Profiting from momentum strategies - Part 1

Momentum is arguably the most well-known trading strategy. A simple strategy of buying stocks that have done well over the past 6 months ("winners"), and shorting stocks that have done badly ("losers"), earns a 1%/month return over the next 6 months. While other trading strategies stop being profitable once they have been discovered (because investors start exploiting them, removing the profit opportunity), momentum has remained surprisingly lucrative ever since Jegadeesh and Titman (1993) first documented it. 

A momentum strategy is attractive because it is market-neutral - since you're buying some shares and shorting others, it can make money in up markets and down markets. Thus, it is relatively immune to market risk. The Sharpe Ratio (a measure of the risk-adjusted return to a trading strategy) of momentum is about 0.6, compared to 0.3-0.4 for just holding the market. I attempt to exploit momentum myself, through the AQR Momentum ETF (ticker AMOMX).

Momentum is also pervasive - it works not only in stocks, but also bonds, commodities and exchange rates as shown by Asness, Moskowitz, and Pedersen (2013). That we see it in so many assets suggests that momentum is due to investors making mistakes - popularized by a branch of research known as "behavioral finance". The main psychological explanation is that investors are slow to react to information - thus, good news takes time to be incorporated in prices, and ditto for bad news. 

However, even though the momentum strategy does well on average, there are some periods where it does very badly, such as in the recent hedge fund crisis - some hedge funds went under because they followed momentum strategies that tanked. For example, between March and May 2009, the "losers" generated 163% returns, but the "winners" generated only 8% returns. Thus, a momentum strategy is somewhat like selling options - it makes money on average, but sometimes does really badly.

This new paper by Kent Daniel of Columbia GSB, a former Managing Director in Sachs Asset Management and Toby Moskowitz of Chicago Booth, a former winner of the Fischer Black Prize for outstanding contributions to finance research by someone under 40, shows you when to get out of momentum strategies - and thus how to make momentum even more profitable. 

The answer is surprisingly simple - get out of the momentum strategy in times of market stress, when 1) the market has recently declined, and 2) market volatility (measured by the VIX volatility index) is high. Here's a simple intuition. If the market has recently declined, the "loser" portfolio must have declined much faster than the broader market. Thus, it has a high beta (= sensitivity to the market). The "winner" portfolio has a relatively low beta, which is why it didn't decline so much. After times of market stress, the market typically recovers. Thus, the "loser" portfolio, which has high beta stocks that are sensitive to the market, does especially well in the market recovery, and so you want to get out of the momentum strategy. Kent and Toby find that this surprisingly simple enhancement to the momentum strategy doubles the Sharpe ratio from 0.6 to 1.2.

Does corporate social responsibility improve firm value?

Below is an article I wrote two months ago for the World Economic Forum. Since it's posted on the password-protected section of the WEF website, I reproduce it here.

Does corporate social responsibility (“CSR”) improve firm value? When companies make decisions, should they care only about shareholders or should they take other stakeholders (e.g. employees, customers, the environment) into account? This is a decades-old debate, but despite many cogent views on both sides, there’s surprisingly little hard evidence. 

In 1970, Milton Friedman famously wrote that “the social responsibility of business is to increase its profits”. This view isn’t as hard-hearted as it may sound. Friedman argued that a company can only increase its profits by taking other stakeholders into account – producing high-quality products, treating its employees fairly, and having a good environmental reputation. Under this view, firms should focus exclusively on profits, and everything else will fall into place.  Considering other stakeholders beyond the profit implication is at the expense of shareholders: a dollar spent on reducing pollution (beyond the level that will avoid an environmental lawsuit) is a dollar that cannot be paid as dividends. 

However, advocates of CSR argue that the Friedman view only holds in theory. In practice, it’s extremely difficult to quantify the profit implications of most socially responsible actions. A company could decide whether to grant an employee compassionate leave by trying to calculate the potential loss in morale and productivity if the leave was withheld, but these consequences are very hard to quantify. The CSR approach would be to grant the leave simply because it’s the right thing to do – because the goal of the company isn’t only to maximise profits, but to treat stakeholders with compassion. Treating employees fairly will eventually manifest in greater staff retention and future productivity. However, these long-run effects are difficult to quantify, so a firm focused exclusively on profits will not invest in its stakeholders.

Whether CSR improves firm value has been studied extensively by management scholars. Most studies find a positive correlation between CSR and measures of firm performance, such as profits. However, correlation doesn’t imply causation. It may not be that CSR causes a firm to perform better, but instead that firm performance causes CSR – only firms that are performing well can afford to spend money on its other stakeholders. In addition, some studies consider only one industry, or a short time period, and so are hard to generalize.

I decided to tackle this long-standing management question using a methodology from a different field – finance. This approach involves linking CSR not to profits, but to future stock returns, which reduces reverse causality concerns. If it was high profits that caused CSR, then the high profits would mean the company’s stock price would already be high today, and so we shouldn’t expect higher stock returns going forward. 

