant figure in recent years. At first sight, if an alternative currency is ascendant, it is not showing in the data yet. It is worth noting that China, who took over the United States as the largest trading partner of Saudi Arabia since 2011 (thanks to the US shale oil revolution which no longer made Saudi Arabia oil essential), has been pressuring the Gulf State to accept payments in Yuan for its oil and natural gas imports for a while. Incidentally, the two countries have gotten increasingly close recently. In fact, in the first quarter, Saudi Aramco acquired a 10% stake in the privately held Chinese refiner Rongsheng Petrochemical Co., Ltd. for about $3.6 billion and separately agreed to supply 490 000 barrels of crude oil per day to a Rongsheng subsidiary^[26]. So perhaps it is just natural for the two countries to move away from the construct of a settlement currency convention between the United States and Saudi Arabia dating back to the 1970s. It is also possible, from a Saudi vantage point, that this is merely a way for the Kingdom to express that it does not regard its alliance with the United States as important as before, that it can prevail without the United States. Still, if the promiscuity between China and Saudi Arabia led to the settlement of crude oil exports to China in Yuan, what would it mean? Well, it turns out that the value of Saudi Arabia petroleum exports to China was 38,3 billion US$. By comparison, the value of the global trade was 32 trillion US$ in 2022. Therefore, the value of Saudi Arabia petroleum exports to China represented approximately 0,12% of global trade volume. Based on the above, it does not seem that the US dollar term as the world’s reserve currency is coming to an end. It is likely just a slow-moving process by which central bankers aim to diversify foreign currency reserves and by which partners attempt to settle trade in their own currencies as opposed to an intermediary currency, something which has been made more possible with to the reduction in currency trading cost and other factors. Notwithstanding the above, it is possible that in a fractured geopolitical landscape, bi-lateral deals become frequent, and that the de-dollarization trend accelerates. But for the time being, the stability, depth and breadth of the US dollar and US dollar denominated assets coupled with the country’s military might and arbiter of conflicts history all lead me to believe that its demise is exaggerated. In fact, the US dollar index is only a few percentage points off last year’s peak. After all, Saudi Arabia might find some use for the Yuans it receives in exchange for oil, but I seriously doubt that the same approach can be extrapolated to the currency of trade partners like Indonesia, South Africa or Pakistan… If I am wrong and that demand for US dollars internationally falters precipitously, this could cause the borrowing rate of the United States to increase noticeably and for US imports to turn into a source of inflation for the first time in over 50 years. Thank you for your support, Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer [1] The University of Michigan indicator was at its lowest level since May 2020 at the end of February 2023. [2] Source: FactSet [3] https://patrimonica.com/rising-inflation-what-asset-owners-can-do-about-it/?lang=en [4] Unless specified otherwise, index performance references total returns denominated in local currency terms. [5] Source: Federal Reserve Bank of St-Louis, Weekly US Commercial Banks Deposits report. [6] It was a consortium of banks led by JP Morgan that provided a 30 billion deposit backstop to First Republic Bank. [7] Founded in 2015 in San Francisco by Sam Altman and a group of entrepreneurs including Elon Musk (Tesla, Space X, The Boring Company…) and Peter Thiel (PayPal, Palantir Technologies). The firm is also behind the DALL-E-2 and Whisper.AI applications. [8] Source: Statista. [9] Source: SiliconAngle. [10] Goldman Sachs Economic Research, The Potentially Large Effects of Artificial Intelligence on Economic Growth, Hatzius and all. March 26, 2023 [11] Accession resulted in the reduction of tariffs and barriers to free trade. [12] https://www.openculture.com/2023/02/noam-chomsky-on-chatgpt.html [13] The Guardian, January 17, 2023 [14] https://futureoflife.org/open-letter/pause-giant-ai-experiments/ [15] Karl Benz is credited for the first functional four-wheeled automobile powered by an internal combustion engine in 1886. By contrast, the state of Connecticut was the first to install three-way traffic lights in 1930, 44 years later. [16] Ralph Nader, Unsafe at Any Speed: The Designed-In Dangers of the American Automobile, Grossman Publishers, 1965. [17] Ralph Nader, Unsafe at Any Speed: The Designed-In Dangers of the American Automobile, Grossman Publishers, 1965. [18] The Illuminating Engineer, Public Lightning in Baltimore, 1909. [19] Sam Altman’s twitter feed, December 10, 2022. [20] https://www.imd.org/faculty/professors/michael-wade/ [21] Lacey, Robert. Ford: The Men and the Machine. Boston: Little, Brown, 1986 [22] According to Haver, the EV/EBITDA of companies involved in a digitization theme have derated between 28% (Healthtech) and 42% (Fintech) between November 2021 and October 2022. [23] Webster: a collapse (as of a society or regime) marked by catastrophic violence and disorder. [24] Source: International Monetary Fund estimates [25] Other than the Euro, the Japanese Yen, and the British Pound. [26] Source : Reuters.   Photo credit  

