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Today, we will learn more about:

1. Circular Economy Deep Dive

2. Karen Karniol-Tambour (co-CIO at Bridgewater Associates) Podcast

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Circular Economy Deep Dive

Integrating sustainability into financial, economic, and political decision-making has been a key focal point, particularly in recent years when metrics like carbon impact and material waste have trickled into corporate performance objectives and investor inquiries. The essence of a circular economy (CE) is a regenerative economic system in which resources are kept in use for as long as possible, waste is minimized, and material is reused or recycled at the end of its service life. A CE aims to replace the traditional, linear economy of “take-make-waste” with a sustainable solution that prioritizes the preservation and growth of natural resources and ecosystems. In this post, we will provide an overview of CE models, survey the success and prevalence of the CE in financial markets, and consider recent policy implications to assess where CE investing goes from here.

CE Overview

The Ellen MacArthur Foundation, a prominent think tank in the ESG space, explains that the CE is based on three principles: (1) eliminate waste and production, (2) circulate products and materials at their highest value, and (3) regenerate nature. In a CE, material continuously flows between the technical cycle and the biological cycle. In the technical cycle, processes like reuse, repair, remanufacture, and recycle keep products in circulation. In the biological cycle, nutrients within the material used to make these products are returned to the Earth. Bain’s 2022 Technology Report explains that successful CE efforts do three things well: they (1) identify new ways to create value, (2) anticipate disruption to profit pools, and (3) plan for scale.

Enthusiasm for circularity objectives varies by industry. Bain’s aforementioned report found that approximately 50% of manufacturing, 40% of retail, 33% of technology, 25% of healthcare, 20% of professional/technical services, and 15% of finance companies have committed to specific circularity objectives. Among these committed companies, technology and manufacturing companies are most likely to have a highly detailed sustainability plan for accomplishing their objectives, whereas the plans of retail companies tend to be more limited. Accenture Strategy estimates that fully leveraging the CE could generate $4.5tn of additional economic output by 2030.

HP’s climate action strategy is organized into three groups: circularity, carbon emissions, and forests. The company aims to transition to a “fully regenerative economy” and has committed to achieving zero waste in operations by 2025 and 75% circularity for products and packaging by 2030. HP has transitioned many products from transactional hardware sales to software-as-a-service models, prolonging the life of hardware (and generating second and third-use revenue streams) whilst delivering the same value to customers.

Patagonia offers to exchange used merchandise for a Worn Wear credit, clean and restore the garments, and resell them on its website at a discounted price. The company applies its “Ironclad Guarantee” to items purchased from this line and has expanded its repair and workshop offerings for garments in unacceptable condition. Patagonia does not accept merchandise embroidered with logos, rendering the essential vest component of the midtown uniform ineligible (its website remarks “We hope to change this in the future”).

Financial Success & Market Prevalence

A Bocconi University research study of over 200 publicly listed European companies across 14 sectors found that circularity can be used as a risk mitigation strategy and that CE investments can provide superior returns. “Circularity scores” for each company are computed using Thomson Reuter’s Eikon ESG dataset.

A 0.1 increase in this score reduces the debt default probability by approximately 9% and 5%, over a one-year and five-year time horizon, respectively. Furthermore, the one-year debt default probability for the top quartile of companies by circularity is 0.04%, compared to 0.50% for the bottom quartile. The five-year debt default probability for the top quartile is 0.91%, compared to 2.35% for the bottom quartile.

Risk-adjusted returns are higher for high circularity stocks, as measured by their Sharpe and Treynor Ratios. We will provide an overview of these concepts in the subsequent paragraph.

The Sharpe Ratio measures returns on equity compared to its risk, as computed by Ri – Rf / σi, where Ri is the return on the investment, Rf is the risk-free rate, and σi is the standard deviation of the investment’s returns. The Treynor Ratio measures the additional return in equity generated by an additional unit of risk, as computed by Ri – Rf / βi, where Ri is the return on the investment, Rf is the risk-free rate, and βi is the market beta of the investment. The Sharpe and Treynor Ratios are connected through the definition of risk. Total risk is the sum of systematic risk and unsystematic risk. Systematic risk, also known as market risk, is the risk inherent in all assets. Unsystematic risk, also known as specific risk, is the risk unique to a particular industry or company. With the Sharpe Ratio, we divide the investment’s excess returns by the total risk (standard deviation). With the Treynor Ratio, we divide the investment’s excess returns by the systematic risk (beta) only.

