What I learned at Davos 2022 about the future of finance

The mood at Davos was the gloomiest since 2009. The war in Ukraine, surging inflation, tightening monetary policies, dismal markets, crypto unravelling, and a long economic hangover from COVID-19 are disorienting investors and business leaders. The quotidian chaos of markets is challenging even the steadiest hand.

The conversation was dominated not only by who was there, but by who was not. Russians were barred, Chinese didn’t travel due to COVID-19 and there were few from those countries likely to be most impacted by the looming food crisis.

What do the shocks and the macro regime change mean for central banks and asset prices? The issues were debated incessantly.

Given a 40 year high in inflation, a key conversation was the different causes and degrees of embeddedness of inflation around the world.

Many were worried by the risk of oversteering – just as the Fed acted far too slow as the economy was accelerating, investors fear they may act too quickly to catch up as the economy is slowing and cause an unwanted recession. But equally other investors worried about a wage/price spiral dynamic setting in. As one former central banker told me, no one, including the central banks, believe their own models.

One interesting discussion, The Outlook on Inflation, was whether the Euopean Central Bank’s (ECB) inflationary challenge is more pernicious than in the US. Professor Jason Furman – echoing Professor Charles Goodhart – certainly thinks so. Europe’s inflation was largely imported and a supply shock, causing a much sharper cost of living crisis than in the US where a much higher proportion of US inflation comes from the voracious demand of US consumers and strong wage growth. That said, if you add in Brexit, the UK’s cost of living crisis could potentially be worst of the three.

Investors debated the new investment regime, one in which rising interest rates, higher levels of inflation, fragmented de-globalization, heightened geopolitical risks and shifting structural forces, including a changing relationship between stocks and bonds, are creating the need for a new approach to building a resilient portfolio. For the past two decades stock/bond corelation has been negative and aided diversification – but this hasn’t been true in past periods of elevated inflation.

The only rational thing to do in the face of deep uncertainty on inflation is to diversify – this was the only area of agreement in a lively investment session. Energy and commodities are essential inflation protecting assets, argued several, using the 1970s playbook. Collectibles and real estate could help in this scenario too. Avoid unprofitable tech for further sell-offs, if the 2000 dotcom bubble parallel held. And of course, many talked up private assets. Wider distribution of outcomes and more divergence of assets, sectors and securities performance will be challenging but could help insightful active investors.

While many investors now expect and are pricing in a recession – or at least investing that way – recent data points towards a more balanced picture. The most recent US bank lending survey highlighted benign lending dynamics. While the ECB’s bank-lending survey showed the highest credit impulse since Q1 2019. Most corporates at Davos 2022 said their business are in decent shape. One of the leaders of a global search firm said given the labour market is so tight and corporates have found it so difficult to hire, many have told them they will not wish to let go of staff so quickly. If true, and the Fed is waiting for a pickup in the unemployment rate to show “demand destruction” policies are starting to kick in, this could lead to additional pain.

Condoleeza Rice once said energy policy was about triaging the 3Es: economic growth, environment concerns and energy security. Energy transition triage was one of the most debated topics at Davos. While its widely accepted the “strategic mistakes” made by several European countries which prioritised cheap fuel from Russia over energy security and the environment, the conundrum is the pace and trajectory of decarbonization from here.

In addition to a huge, promised acceleration in renewables and innovation, there has been a re-assessment by many at Davos of the need for investment in fossil-fuel financing during the transition – not only for maintenance capex, but also for a limited number of new projects “anchored in pathways that are consistent with the carbon budget”, as Mark Carney recently argued. A number of asset owners told me they will only invest if the new infrastructure could be converted to greener fuels (such as hydrogen). Resilient energy grids will also require far more redundancy. That re-appraisal by policymakers means gas may be used as a winter swing provider of energy for decades to come, likely underwritten by states. Making this bet, several leading private equity firms are intensely focussed on investing in say LNG terminals, pipes and ships.

There was also frustration about the need for a step increase in transition finance – both in the West and emerging markets. In the West, much of investors’ time and money has understandably been focused on high growth companies enabling and providing solutions towards a green economy. Regulations have re-inforced this: take the EU’s green taxonomy which largely focuses on the green-est of green.