Disinflation and Other Platitudes

Montreal, January 13, 2023 The last quarter of 2022 was choppy across asset classes. To be specific, market participants were initially encouraged by a relatively strong US earnings season coupled with signs of decelerating inflation and labor market resilience, causing broad equity markets to jump by more than 10% between October 1^st and November 30^th. However, sentiment turned when Federal Reserve Chairman Jerome Powell reiterated that it was premature to consider materially slowing the pace of interest rate hikes and new COVID lockdown measures were implemented in China. Both headlines were seen as hurting the odds of a growth recovery, leading equity markets to pare some gains later in the quarter. In the end, the MSCI All Countries World Index[1], S&P 500 Index and the S&P TSX Composite advanced 7.36%, 7.42% and 5.96%, respectively, during the quarter. Still, this performance leaves a sour taste given as MSCI All Countries World Index, S&P 500 Index and the S&P TSX Composite ended the year 2022 with declines of -15.98%, -18.51% and -5.84%, respectively, their worst outing since 2008. From a stylistic standpoint, Value oriented stocks outperformed Growth stocks by a margin of nearly 10% during the quarter, and 25% for the year in a sharp reversal of a paradigm that persisted for the prior 10 years. The major cause of the outperformance of Value over Growth is the performance of the Energy sector whose constituents tend to be more heavily represented in Value indices relative to the Consumer Discretionary and Technology sectors whose constituents tend to be more heavily represented in Growth indices. To this point, the energy sector is the one that gained the most during the quarter as the prospect for a looming energy shortage in Western Europe in the winter months would help oil producers and refiners preserve margins in spite of a decelerating global economy. In contrast, the MSCI World Consumer Discretionary Index and the MSCI World Technology Index were laggards as an increasingly blurred holiday season picture for retailers and automobile manufacturers took their toll on those sectors. The recovery in fixed income was less pronounced as market participants attempted to reconcile the evolving inflation and growth headlines with the not so reassuring guidance coming from central bankers. Aided by a relatively benign corporate bond default picture and lack of issuance, the high-yield market, as proxied by the ICE Bank of America Global High Yield Index, was well bid and performed best with a gain of 5.03% during the quarter. Investment grade corporate bonds, as proxied by the ICE Bank of America Global Corporate Index also partly reversed prior quarters woes with a gain of 3.22%. Sovereign bonds underperformed due to their higher interest rate sensitivity as central banks maintained their aggressive tightening stance. To this point, the ICE Bank of America Global Government Bond Index posted a loss of -0.31% during the quarter. As short-term interest rates relentlessly inched upward, floating rate fixed income instruments, whose coupon payment rate increases with increases in interest rates, generally performed better in an otherwise difficult year. In fact, the ICE Bank of America Merill Lynch Floating Rate Treasury Index appreciated 1.01% in the fourth quarter and 2.08% in 2022. Notwithstanding the generally positive performance across most fixed income markets in the closing quarter of the year, with the exception of floating-rate debt which posted a modest positive return and short duration instruments which posted mid-single-digit losses, virtually every fixed income market strategy recorded losses ranging between -10% and -15%. Pierre Elliot Trudeau and René Lévesque were respectively the Prime Ministers of Canada and Québec the last time such horrendous performance was observed on what is generally perceived as a defensive asset class. Commodities markets, as proxied by the S&P GSCI Commodities Index, gained 3.44% during the quarter and finished the year with a performance of 25.98%. A look at the different component reveals a mixed picture with the metals groups posting strong gains while the energy segment and the agricultural sectors were nearly unchanged in the quarter. CRYPTO: LAST MAN STANDING Many entrepreneurs have been attracted to the digital assets industry[2] since its establishment a little over ten years ago. Unfortunately, not all of them were well intentioned or well organized. Starting with the failure of Mt.Gox[3] in 2014, the industry has demonstrated an unusual propensity of fraud, embezzlement, theft and mismanagement. There