The next decision is how to measure CSR. The main challenge is that CSR is extremely difficult to measure objectively, as it’s intangible. Tangible measures do exist – for example, one could measure workplace diversity by whether there’s a minority on the board. However, tangible measures are relatively superficial and thus easy to manipulate. For example, a company that cared little about workplace diversity could put a token minority on the board to “check the box”. A separate challenge is that CSR comprises of many different dimensions – responsibility to employees, customers, the environment, etc, and it’s unclear how to weight these different constituencies. 

I thus focused on one particular dimension of social responsibility – employee satisfaction. I chose this dimension as a very thorough measure of it exists. Since 1984, there has been a list of the “100 Best Companies to Work for In America”.  This list is compiled by surveying the employees themselves – it’s the ultimate in fundamental, grass-roots analysis. Two hundred and fifty employees are randomly selected in a firm and asked 57 questions on various aspects of employee satisfaction (credibility, respect, fairness, pride/camaraderie), which had been developed through extensive discussions with managers, employees and workplace experts. As a result, it’s arguably the most respected measure of employee satisfaction.  Equally importantly, it has been available since 1984, and thus I have a long time-series which comprises both recessions and booms. 

The first list came out in a book in March 1984, then another book in February 1993, and then in the January edition of Fortune magazine every year from 1998.  My methodology involves buying a the Best Companies in April 1984, rebalancing the portfolio in March 1993 to take the new list into account, and then rebalancing it every February from 1998.  The one month delay is because I wish to test not only that employee satisfaction improves firm value, but also whether the market recognizes this link.  Even if employee satisfaction improves firm value, my strategy should earn no returns if the market recognizes this link.  As soon as a company appears in the Best Companies list, its stock price should go up, so I shouldn’t be able to generate returns by buying it one month too late. 

I compare the returns of the Best Companies not only to the overall market, but also to companies in the same industry.  For example, Google is frequently in the Best Companies list, but its high returns could be due to the tech industry doing well, rather than its employee satisfaction.  I also compare each company to peer firms with similar characteristics (e.g. size, dividend yield, recent performance, valuation ratios).  In short, I try to control for as much as possible, to isolate the effect of employee satisfaction.  I also remove the effect of outliers, to ensure that any superior performance of the Best Companies isn’t due to a few star performers such as Google.

I find that the Best Companies beat the market by 2-3%/year, over a 26-year period from 1984-2009.  This outperformance is highly statistically significant, and also economically meaningful – a fund manager who beats the market by 1%/year for 5 years is considered to be skilled.  Moreover, this outperformance is based on a very simple trading strategy using public information on large firms.

The results have three main implications.  First, they suggest that employee satisfaction is beneficial for firm value.  While it may seem natural that companies should do better if their workers are happier, this is far from obvious.  Indeed, the 20th century way of managing workers is to view them as any other input – just as manager shouldn’t overpay for or underutilize raw materials, they shouldn’t do so with workers. High worker satisfaction may be a sign that workers are overpaid or underworked.  However, the world is different nowadays.  Human capital is the main asset in many firms, and employee welfare can improve productivity, retention, and recruitment.

Second, even though employee satisfaction may be beneficial in the modern firm, the market doesn’t recognize this link. Even though I wait a month before forming my portfolios, the strategy generates superior returns.  Similarly, the Best Companies typically report earnings that beat analyst expectations – analysts aren’t aware of the benefits of worker welfare.  Indeed, I show that it takes 4-5 years before the market fully incorporates the value of employee satisfaction.  This may be because traditional methods of valuing companies are based on the 20th century firm, and emphasize tangible factors such as short-term profits.  This result has broader implications for firms’ incentives to invest for the long-run.  If investors continue to value companies based on short-term profit, then managers will pursue short-term profit rather than long-run growth.

Third, Socially Responsible Investing (SRI) – incorporating social considerations into portfolio choice – can add value.  The traditional view is that SRI is costly to investment performance, as it involves screening out good investments and screening in bad investments.  However, the Best Companies strategy generates high returns while supporting companies who treat employees responsibly – investors can do well and do good.  This result is a consequence of the first two implications – employee satisfaction is beneficial (the first implication) but the market doesn’t recognise that it’s beneficial (the second implication).

In concluding, it’s worth highlighting some caveats to my study.  First, I’ve only shown a link between stock returns and employee satisfaction, and not other dimensions of CSR.  Further research must be done to study whether there’s any link with environmental protection, animal rights, etc.  However, since the traditional view is that no dimension of CSR should add value, the results are an important first step towards demonstrating the benefits of CSR more broadly.  Second, while I control for many observable factors (industry performance, firm size, dividend yield, etc.), I can’t rule out the explanation that an unobservable variable (e.g. good management) causes both employee satisfaction and superior returns.  If so, my first implication is no longer causal – improving employee satisfaction (without changing management) won’t improve stock returns.  However, the other two implications remain.  It remains the case that the stock market misvalues intangibles – just that the intangible being misvalued is good management rather than employee satisfaction.  It also remains the case that a socially responsible investor could have bought companies that treat their employees well and earned superior returns.