Let’s return to the study. A 0.1 increase in circularity score translates to a 0.204 increase in Sharpe Ratio and a 0.163 increase in Treynor Ratio. Similarly, the top quartile of companies by circularity exhibits a Treynor Ratio of 0.22, compared to -0.73 for the bottom quartile. These findings are bolstered by examining the spread in performance between Unilever’s five-year bond price and that of a peer company with a lower circularity score.

A number of debt and equity instruments related to the CE have been created to capitalize on these opportunities, such as green bonds and climate bonds. Green bonds are linked to projects with a positive environmental impact, whereas climate bonds are linked to the subset of projects within this group that reduce carbon emissions or mitigate climate change. Goldman Sachs predicted that $652bn in green bonds will be issued in 2023, and Moody’s estimated these will account for 15% of total bond issuance, up from 13% in 2022. AUM for funds related to CE grew from $0.3bn in December 2019 to $2bn in June 2021, and the number of CE-focused private market funds has grown from three in 2016 to over thirty today.

BlackRock, the world’s largest asset manager, declared in 2020 that climate change would become central to its investment decisions and has largely spearheaded circularity efforts in the financial sector. BGF Circular Economy is BlackRock’s CE public equity fund, in which at least 80% of total assets come from “companies globally that benefit from, or contribute to, the advancement of the ‘Circular Economy.’” The fund launched with just $20mm in seed funding, raised nearly $1bn in its first year, and is currently sized at $1.8bn. Among the largest holdings in the fund include Republic Services (waste collection), Microsoft, Coca-Cola Europacific, and Waste Management. BNP Paribus also created a CE ETF that is comprised of stocks of 50 global companies engaged in the CE across industries and is currently sized at $800mm. Among its largest holdings include NVIDIA, Advanced Micro Devices, Danone, and DENSO.

Intesa Sanpaolo, headquartered in Italy, is one of the largest banks in Europe. Among its numerous circularity objectives is Plafond, an EUR 6bn credit facility earmarked for companies aligned with the CE model. Plafond primarily focuses on small- and medium-sized businesses with $1-6mm EBITDA. The facility is synergetic, because it directs credit exposure towards circular companies that tend to be less risky and more resilient and provides a financial instrument for ESG-minded investors. Intesa Sanpaolo is one of over 300 worldwide banks, including 4,400 investors and 500 service providers (representing $121tn AUM), which has committed to the UN’s Principles for Responsible Investing. These Principles are intended to support the UN’s 17 Sustainable Development Goals, of which circularity is proposed as a key driver to achieving seven of them.

Policy Implications

Legislation will help circularity efforts in the coming years, primarily by catalyzing the growth of circularity initiatives via federal funding.

Europe: In March 2020, the European Commission created the Circular Economy Action Plan (CEAP) as part of the EU’s Green Deal, following its initial circularity plan published in 2015. CEAP is described as one of the “main building blocks” of the Green Deal and as “a prerequisite” to achieving its objectives, which include climate neutrality by 2050 and economic growth decoupled from resource use.

Japan: In January 2021, Japan’s Ministry of Economy, Trade and Industry and Ministry created the Disclosure and Engagement Guidance to Accelerate Sustainable Finance for a Circular Economy. Japan boasts the most entrenched circularity plans, dating back to the Fundamental Plan for Establishing a Sound Material-Cycle Society in 2003. This development provides counsel to companies on how to communicate the financial incentives of the CE and how to link governmental circularity objectives with corporate performance.

China: In July 2021, the National Development and Reform Commission published its Development Plan for the Circular Economy. The Plan mandates that by 2025, the country should have a fully implemented circular agricultural production method and improved resource recycling and utilization.

US: In April 2023, President Biden signed an executive order creating a new Interagency Policy Committee on Plastic Pollution and a Circular Economy following a roundtable in February 2023 with the Ellen MacArthur Foundation. This Committee is part of Biden’s larger National Climate Task Force and builds off of his Bipartisan Infrastructure Law success (primarily related to clean energy) from November 2021. EPA regulations surrounding emissions and electronic waste are also likely to increase, and circular models can facilitate adherence to these stricter objectives.