have even been curious disappearance cases that remain unresolved to this day. The industry’s resilience has been tested on many occasions and survived, but it realized that improvements were needed for it to emerge from the financial markets fringe and gain the seal of acceptance of institutional investors. Then came along Sam Bankman Fried (“SBF”), a Massachusetts Institute of Technology (“MIT”) graduate, son of two Stanford Law School professors and adherent of William McCaskill’s effective altruism movement[4]  who seemed to be a pro-regulation prophet by actively welcoming the Secutities and Exchange Commission’s (“SEC”) scrutiny of the industry. SBF’s awkward demeanor somehow made him seem more authentic. As such, merely two years after founding FTX, the 30 year-old former Jane Street[5] trader quickly acquired the status of crypto’s “good guy,” a role that came with ancillary benefits that took the form of celebrity endorsements from the likes of Golden State Warriors point guard Stephen Curry, Shark Tank’s Kevin (“Mr. Wonderful”) O’Leary and then power-couple Tom Brady and Gisele Bundchen. SBF used sums amassed in various FTX financing rounds to buy rights to the Miami Heat stadium in Florida and became a top 10 individual contributor to the US presidential campaign for the 2022 cycle[6] . SBF made everything look like crypto gamblers should trust FTX above all else. Yet, in early November, FTX imploded in a whimper, the company filed for bankruptcy and SBF resigned as CEO. Valued at 32 billion US$ a few months prior, according to the testimony of John J. Ray III[7], FTX may be the biggest corporate fraud since Enron. After incomprehensibly appearing to be starting a media tour by participating to a long fireside chat with the New York Times and various podcasts in the ensuing days, SBF was summoned to the Manhattan federal court and was released on a 250 million bail. If you have any doubt about the seriousness of the accusations, consider that Bernie Madoff’s bail was only 10 million… In hindsight, there were red flags everywhere. First, FTX and its affiliates employed inexperienced and unqualified personnel in key roles, some of which with questionable background. This may have been acceptable for a small organization but atypical of a company valued at 32 billion US$ serving over a million customers. Second, it may transpire that SBF had been romantically involved with an FTX C-Suite executive. Third, the use of record keeping and HR management systems typically seen in much smaller organizations was unusual. Fourth, the prevalence of risks of conflicts due to transactions with affiliates (FTX and trading affiliate Alameda) and with firms having previously provided funding to FTX was problematic, as were loans to employees. So the question is: if so many bright and well-advised people failed in their due diligence of FTX and SBF, how could we have avoided it? The sad reality is that for many people, the concept of due diligence consists to sit for a couple of hours and to listen, unprepared, to a high-level sales pitch by a promoter who cold-called them a few weeks earlier. The reality is that due diligence is like the work of a police investigator. In fact, the due diligence practitioner looks for signs that invalidate the story that he/she is being told. A good example, in my opinion, is the character of Inspector Columbo, which was played by Peter Falk and which aired on NBC in the 70s. Columbo had a  famous catchphrase which was particularly annoying to suspects: “just one more thing!” Sometimes, suspects gave up or inadvertently incriminated themselves. But that was the idea. The approach should be designed to spot inconsistencies, contradictions and missing pieces of information in the story before the suspect is taken out of the penalty box. It sometimes means to be persistent at the risk of being borderline annoying. But it is necessary, because the cost of being wrong is too high. In a way, the due diligence practitioner is the Inspector Columbo of the financial world. Bitcoin lost approximately two-thirds of its value in 2022. Many participants relying on low borrowing costs to establish speculative positions have deserted the space. Some viewed SBF as the last man standing at the end of a crypto winter. Now that a mighty prophet is down, the question is whether there will be someone standing at the end or if the digital assets industry is beyond repair and therefore destined to irrelevance. ESG’S NEEDED REBOOT A few years ago, I wrote about the concerns I had about investment strategies that apply Environmental, Social and Governance (“ESG”) related filters in the stock selection process[8]. I argued that their performance was more attributable to coincidental factor exposure shared with other strategies than to the ESG metrics utilized and that ESG investment strategies were little more  rebranded large-cap growth strategies. These assertions were confirmed by an all of our quantitatively driven investment managers who are failing to develop insights from ESG filters that are not