Further reading:

Edmans, Alex (2011): “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices”. Journal of Financial Economics 101(3), 621-640

Edmans, Alex (2012): “The Link Between Job Satisfaction and Firm Value, With Implications for Corporate Social Responsibility.” Academy of Management Perspectives 26(4), 1-19

Trading Strategies Based on Analyst Conference Calls

The idea from this blog came from the "Extra-Curricular Topics" I teach in my MBA classes, a 10-minute interlude where I teach an academic paper with significant real-world relevance. This expanded to an opt-in Google Group where I wrote to former students summarizing an interesting paper that I come across in a seminar or conference, and from there came this blog. However, the first few blog posts ended up being on different topics - this is the first post on the intended theme. 

One very interesting paper I saw presented at the LBS external seminar series is http://www.people.hbs.edu/cmalloy/pdffiles/malcolou.pdf by Lauren Cohen (HBS), Dong Lou (LSE), and Chris Malloy (HBS). It uses analyst conference calls to form a trading strategy. After Regulation FD, firms are no longer allowed to disclose information selectively to certain groups of investors and not others, so analyst conference calls are an important way in which they disseminate information. All analysts are allowed to participate. 

However, what I didn’t know until I saw the talk, was that firms can choose which analysts they would like to speak and ask questions in the meeting. Analysts can signal if they would like to ask a question, but the firm has full discretion on which analysts to call upon. The paper shows that certain firms will selectively choose optimistic analysts (i.e. those who give them high ratings) and prevent pessimistic analysts from doing this. Such a strategy is bad in the long-run, because analysts that are not allowed to speak may end up dropping their coverage of the firm (and analyst coverage is useful for boosting stock liquidity). However, myopic firms who are focused on boosting the short-term stock price may engage in this strategy – indeed, these are firms that are just about to issue equity (so they want to prop up the short-term stock price) and end up announcing earnings that just meet the earnings forecast or beat it by 1 cent (suggesting they’ve done something myopic like cut R&D to meet the target).

The conference call information is public information which can be used to form a long-short strategy: sell the firms that engage in such manipulation and buy the firms that don’t. This strategy earns 95 basis points per month, nearly 12% per year, which is huge alpha. The manipulating firms also end up having negative earnings announcements in the future, having to restate previously announced earnings (implying that the previous earnings were falsified), and using discretionary accounting accruals to artificially boost earnings. This paper is a great example of using a clever institutional detail (the fact that it’s the firm who gets to decide who speaks on a conference call) to find an extremely profitable trading strategy.

You might think - shouldn't the SEC ban companies from being allowed to selectively pick and choose who speaks? Well, actually there's a good reason for allowing companies this discretion. It allows them to stop Bruce Wayne from Wayne Enterprises from calling in (see p13 of http://dealbreaker.com/uploads/2013/05/ARCHER_OL-Transcript-2013-05-30T12_001.pdf). 

Top Ten TED Talks

London is a great city, but one of its downsides is that it takes a long time to get to most places. The TED Talks app has significantly enriched my commutes. Here are my top ten TED talks:

1) The Family I Lost in North Korea, and the Family I Gained (Joseph Kim). Perhaps the most poignant TED talk I've heard, about a boy who list his family in North Korea. About how simple acts of kindness can transform someone's life.

2) Are We In Control Of Our Decisions? (Dan Ariely). On how "nudges" (e.g. by companies selling products, or policymakers) can radically affect people's behavior. One of the leading lights in behavioral economics; his other TED talks are also excellent.

3) Perspective Is Everything (Rory Sutherland). Fascinating talk on "framing" (a concept in behavioral economics on how you present a concept). By a top advertising professional, as knowledgeable as any top behavioral economist on this field; his other TED talks are also excellent.

4) The Puzzle of Motivation (Dan Pink). How intrinsic motivation is much more powerful than extrinsic motivation (using rewards). I thought I already knew this idea, but this went into far greater depth than what I'd heard before. 3 million views.

5) How Great Leaders Inspire Action (Simon Sinek). Leadership and inspiration doesn't require you to do superhuman feats (what you do), but stem from how and why you do something. 2.5 million views.

6) Your Body Language Shapes Who You Are (Amy Cuddy). How adopting particular body language has a causal effect on your performance. This is something I was naturally skeptical about, being an dull economist, but this was an illuminating talk based on scientific evidence.

7) The Way We Think About Charity is Dead Wrong (Dan Pallotta). We often think that charities shouldn't spend on advertising, on hiring good managers - but such investment pays many times over.

8) Teach Every Child About Food (Jamie Oliver). The critical importance of nutrition for health. You may think that you've heard it all before, but this is powerfully and cogently argued, and has the potential to change your everyday life.

9) Building US-China Relations By Banjo (Abigail Washburn). The power of music to create community and cross boundaries - that diplomats, politicians and economists couldn't cross.

10) The Surprising Science of Happiness (Dan Gilbert). We spend our whole lives chasing after happiness, but we can actually manufacture it ourselves.

Davos in a Nutshell (Non-Economics Sessions)

Perhaps the most illuminating sessions in Davos were ones unrelated to economics, and thus gave me insights into topics that I would not normally get the chance to learn about. Here is a short summary.

While these sessions were on quite different topics, one common theme to many was the "neuroplasticity" of the brain. The brain is not fully formed after childhood, but you can keep developing it, e.g. through meditation, mindfulness (paying attention rather than being distracted).