The flip side of this has been to stigmatise lending to help laggards transition to a lower carbon economy. With the spike in energy prices, the desire by firms to become more efficient and decarbonize is profound. Moreover, a meeting with some of the world’s largest asset owners underscored their interest in driving “real world” impact than “paper portfolio” decarbonization, and the potential of good cash generation from helping industrials, utilities and the like transition. I sensed an inflection likely in “kharki finance”, aided by innovations in measurement.

Transition finance in emerging markets was also in keen focus – as some two-thirds of the $3-4 trillion estimated to transition the world’s economy. The private sessions expressed frustration that development banks need more capital, innovation in structures and greater cooperation. The signs of large progress on this by COP27 were not encouraging, if the mood at Davos 2022 was right

On the fringes, the frustration of overly simplistic Environmental, Social and Corporate Governance (ESG) were evident, partly triggered by the HSBC kerfuffle. Leading investors have already been trying to unpick ESG into far more specific hypotheses (than crude balanced scorecards). For many investors at Davos 2022, including me, it’s important to debate and analyse the possible effects of climate change. And it's not just physical risks: it's also regulatory change, tax, litigation and so on. And on HSBC, let's be sure when thinking about these issues that we get the facts right: Amsterdam isn’t 6m beneath sea level, but 2m, for example. An extra 4m would mean over 80% of Holland would be below sea level.

Crypto was, of course, a hot topic. It’s remarkable that the collapse of an ecosystem worth more than $50 billion created no contagion. For now, crypto largely operates as a distinct ecosystem outside the perimeter of traditional financial markets and its regulation. But this may be turning.

The historian Niall Ferguson told me during the global financial crisis that he wished more central bankers and financiers had studied history, not economics. He was right. The decentralized finance world is getting a pacey lesson in the history of finance – whether currency pegs breaking, runs on funds and the mechanisms to build trust in money.

I was struck meeting several giants of the payment world that the largest stablecoins are now hoping – and arguing passionately behind the scenes – for regulation. The penny has dropped that without regulation they can’t inject the trust and stability which a financial system at scale needs. But regulators tend to take their time and it is far from clear who will win the monetary horse race.

The flip side, I sensed, was that central bankers breathed a sigh of relief that they can slow the pace of studies of central bank digital currencies. Currently, 91 countries around the world are weighing up the idea of a central bank digital currency (CBDC) according to the Atlantic Council. Aside from China and some small markets, in the main these are desk exercises looking to create what I think of as a goldilocks CBDC. Not too large to risk the unravelling of the banking system, but not too small to be irrelevant.

Fixing bottlenecks is simpler than creating a new system at scale. Just think about the failure of the ECB’s plan to create a rival to Mastercard and Visa – the European Payment Initiative – which was quietly wound up earlier this year. From my conversations at Davos 2022, I’d expect far more focus on upgrading wholesale payment systems, enhancing messaging standards, and cross border protocols and heel dragging on radical CBDC projects.

While crypto may be on the wane, there has been a sea change in the perceived threat level of disruptive financial new entrants to bank profits. Competition from tech giants, retails and payment firms is intensifying. Allied to this, a more digital money world has intensified the winner-takes-most dynamics in finance – more akin to what we see in tech.

The strategic response – more focus on platform scale, more tech spending and more acquisitions. JPMorgan’s investor day – during Davos 2022 – exemplified this. A hot topic over Davos coffees was rising appetite for fintech M&A. Larger financial services and fintechs are beefing up M&A teams to make acquisitions. The combination of a sharp fall in prices of fintechs (off over ~50% on average from peak using the global fintech ETF), some fintechs struggling to get to generate cash plus high cash/capital positions at banks means the set-up for a sharp pick up in M&A is there. Clearly not all the innovative experiments have worked, private companies may try to hold out for better valuations and buyer risk aversion may kick in, but the slide rules are out.

In my 2020 post-Davos note I wrote:

“Last year’s downbeat mood was another good example of Davos being a contrarian indicator – as many large conferences often are, because they expose what’s already embedded in market expectations. So this year’s lack of worry was worrisome.”

Let’s hope that the current consensus is once again – as in 2009 – too bleak, as business and policymakers respond earnestly to these transitions and risks.