already captured by an existing, traditional filter. Another concern I highlighted was that it was possible for an issuer to be included in an ESG screened portfolio of stocks even though it scored low on one or two of the three pillars as long as it scores above market or industry average on the remaining one, which means that investors who choose to embrace the ESG concept may find compromises. So I had, let’s call it, philosophical concerns. Those investing in ESG strategies recently found themselves with more than simply philosophical concerns to address. First of all, performance of the majority of ESG strategies has been underwhelming relative to main indices since the third quarter of 2021. Incidentally, it has been somewhat in line with that of fundamentally oriented strategies emphasizing large capitalization tech sector stocks, as I had foretold. Fossil free strategies naturally fared worse in relative terms. Secondly, as he had hinted following his appointment in 2021, SEC Chairman Gary Ginsler instructed his team to pay particular attention to disclosures that investment advisers and funds make about the consideration of ESG factors when making investing decisions. As a result of these investigations, in late November, the SEC charged a subsidiary of Goldman Sachs for failures to follow policies and procedures involving two mutual funds and one separately managed account strategy marketed as ESG investments. To settle the charges, Goldman Sachs agreed to pay a 4 million US$ penalty. Apparently, while Goldman Sachs had implemented a formal process for screening investments on certain ESG metrics but the process was not systematically followed. This naturally leaves investors wondering whether the ESG label on an investment product is something real or just a marketing ploy designed to extract more fees from them under the appearance of a value-add service. Thirdly, ESG came under attack from some state legislators late in the summer. For example, Governor Rick DeSantis had the Florida State Senate pass a resolution requiring that the state pension fund invests in companies that only consider “pecuniary factors” and “do not include the consideration of the furtherance of social, political, or ideological interests.” This effectively prevents state investment of any asset management fund that considers ESG criteria in their investment process. Texas took a similar approach when passing two separate bills which prohibit the state from contracting with ESG organizations that boycott the fossil fuel or firearm industry. Shortly after the bills passed, the state comptroller even released a comprehensive list of boycotted organizations. At the time of writing this, many other states are considering similar legislation. Blackrock, the largest investment manager in the world with just under 9 trillion in assets as of September 30, 2022, and which is widely recognized for its ESG credentials was the most often cited manager by legislators in their justification. To be clear, I do not believe that these efforts will stop ESG’s ascendency. If anything, these are painful yet necessary steps in order for ESG related disclosure to become standardized globally and for mandates to become more specialized and less subject to inner contradictions. However, this backlash may prompt some investment firms to roll back their ESG agenda to circumvent divestment by certain politically motivated groups or avoid losing their future share of a growing pie. A FEW WORDS ON OBESITY, ALZHEIMER AND HARD-CORE PHYSICS As we turn the page on a somber year that brought us a fistful of adverse geopolitical and macroeconomic developments, I thought it was worth discussing a few of the positive developments that caught my attention to brighten the mood. The first one was the US Food and Drug Administration (“FDA”) decision to give the “fast track” designation to Eli Lilly and Co.’s tirzepatide molecule for the treatment of adults with obesity, or overweight with weight-related comorbidities[9]. The drug could be approved for obesity treatment in the first half of 2023. The molecule which was already approved earlier in 2022 for the treatment of type II diabetes by the FDA and is sold under the name Mounjaro™, has aced a recent phase III clinical trial, yielding far better results than those provided by Wegogy and Saxenda, the blockbuster drugs previously approved for obesity treatment. This disease is known to promote the development of other conditions such as type II diabetes or cardiovascular diseases. This leads to and complicates the treatment of other diseases such as cancer and, as we have seen with the pandemic, respiratory diseases. Thus, not only does obesity increase the risk of death, it indirectly contributes to a considerable reduction in the life expectancy of patients. Obesity also imposes a significant burden on public finances and represents nearly $200 billion per annum in direct and indirect costs in the United States alone[10]. As such, Wall Street analysts estimate that the annual sales of tirzepatide for obesity