Meditation

A Buddhist monk led a session on "compassionate" meditation, which is quite different from standard meditation:

• Picture a loved one in suffering, and being relieved of this suffering. Then, move to acquaintances, strangers, enemies, and dictators. This simple practice helps us show compassion in our everyday life
• A little bit of meditation every day is better than 8 hours once a week. You water plants every day rather than throwing a bucket once a week.

Exploring Our Limits: Workshop on Creativity

• Jeremy Balkin (Karma Capital, Give While You Live, 5x marathon runner)
• Modern society tells kids to conform, to color within the lines, but we need risk
• For each of us, there's one thing we haven't done because we're scared. Think what this is, and do it
• We're all born as naked vulnerable beings, and we'll all die as naked vulnerable beings. What matters is what we do in between. And we don't know at what point death will come
• We're told that running 26 miles is physiologically dangerous. But, humans used to run to get food. And technology is evolving (e.g. better shoes) to help us. The world has changed a lot in the past 5 years, even in the past year. There's almost nothing we can't do
• Lewis Pugh (first person to swim across the North Pole)
• Jeremy Clarkson doesn't get his ideas for Top Gear by sitting in the BBC studio, but going to the pub, having a few beers and allow his imagination to get wild
• Lewis himself decided to swim the North Pole and Everest in creative moments, on a whim
• Creativity and imagination never takes place in the office, but with friends. You don't make a wild decision based on an economic cost-benefit analysis, but on a whim
• Use the "4am test". If a crazy idea makes sense to you at 4am in the morning, it's probably a good idea
• Bobby Ghosh (TIME magazine World Editor)
• 10 years from now, you'd like to think "I'm proud I did this wild and dangerous thing", but also "I'm proud I did not do this wild and dangerous thing". We often extol the virtues of being wild and crazy, but judgement is also required. Sometimes not doing something wild is the boldest decision
• Ask yourself: "When is the last time you did something for the first time?" Hopefully, the answer is "recently"
• Celine Cousteau (granddaughter of Jacques Cousteau)
• You need a team of people to help you - you can't do it alone. We like to promote the "self-made millionaire". No-one is self-made. Entrepreneurs have customers, employees
• Must connect with the hearts and guts with everyone in your team. This principle also guides you on choosing your team-mates: are they in?
• You need to give yourself space for creativity to happen. We're obsessed with doing things. Don't do, just be
• Tina Seelig (Stanford, moderator)
• Privilege.  If you're an MBA student (or professor) at a top business school, you're privileged, There are others who should be here who aren't here
• Platform. We are lucky to have a platform - use it to help those in need
• Perseverance. Nothing comes for free
• In baseball, if you hit 0.300, you're a great hitter. Encourage people to make mistakes when stakes are low: don't be a perfectionist on small things

Making Better Decisions

This was the session that I served as a discussion leader (on behavioral finance). Sendhil Mullainathan of Harvard was one of the co-facilitators (with Eldar Shafir of Princeton, his coauthor on a book called "Scarcity"). He talked about two topics: bandwidth and scarcity:

Bandwidth

• We talk a lot about time management, but what's more important is "bandwidth" management. You only have a limited capacity for difficult tasks
• The biggest predictor of a plane crash is whether the pilot is in a bad relationship
• Tools to manage bandwidth
• Delegate unimportant decisions to others
• Manage expectations. If others know that you may not reply to email instantly, this removes the mental burden of having to constantly check email
• Don't pack every item in your schedule. You can't go from one meeting on a hard topic to another meeting on a hard topic. Your mind will wander and you will lose focus. You need to build in "bandwidth breaks" during a day, else you'll be ineffective
• Respect other people's bandwidth. We think it's unacceptable to charge kids $100 to apply for a scholarship, but it's OK to make them fill in a 40-page form
• Listen to hear the other person, rather than to prepare your reply to the other person. You can't do both, as you have limited bandwidth

Scarcity

• If you're overcommitted, you may think you should drop everything from your schedule so that you have lots of time. But, then you'll take on unnecessary commitments
• A woman with lots of debt still keeps spending. She's a bad debtor of money, spending money she doesn't have
• We're often bad debtors of time, spending time we don't have
• The tagline of their book "Scarcity" is "Why having too little means so much". When we experience scarcity, we focus on the one thing to make ends meet right now
• Sometimes it works: we can be super-productive when you have a deadline
• But, long-term consequences: spending money you don't have involves taking payday loans
• Thus, there's an optimum amount of scarcity - not too much, nor too little

Mindfulness (Goldie Hawn)

• For further color, read the TIME Magazine article "The Mindful Revolution", http://sfinsight.org/MindfulRevolutionTIME.pdf.
• The more attentive you are, the more your brain circuits wire together and fire together. Mindfulness has been scientifically proven to change the neuroplasticity of the brain
• Mindfulness - focusing on one thing - teaches self-control, and ensures that you can control your emotions rather than being reactive
• Hot cognition: you make decisions based on emotion
• Cold cognition: you can distance emotion from decisions
• The "Stanford marshmallow experiment" showed that, whether kids were able to resist eating a marshmallow, was a significant predictor of future success
• Being distracted (e.g. checking phone during dinner, or doing urgent stuff over important stuff) is like eating a marshmallow or not controlling your hot cognition
• Psychology used to be about fixing broken things. Nowadays, positive psychology is about building on the good things in people. This involves attentiveness and focus