Sustainability and the circularity solution will continue to be charged topics as the impacts of our climate recklessness become increasingly apparent (especially for those of us inhaling NYC’s orange fog). Going into the weekend, we are thinking more about the emerging role of circularity on revenue and cost streams, investor/investment demand, and our financial system more generally.

Invest Like The Best w/ Karen Karniol-Tambour

This episode of Invest Like The Best is with Karen Karniol-Tambour, the co-CIO at Bridgewater Associates (the investment firm led by Ray Dalio with over $100 billion in AUM). This conversation delves into the potential impact of AI on macroeconomics, investment strategies, and portfolio construction while highlighting the importance of adapting to changing market dynamics and reevaluating traditional assumptions.

Karen highlights the impact of previous macroeconomic forces like globalization and automation on the labor market, leading to significant changes in productivity, profits, and social and political consequences over several decades. She suggests that AI could have an even bigger and faster effect on the labor market, affecting a larger portion of the workforce. Karen emphasizes the need to consider the balance between AI's potential benefits and the massive inflationary forces in the current economic landscape.

Patrick (the host) and Karen also discuss the implications of AI on investment decisions and portfolio management. While it is still uncertain how effectively AI can be used to gain an investing edge, Karen acknowledges the importance of studying and exploring its potential. She mentions that AI could play a role in making investment decisions, but the historical limitations and uncertainties in macro markets (what Bridgewater focuses on) pose challenges. Furthermore, the potential for misinterpretation could also make it used for investing purposes.

Karen highlights the tension between the historically successful containment of inflation by central banks and the potential for a different economic landscape where inflation becomes a concern. Karen suggests that markets are assuming a modest economic slowdown and quick easing by the Federal Reserve, anticipating inflation to return to reasonable levels. However, she points out the asymmetric nature of the market, where a significant economic slowdown could negatively impact stocks, and the already priced-in easing measures may not surprise the market. Since the prevailing valuations indicate that the market expects a modest economic slowdown without a significant recession, and assumes that the Federal Reserve will ease monetary policy to manage inflation, Karen highlights the potential for disappointment in market expectations. To address this, she believes market diversification efforts can help, such as considering investments in countries like Japan or China and reevaluating the role of gold as an alternative asset in the current environment.

The conversation then shifts to portfolio management. Karen explains how gold, unlike AI, is a historical store of value that has been considered valuable for thousands of years. While gold doesn't generate earnings or interest, its appeal lies in its potential to protect against inflation and asset confiscation. Asset confiscation refers to the idea that a currency can be weaponized in times of considerable economic uncertainty or geopolitical conflict. For example, the US could stop accepting dollars from Russia, thereby rendering Russian savings less valuable. Alternatively, the Russian need for capital to deploy to war efforts could make it difficult for citizens to withdraw securities they hold. Weaponizing a precious metal in either of these manners is nearly infeasible.

She notes that geopolitical shifts and volatile inflation are making gold more attractive to central banks and investors. Karen also emphasizes the importance of considering big, longer-term macro variables in portfolio construction. While these variables may move slowly, they shape assumptions about assets and influence diversification strategies. She mentions that emerging markets, for example, are exhibiting different correlations and monetary policies due to their unique inflation concerns.

Talking about geopolitics, Karen also highlights the rise of China as a significant factor that challenges the assumption of the U.S. as the dominant superpower. Karen points out that while U.S. stocks and tech have performed exceptionally well in the past, their outperformance is already priced in, while China's potential and attractive valuations are relatively overlooked (this belief should not surprise us as Bridgewater has been a heavy investor in China). Furthermore, she highlights the importance a nation's governance plays in asset prices, from how they would handle things like the debt ceiling and political polarization.

Karen concludes her conversation by highlighting which asset classes she believes are overrated/underrated. She outlines that US stocks are overrated because of high valuations and major downsides. On the other hand, areas such as Emerging Markets and Gold are undervalued asset classes since they have been overshadowed by other investment options. Gold, for instance, is positioned to benefit from geopolitical factors and volatile inflation.

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