treatment could exceed 25 billion[11], which would dethrone AbbVie’s arthritis drug Humira, the current record holder (excluding the mRNA vaccine of Pfizer/BioNtech which we dismiss as a one-off). The second positive development also came from the medical sector, this time related to the treatment of Alzheimer disease, which has eluded science for three decades. In June 2021, the FDA approved aducanumab, a drug developed by Biogen and sold under the name Aduhelm™, for the treatment of some cases of Alzheimer's disease. That said, because of the risks of significant side effects, including brain swelling and brain bleeding, and allegations of improper interactions between FDA officials and Biogen’s scientific team during the approval process, aduhelm™ hasn’t been widely prescribed to the despair of the Alzheimer community which has unfortunately grown accustomed to false hopes and controversies. Thankfully, another Alzheimer drug, lecanemab, developed by the Japanese pharmaceutical group Eisai (in partnership with Biogen) has shown promise. The drug, which is expected to be available as soon as January 2023 under the name leqembi™, has been shown to slow the cognitive decline by 27% in patients with early stage, mild cognitive impairments. This is not a recommendation to buy the stock of Eli Lilly, Eisai or Biogen. If anything, the positive developments associated with these therapies is already likely reflected in the price. The purpose of this discussion is to highlight the progress being made in the field of pharmacology, which will ultimately contribute to improving longevity and the quality of life of individuals who are suffering from devastating conditions. The third positive development took place at the Lawrence Livermore National Facility when, on December 5^th when a team of nuclear physicists succeeded in producing more energy from the fusion of atoms than the laser energy that was used in the process. It was the first controlled fusion experiment to reach this milestone and the first real step towards the development of a potentially limitless, environmentally friendly energy supply. The concept of nuclear fusion was theorized in the early 1930s[12] when scientists realized that this was how the sun was powering itself. It is a process by which laser beams deliver a large quantity of ultraviolet energy into a fuel capsule that contains atoms (typically hydrogen isotopes like protium, deuterium and tritium) which the laser binds together while releasing energy. The main advantages of nuclear fusion over nuclear fission include reduced radioactivity and waste, fuel supply abundance (hydrogen isotopes) and safety. That being said, considerable challenges need to be resolved. For instance, the heat required to produce the atomic reaction is over 100 million degrees. That needs to be contained! As such, in the best-case scenario, the technology is probably still decades away. For this reason, it is too early to consider investing in the next SPAC (Special Purpose Acquisition Company) that has the word “nuclear fusion” in its business plan. Nonetheless, given the urgency triggered by accelerating climate change, this could be a logical source for large-scale government-funded research for years to come, a modern-day equivalent of the Manhattan Project or the race to the moon. PORTFOLIO TUNING FOR 2023 I believe that the year ahead will force investment management professionals to make various playbook adjustments. In effect, for the first time since the Global Financial Crisis (“GFC”) of 2008, ultraloose monetary policy is less likely to come to the rescue of risky assets during sharp drawdowns. As I have mentioned before, central bankers of the Western world, through their concerted actions, have been the largest single contributor to financial assets widening gap between their price and their intrinsic value and to the abating of volatility. While I fully expect central banks to continue to intervene during severe market disruption, I believe their actions are more likely to be less “open-ended” than they have been until recently. In normal times, I believe central banks will be more tolerant to drawdowns and that this will translate into faster movements and longer lasting trends across and within markets. Indirectly, it means that the latent level of risk present in the market is perhaps more elevated than at any other point since the GFC. From a portfolio construction standpoint, it means that if a portfolio’s asset mix was calibrated with a specific absolute risk profile in mind a few years back, it probably needs to be dialled lower. All else equals, we have reduced exposure to riskier assets in discretionary portfolios since late 2021 and are maintaining that stance entering into 2023 for that reason. We made similar recommendations for non discretionary mandates. When I ask myself what would make me want to adopt a more optimistic stance, again, yesteryears quasi-programmed action to rebalance in favor of risky assets every time they declined by 5% to 10% may not be appropriate. Instead, going