Mindfulness Dinner

• Otto Scharmer (MIT): the success of an intervention depends on the internal state of the interviewer 
• For someone to be a good leader or teacher, the people he's leading or teaching must be mindful
• Tania Singer (Max Planck Institute): mindfulness isn't just attention (like being a sniper). It doesn't just make you more efficient
• Mindfulness has an ethical dimension. Being present and aware of what it exists, and accepting what exists: compassion for others, self-acceptance for yourself
• Buddhist monk: mindfulness isn't just being aware of your thoughts, but also countering bad thoughts
• People are born with traits. However, by accumulating moods, you scientifically modify your traits by changing the neuroplasticity of the brain.
• Being a restless monkey all the time is bad. Be deeply aware of what's going on 
• The founder of Twitter mediates for 10 minutes a day, even though Twitter seems the opposite of mindfulness

Should Drugs Be Legalized?

• Governor Rick Perry (Texas): I'm the only one on this panel against the legalization of drugs, but I come to this debate with an open mind
• Kenneth Roth (Human Rights Watch): decriminalize drugs, so that we can regulate them like alcohol, tobacco
• Treatment is key, but treatment is undermined by criminalization, so victims run away from treatment
• Kofi Annan: drugs have destroyed many people, but government policies have destroyed many more. 
• The US spends more money on prisons than education
• We don't need to legalize drugs, but we should decriminalize them - there's an important difference. You can decriminalize possession, but still keep supply illegal (as in Colorado)
• Juan Manuel Santos (President of Columbia): drug policy is currently decided by law enforcement people, but it should be discussed by public health people
• Criminalization creates drug cartels and the potential for huge profits. This leads to murders - profits are so high that people are literally willing to kill for them
• Tobacco and alcohol firms make normal profits because these substances are legalized
• The Surgeon-General of the US said 8 million deaths have been prevented by the legalization of tobacco
• Roth: decriminalization doesn't mean throwing your hands up and giving carte blanche. Use education, drug substitutes
• Perry: I won't jump in front of the parade just because this is the way public opinion is going. Instead, science should lead us
• In the 5 years since decriminalization of drugs in Portugal, the murder rate has risen 40%
• Marijuana today is much more potent than in the past - it's genetically modified
• The fact that Texas is stricter than other states doesn't mean that Texas is too strict, or that the other states are too lax. The 10th Amendment was to give states authority to set laws, and then people can choose where to live. We shouldn't have the "one-size-fits-all" mentality that seems to come out of DC.
• Perry: something must certainly be done, but there are other steps we can take besides criminalization
• Go after the money. Crack down on banks who allow money laundering 
• Science can create drug substitutes. Decriminalization dissuades drug users from moving off drugs onto substitutes.
• Annan: decriminalize consumers, stay harsh on suppliers
• Audience question: does it apply to all drugs?
• Santos: we need a different approach for each different drug, since each drug is different
• Perry: the others on this panel have used economic arguments for legalizing drugs - that legalization will remove cartels. But, if so, the economic argument would apply to all drugs. This exposes the fallacy of a purely economic argument. Instead, we should look at the science of each drug. We should also think about the medical cost of sending the message that it's OK to smoke marijuana
• Roth: but we're not sending the message that tobacco is OK. Packets say "smoking kills"
• Perry: but that used to be the message. Films, celebrities portrayed the image of smoking being cool. We haven't spent enough since then to reverse this image. 

Closing Address

• Pope Francis: humanity should be served by wealth, not ruled by it
• Jim Wallis: Hope is believing in spite of the evidence, and then seeing the evidence change
• When we return home, we will be confronted by the tyranny of the urgent - but we need to be mindful of what's morally urgent
• Think about: what's the one thing I will commit to right now to help support the World Economic Forum's mission to improve the state of the world?

Eradicating World Poverty: Inspiring a New Generation to Act

This is a summary of a Davos session on "The Post-2015 Goals: Inspiring a New Generation to Act" on the eradication of world poverty and the millennium development goals. It featured, among others, David Cameron, Bono, and Ngozi Okonjo-Iweala (the Nigerian Finance Minister and the most impressive person I heard at Davos):

• David Cameron: tackling poverty is a holistic issue. We can't tackle poverty without tackling climate change, governance, corruption, justice, democracy, gender equality. Many of these reasons are why North Korea is poor but South Korea is rich
• Growth is insufficient. It must be in areas that create jobs for poor people (e.g. agriculture, housing), and we must create a social safety net
• People want two things: a job, and a voice. Can't just focus on the former
• As a result, the Millennium Development Goals (established following the 2000 Millennium Summit of the United Nations) cover eight different areas:
• Eradicate extreme poverty and hunger
• Achieve universal primary education
• Promote gender equality and empowering women
• Reduce child mortality
• Improve maternal health
• Combat HIV/AIDS, malaria, other diseases
• Ensure environmental sustainability
• Develop a global partnership for development
• Bono: I write lyrics like I write poetry. But, goals must be the opposite: hard and precise.
• Bono: 
• We should get out of the way of poor people. Ask them what they want, rather than presuming that we know
• Capitalism can be a great creative force, but also a great destructive force. Even if it's not immoral, it's amoral
• Bono: to me, transparency is even more important than debt cancelation
• If a firm is registered on the NYSE, it must publish what it pays executives. But, declared and actual pay is different. 
• Companies always lobby against transparency. The American Petroleum Institute lobbied against the Extractive Industries Transparency Initiative, which requires oil, gas, and mining companies to disclose the payments they make to governments for extractive projects
• The government must also be open. The question shouldn't be "are we open for business?" but "are we open"?
• Ngozi Okonjo-Iweala (Nigerian Finance Minister):
• Nigeria is forward-thinking compared to the rest of Africa, but shouldn't try to be an oasis in a desert, because the desert always wins
• Africa needs to move beyond extracting resources and use them to create wealth and equality
• Nigeria's policies are targeted. Use conditional cash transfers to encourage kids to attend school. Don't just receive aid, but use it to leverage private sector resources better
• We write off whole countries when there's a bit of sectarian conflict. But, even in such countries, we can try to get kids into school. As peace is being brokered, the next generation can get an education
• Cameron: 
• I reallocated the aid budget from India and China to other countries. India and China have resources to help themselves
• Some of the fastest-growing countries in the world are in Africa. But, there's lots of red tape hindering trade between African countries. Thus, lots of infrastructure has been build to export goods out of Africa, rather than trade within Africa
• Ngozi: gender inequality isn't limited to developing countries. Only 15% of Davos is female. But, because Nigeria is poorer, we can least afford it. I have to take the bull by the horns
• Girls' literacy is key. With the UK's Department For International Development, we pioneered conditional cash transfers to get kids into school. Attendance rose 40%
• Ngozi: everyone agrees we should invest in developing countries
• But, we typically think of investment being in hard assets - building schools and infrastructure
• We need to invest in soft skills: training midwives, teaching a mother to give water to a baby with diarrhea
• An educated woman has 2.1 kids, an uneducated woman 8.9
• Cameron: the UN must agree on a set of specific, measurable, inspiring goals that apply to everyone. We shouldn't have separate goals for the rich and poor. Anti-corruption, justice, transparency are goals for all countries
• Jasmine Whitbread (CEO of Save the Children): goals are universal, but the strategy to achieve them may differ across countries. 
• Tidjane Thiam (CEO of Prudential): we don't want to talk about Africa changing. Africa is still the same - it's weather and resources are the same. Instead, we want to talk about Africans changing - a change in people's attitude
• Bono: next year will be the 30th year of Live Aid. I hope that Bob Geldof and I are just guests - that we won't need Live Aid any more

Davos in a Nutshell (Part 2)

Here are key takeaways from additional sessions I attended in Davos. The last blog mainly covered sessions that were statements of fact (e.g. current economic indicators); here I cover sessions on which there was an exchange of opinions - in particular, different viewpoints around the world on what economic policies to adopt.

Economic Policy Around The World

• Mark Carney became governor of the Bank of England and adopted forward guidance - indicated that he would not raise rates until unemployment fell below 7%. He expected this to take 3 years, but it's likely to take 6 months - unemployment is currently at 7.1%. 
• Thus, just before Davos he issued a statement saying he wouldn't automatically raise once unemployment fell below 7%
• Since then he's said that he will use the output gap (the difference between actual GDP and potential GDP), rather than unemployment to guide policy
• Geoff Cutmore (CNBC anchor, moderator of this session): is this back-tracking a sign that monetary policy has failed?
• George Osborne: no. We're only discussing this because unemployment has fallen rapidly to 7.1% - because the exceptionally supportive monetary policy has worked
• 7% was never going to be a trigger for action, merely a threshold - one of many things that the Bank of England would consider when deciding whether to raise rates
• Moreover, the interest rate isn't the Bank of England's only tool. It has tightened the mortgage approval process and used the Funding For Lending scheme. The Bank of England is second to none in having all the relevant tools at its disposal - the interest rate and a variety of macroprudential tools
• Larry Summers: I'm worried about macroprudential complacency, due to human error
• Governments missed the 1987 stock market crash, the 2007 financial crisis. 
• Spain's countercyclical capital requirements didn't protect it against the real estate bubble
• Thomas Jordan (governor of Swiss National Bank): we don't do forward guidance, but this doesn't mean it's bad. Different policies are good for different countries. 
• Switzerland targets the exchange rate 
• Also has tried to rein in the property bubble through bank capital regulations, rather than interest rates
• Cutmore: the UK has seen a fall in the savings rate, and a housing market recovery, but no increase in exports nor productivity: rapid fall in unemployment despite modest rise in GDP suggests productivity hasn't risen. Growth has been bubbly, not balanced. 
• Osborne: the job is indeed only half-done. But, the progress has been good. The recovery has indeed been generated by the consumer, but income-generated, not debt-generated. Now we must hand over to business investment and exports
• Haruhiko Kuroda (Governor of the Bank of Japan): Abenomics contains three arrows: 
• Flexible fiscal policy: short-term fiscal stimulus, but the government aims to eliminate the deficit by 2020
• Supportive monetary policy: Quantitative and Qualitative Easing (QQE)
• Structural reforms
• Kuroda: Abenomics has worked so far. It aimed to achieve a 2% inflation target in 2 years. We're 9 months in, and consumer price inflation is at 1.2% (excluding fresh food)
• There's still a way to go; it's premature to discuss tapering. But, we're watching how other banks (e.g. Fed) are managing the tapering process
• The Fed only started tapering the second time around. The first time around, it blinked: in September 2013, Bernanke decided not to taper. In December, it reduced QE by $10bn/month to $75bn, and said it would wind down QE by end of 2014
• Monetary policy shouldn't be conducted in isolation. As we taper monetary policy, we can't do too much fiscal contraction 
• Larry Summers: 
• We are way better off than in 1929 due to good policy, but growth has only kept pace with population growth
• We have significant structural issues: structural unemployment leads to hysteresis, meaning that US output is way less than potential. 
• We don't know how to have sustainable growth. The growth in 2003-6 was said to be good because unemployment fell without inflation rising, but this was due to credit expansion and a fall in lending standards. 
• Summers: the good news of the past year allows us to shift focus from the public deficit to other deficits in the economy, such as the public investment deficit
• Construction unemployment is in double-digits. The US can borrow for 30 years at 3% in a currency that we print ourselves. Why not fix JFK airport?
• We spend 25% less on life sciences than 5 years ago. That's a deficit too
• Deficit isn't just financial debt, but other debts we bequeath to future generations
• Jordan: businesses will only invest when the feel confident; the near-death of the Euro made this much harder. Policymakers can't force a company in a free market to invest, but they can do everything to create conditions that support investment.
• Cutmore (to Osborne): Why are businesses not investing? What do they fear?
• That your government won't be around to follow through on its policies?
• The U-turn on forward guidance, which creates policy uncertainty?
• Osborne: we're building nuclear power stations and investing in fracking, which other governments aren't. The UK is prepared to take difficult decisions