forward, it is more likely to be a function of how much sentiment and consensus have deteriorated relative to what is happening in reality. As a matter of fact, this is how it used to work, pre-2008. The persistent increase in inflation that triggered the fastest increase in short-term interest rates in four decades caught almost everyone – myself included – by surprise in 2022. While inflation may remain well above central bankers comfort zone for a couple of years, the inflation story will likely shift from a focus from its absolute level in the short term to its possible range a few years down the road. Here is why. Central bankers are unwavering in their efforts to curb the drivers of inflation that are caused by unsustainable aggregate demand. They are raising the cost of money so that agents are incited to save and delay consumption decisions. Judging from the steep declines in new house prices, car sales and durable goods, the measure seems effective. However, there are variables that drive inflation on which central bankers have little to no control and which may play out in ways that are difficult to predict. First, the working-age population is set to decline in the developed world. This is likely inflationary as there will be fewer workers and that the ones entering the workforce are typically less productive than those exiting. If labor movements succeed in organizing themselves in the developing countries, it would be even more inflationary as it would impact import prices in the developed world. Second, persistent geopolitical tensions likely mean that globalization has peaked. This in turn means that complex supply chains will have to be rewired and multiple redundancies will have to be established. This is also inflationary but will vary greatly from sector to sector. Third, the transition towards a low-carbon economy is causing energy supply and demand mismatches. This too is inflationary and highly volatile from country to country. Overall, I do not dismiss the possibility that central bankers manage to cause enough damage for demand for goods and services to normalize at a level that result in inflation stabilizing around 2% as it has in the past 20 years prior to 2021, but I think this has become increasingly unlikely. Which brings me to what is priced in. Interestingly, in spite of this blurry supply side portrait, inflation expectations over the next five and ten years in the US are essentially at the same level as they were 2 years ago. In fact, in spite of having seen inflation reach levels not seen in forty years, Treasury Inflation Protected Securities (“TIPS”) did not do better than nominal government bonds in the past year. Indirectly, it means that the consensus is still counting for long-term levels of inflation to drop to historical levels within a couple of years. I think this is optimistic and as such, TIPS could represent a cheap option on potential un-anchoring of longer-term inflation expectations and outperform nominal bonds going forward. We are looking for ways to express that view tactically across portfolios to improve risk-adjusted returns. Speaking of nominal bonds, the yield to maturity on high quality corporate bonds with maturities before 2028 now exceed 5%. This is higher than the expected level of the discount rates at the end of this hiking cycle. Therefore, I believe there is minimal downside risk for this segment at this stage. It also represents an interesting alternative to cash with the potential benefit of capital gains should short-term interest rates decline over the medium term. Anecdotally, a year ago, it was nearly impossible to earn risk-free or quasi risk-free returns exceeding 2%, and nearly impossible to expect returns exceeding 5% without loading up on high yield and emerging market bonds. In fact, that was the case for most of the last decade during which there were no alternatives to stocks. Well, there are alternatives on tap nowadays. I am less enthusiastic about bonds of longer maturities, particularly government bonds. First of all, the term structure of interest rates is inverted both in Canada and in the United States, which means nominal yield on long-term bonds is lower than the nominal yield on short-term bonds. While this is often the case in the months leading to a recession, we note that the current level of inversion is close to an all-time record. For this reason, investors do not seem appropriately compensated for underwriting term risk. Additionally, as the Federal Reserve has recently started to reduce its balance sheet and no longer purchases bonds issued by the US Treasury, future issuance of US government debt will have to be absorbed without one of its most significant buyers. Considering that central banks purchase had the effect to artificially suppress interest rates by as much as 1%, the path of least resistance for long-term treasury yield should be higher. Ultimately, long-term treasury bonds should remain good defensive assets in the event that growth disappoints relative to expectations but are likely going to perform poorly