Rebuilding Banking in Europe

• A few months ago, probability of Italian default was 40%; the world had stopped funding some European firms. Credit default spreads were high, liquidity and bank capital were low
• So we've come a long way in a short space of time. The ECB took decisive action, and fiscal policy became more credible
• Tail risks (e.g. fear countries exiting the Euro) have been alleviated. As of January 2014 we now have more members of the Euro (Latvia has joined, so now 18 members) not fewer
• But, there's still a long way to go
• Anshu Jain (Deutsche Bank): 3/4 of credit in Europe comes from banks, not capital markets, so banks are key to the health of the overall economy
• While the European economy has recovered a little, this hasn't manifested in greater lending, either to businesses or households. Some people think that one more push (e.g. the Asset Quality Review) will finally get lending going again. 
• But, this is wishful thinking. The problem isn't insufficient supply of loans (we've already had a huge fall in bank funding costs which has increased loan supply), but an insufficient demand for loans. 
• Businesses won't demand loans for investment while there's still uncertainty over policy, and uncompetitive labor markets. 
• The European Central Bank will be the single regulator of all banks in the Eurozone from 2014. It will conduct an Asset Quality Review throughout Europe to "stress test" banks' portfolios, to see if banks are healthy.
• Are you worried that it will unveil severe problems? Jeroen Dijseelbloem (Dutch Minister of Finance): I hope so! We want to find problems so that we can fix them. 
• Having banks fail will show that the stress tests were done seriously. Europe first did some stress tests in 2010, but they were viewed as not tough enough. National supervisors did them independently, with little coordination. Thus, they had incentives to hide problems. This is why Ireland and Spain didn't fail more banks
• However, we must realize that stress tests aren't a panacea. They can't tell you definitively the quality of a bank's loan portfolio - this quality keeps changing. This is why bank capital is necessary, to help prepare for the unpredictable.
• Interbank lending is low, even with in Europe. The world's willingness to lend to European banks is also low. A stringent stress test will encourage lending to banks that pass the tests.
• Lord Adair Turner (former Chairman of the UK Financial Services Authority): the US's stress tests in 2009 were very successful as they were stringent. Also, it was very clear what would happen if a bank failed: it would be given a certain number of months to raise capital privately; if it failed to do so, there would be a public recapitalization.
• Dijseelbloem: but EU does have a clear set of next steps if a bank fails the stress test. It will be given time to deal with its problems. If unsuccessful, it must engage in a "bail-in", where existing bondholders see part of their debt written off (this happened in Cyprus). Only if it's undertaken a bail-in can it request government funds as a last resort. If the government can't recapitalize the bank because  it's too big, it will have to request a loan from the European Stability Mechanism, the eurozone's government bailout fund.
• December 2013: EU finance ministers created a Single Resolution Mechanism. It imposes levies on banks to build up national resolution funds, which will be gradually merged over 10 years into one European pot worth €55bn. This will act as a financial backstop
• When a bank fails, its shareholders and creditors (rather than the taxpayer) should pick up the bill. But, the resolution process may require outside funds, e.g. to recapitalize key parts of a bank before selling it, or provide liquidity. This is what the backstop is for
• While the resolution funds are being built up, the backstop will be the national government (and thus the ESM if the government has insufficient funds)
• €55bn pot criticized as being too small. The Spanish bailout cost €40 bn, ant that's only one country
• But this fund is only the last line of defense. We have been building up other lines of defense. Bank capital is the first line of defense, and banks have been recapitalizing. We also have national resolution funds
• Lord Adair Turner : we need to go further than the mutualization of a guarantee scheme
• We need a single banking union, just like in the US. It's not the case that New York banks just lend to New York, and New York depositors rely only on New York for deposit insurance
• We can't just close down a very large bank that's failing. We will need to put in public capital. This is why the Resolution Fund (financial backstop) is key. Until the fund is in place, we're still in danger
• In the US, there's a pan-US response if a bank fails. In Europe, it's a national response
• Trust is a huge issue in banks at the moment:
• LIBOR and Forex benchmark manipulation
• Commission-oriented salespeople sold Payment Protection Insurance that wasn't needed
• Banker bonuses despite losses
• David Rubinstein (Carlyle): not clear that popularity is the relevant criterion. Even in good times, the public never loves banks or PE. Unlike Apple or Starbucks, most people's relationship with banks involves paying fees 
• Lord Turner: the collapse of the financial system isn't a problem just for industry, but also for regulators and academic economists
• Policymakers used to think that more innovation, more efficiency is always better - they overly believed in market efficiency
• Central bankers thought the financial system unimportant for the real economy
• Most academic models don't contain a financial sector