in almost every other conceivable scenario. It is acceptable to have some for risk control purposes but we continue to recommend a significant underweight. Turning to equities, we are comfortable with the current range of managers employed and the general positioning. In discretionary managed portfolios, our roster is broadly diversified geographically, stylistically and from a market cap standpoint. Heading into 2023, we maintain minor value and low volatility tilts albeit in lower dosage than a quarter ago. When it comes to short-term performance expectations, we do not have strong conviction either way. That being said, we note that the majority of Wall Street strategists and prognosticators think that the S&P 500 will appreciate between 4% and 12% over the next 12 months. Given the level of the risk-free rate and that of the equity risk premium, this is possible. Nonetheless, since we forecast an annualized standard deviation of 12% for the asset class, it is safer to state that there are roughly two-thirds chance that equity indices will return between -5% and +20%. We would point out that the current consensus is for the aggregate earnings of the S&P 500 Index constituents to increase 4,4% . This may be challenged if a recession does materialize because earnings have tended to decline in excess of 10% in prior economic downturns. Equity markets have quickly recovered from prior doldrums. As mentioned above, a more painful hangover may induce a stronger policy response and lead to yet another v-shape recovery but that is not our base case. With regards to liquid alternatives, our fund of hedge funds, which was one of the few bright spots in absolute terms in 2022, welcomed its eighth manager on January 1, 2023. With the latest addition, we now have all grounds covered and we are comfortable maintaining a small overweight given its proven ability to deliver positive returns during market dislocations and because of the diversification benefits that it provides in a context where the likelihood of a joint rally in both equities and bonds is slim, in our opinion. Finally, on the side of less liquid alternative strategies, we continue to advocate an approach designed to achieve and maintain an allocation target several years following the establishment of a commitment program. Like every year, we plan to offer a relatively narrow range of funds spread across the main categories, namely private equity, real estate and infrastructure. Given the rise in interest rates, we plan to pay closer attention to private debt with a distinct emphasis on strategies or sectors where a capital shortfall is looming. Thank you for your support, Dimitri Douaire, M. Sc., CFA Chief Investment Officer   [1] Unless specified otherwise, index performance is reported on a total return, local currency basis. [2] For the purpose of this discussion, I consider the blockchain industry and the cryptocurrency industry as distinct. My comments pertain strictly to the cryptocurrency industry. [3] A bitcoin exchange headquartered in Japan which reportedly handled over 70% of bitcoin transactions in early 2014. [4] William McCaskill, Doing Good Better: How Effective Altruism Can Help You Make a Difference, 2015. [5] A proprietary trading firm. [6] Source: Opensecrets.org. [7] Bankruptcy lawyer who oversaw the liquidation and recovery of assets from Enron and Fruit of the Loom. [8] https://patrimonica.com/the-great-deconfinement/?lang=en, June 30, 2020. [9] Source : Eli Lilly [10] Harvard School of Public Health [11] Source : Bank of America Securities [12] Notably, Hans Bethe. Photo credit

Not so quiet on the East front – Thoughts on the Russia-Ukraine situation

Montreal, February 25, 2022 BRIEF NOTE FROM THE CHIEF INVESTMENT OFFICER[1] Let us preface this note by saying that our thoughts are with all Ukrainians whose Canadian diaspora is the largest in the world after Russia’s[2]. We are praying for a rapid de-escalation of the situation. One of my favorite music band at the moment is an Ukrainian folk quartet called Dakha Brakha. Many of Dakha Brakha’s songs are about the reminiscence of what life was in pre-communist Ukraine. The reason I mention this while some western media outlets are describing the situation that is unfolding in the eastern province of Donetsk and Luhantsk as something totally unexpected, it is worth noting that this is nothing new to Ukrainians who have been indirectly controlled or outright repressed by Moscow for centuries. In fact, the regions that are enduring Russian military strikes today have been under a state of emergency order since 2014. Admittedly, I didn’t think that Moscow would have to act on its open threats but despite this having escalated further than I thought, I still believe that Moscow is prepared to order a general cease fire and a withdrawal of its troops as soon as NATO agree to its demands. Moscow claims that the military operation was needed to protect civilians in eastern Ukraine but I believe this is an excuse as at the same time, it has made abundantly clear, repeatedly, that it wants