Coperation Between China, Europe, and the US

• Theme of session: these are the three largest economies. If they can work together, we can guarantee global growth and world peace. But, how can we foster cooperation?
• Nick Clegg: GATT reflected the old world order. Now, the balance of power has shifted from the west to the east. Thus, trade agreements are bilateral, not global
• Must ensure regionalism and bilateralism don't undermine multinatinoal agreements
• Lloyd Blankfein: trade is always a win-win. Everyone has a stake in everyone else. If oil is discovered anywhere in the world, it's best for the country that discovered it, but it's good for other countries too. The same goes for growth: any growth in the world is good for the rest of the world. 
• China will grow, but we have to manage our expectations. This is quite natural - if China would definitely grow and there are no risks involved, the market would be inefficient
• Angel Gurria (Secretary-General of OECD): it's OK to build brick-by-brick, as long as bricks fit into a coherent bubble
• Agreements should be not just on trade, but intellectual property rights and procurement
• State-owned companies must be on a level playing field with private companies. Common labor and disclosure rules. Need to pay dividends to the Ministry of Finance
• Joseph Nye: we must include Japan in these discussions, and not let tension between China and Japan get in the way
• Clegg: any open economy requires China; the UK is one of the most open economies. Chinese investment in the UK in the last 18 months has exceeded the investment in the prior 30 years
• Thus, UK must stay in the EU to be able to negotiate with clout with countries like China. UK is 60m people, Europe is 500m. 
• Clegg on trade: there's no future in protectionism, but we need to be true to our values. We can't ignore human rights.
• It's insufficient to sign up to new agreements; we must adhere to them, and have teeth in case countries don't adhere
• We've gone beyond haggling tariffs; we're now discussing norms and standards
• Should China see its future with the BRICs rather than the west, because the west isn't growing so fast?
• No, that would be very short-sighted. The US will still be huge. Even though China GDP will soon overtake the US's, China GDP/capita won't for a while, and this is a measure of economic effectiveness.
• Clegg: China should recognize that it's own future depends on sustainability. It can't ignore the environment
• Gurria: China is a big user of coal, which is very bad for the environment.
• China is so large that any actions that it take have global implications.

Challenges Facing US Competitiveness

• The World Economic Forum ranks the US #5 in global competitiveness, up from #7
• There are concerns that the government should stay arm's length with the private sector
• Michael Porter: 
• The US faces structural competitiveness challenges. The few jobs they are generating are in areas insulated from international competition, suggesting that the US is losing international competitiveness
• The problem isn't that the US doesn't have strengths (it has science, technology, entrepreneurship, innovation) but that it has allowed weaknesses to crop up: regulatory complexity, poor infrastructure, public education, tax complexity. Complying with regulations costs $17tr, $10k per employee. The tax system is so complex that companies would rather invest overseas
• Glenn Hutchins (Silver Lake): 
• There will be a global equalization of wage rates as China, former Soviet Union come into competitive markets. This will push US wages down, so wages may not be there to support consumption
• Employment has to be reformed. Unemployment benefit is not means-tested
• There's great opportunities to do trade agreements - no President since FDR has had such ability to negotiate trade, but little has been done.
• Healthcare costs are out of whack; Obamacare didn't get at the cost structure.
• The US will gain 35m workers, of which 43m (> 100%) will come from immigration. China will lose workers due to its 1 child policy
• Eric Cantor (House Majority Leader): we believe in a global economy as it reduces costs for consumers, but access to the US market requires reciprocity in turn
• Porter: the US is complacent. We think we're rich and will be rich foerever, while other countries are fixing regulation, investing more
• Unfunded Medicare liabilities seriously worsen the deficit
• Need to transfer from Defined Benefit to Defined Contribution pension plans, but the president won't go there