NATO to promise not to expand into any more Eastern European countries that border Russia[3]. For the context, Russia already shares a border with five NATO members. NATO, on the other hand, refuses Moscow’s demands on the grounds that all countries have a right to self-determination. With that in mind, I believe that Moscow’s actions in the last 48 hours are designed to verify if NATO’s resolve to protect Ukraine independence is as firm as Moscow’s determination to bring it under its tutelage. Implicitly, Moscow’s actions also signal that it is prepared to have the Russian population and Russian international conglomerates face the cost of severe sanctions, thereby showing that is not constrained by public opinion at home in the way that NATO countries are. In fact, I believe Moscow’s is counting on the fact that the American public has little appetite for another foreign military campaign as it is finally figuring out how costly and difficult it is to help small countries secure independence from belligerent neighbors. Afghanistan, where the US failed to establish political order or a functioning national economy after two decades is just the latest example of that. Prior to that, there was South Korea (1948-50 – North Korea invaded south Korea with the support of China and the Soviet Union), Vietnam (1955-75 – North Vietnam invaded South Vietnam, Laos and Cambodia with the support of China and the Soviet Union). To summarize, I believe that Moscow has concluded that NATO has little willingness to engage in a new war and that in the interim, whatever Moscow does maximizes the odds of keeping Kyiv under its influence. INVESTMENT STRATEGY IMPLICATIONS If the omicron variant or the prospect of runaway inflation were insufficient, it seems that Russia’s invasion of Ukraine has finally provided the excuse to send capital markets into a tailspin. To this point, global equity markets are nearing double digit losses year to date and volatility indicators are on the rise again. This is the kind of scenario that is prompting investors to question their investment strategy. That being said, just like we argued against cutting dramatically the exposure to risky assets when the first cases of Covid-19 were revealed outside of China on the grounds that it was already too late, I believe that selling now, when so much fear and uncertainty is being discounted is not the best option. At the same time, I’m not suggesting to buy either. After all, while I don’t believe that the situation in Ukraine will deteriorate much further, an attack on the Russian natural gas pipelines that cut across Ukraine to supply Germany and other parts of Europe cannot be ruled out at this point. I also do not think that Russia will inspire Beijing to consider similar options for Taiwan but may it will. I would simply point out that while our models still suggest that broad equity markets will continue to appreciate by 5% to 7% per annum on average in nominal terms in our base case scenario, that does not mean that they will appreciate by 5% to 7% every year. We are reminded periodically, as we are now, that markets do not go steadily go up. There will be down years and there will be double digit up years. As we have mentioned on numerous occasions, the key is to ensure that the proportion of an investor’s capital that is invested in risky assets is consistent with such investor’s risk or loss tolerance. From that stand point, I am very comfortable with the positioning that we’ve adopted for our clients. For instance, through the managers that we have selected, we have largely avoided long term government bonds which are proving quite vulnerable to interest rate increases. We have also avoided the most speculative segments of the equity markets which are also proving vulnerable to monetary policy adjustments. We have entirely avoided crowded flavors of the day like companies that had recently IPOed and we never held cryptocurrencies. On the private markets side, we systematically declined opportunities to invest in start-up software firms on multiples not witnessed since the dot-com era. We were instead focused on establishing a portfolio of hedge funds in which underlying funds that would place bets primarily on relative value, higher volatility, higher dispersion and trend following strategies. We saw that as the best strategy to avoid being caught off guard in the event that equity and fixed income disappointed simultaneously. These little actions together contributed to enhance the resilience of our clients portfolios. Lastly, I remain optimistic that I will get the chance to appreciate Dakha Brakha live in Montréal in the not too distant future. Dimitri Douaire, M. Sc., CFA Chief Investment Officer   [1] The title is a paraphrase of the 1930 world war I themed movie “All quiet on the western front” based on the 1929 Erich Maria Remarque novel. [2] Census Profile, 2016 Census: Ethnic origin population, Statistics Canada, 8 February 2017 [3] Since the collapse of the Soviet Union, Russia’s western buffer has been reduced to Belarus   Photo credit