The Big Short

Have you ever seen the film The Big Short?

If not, I’d encourage you to take a look. Not only is it compelling viewing, but you’re also likely to learn a thing or two. It’s all about the financial crisis and the man who made a killing by shorting the inflated US housing market.

What is a short?

Shorting is the opposite of conventional investing (known as “going long”). A short lets you bet on a falling price; a long trade on a rising one.

At Exponential Investor, we’ve got a big short: diesel. And right now, it looks like we’ve made a pretty good call. Quite simply, the bad news for this dirty fuel is piling up.

So, what’s the problem with diesel?

As Bill Clinton might have said: it’s the pollution, stupid. If you base your profit strategy on screwing over society (what economists term “negative externalities”), then you can expect to take a beating – in the long run.

Diesel’s glory days are well and truly over. In just the last few weeks, there has been a swathe of devastating news stories for the fuel. The air pollution it’s responsible for has been linked to antibiotic-resistant pneumonia; 3.4 million premature births annually; and a quarter of all infant mortality. That’s on top of slightly older research, linking it to both Alzheimer’s and Parkinson’s disease.

Diesel is becoming Public Enemy Number One – and quite right, too. It’s killing far more people in the West than all the drunk-drivers, paedophiles, foreign criminals and terrorists combined. In fact, in some city-centre locations, as many as one death in 12 is down to poor air quality. Finally, it’s getting the attention the issue merits.

From an investment point of view, the name of the game is to find stocks which are going to be damaged by a big clean-up of air pollution. These might suffer a regulatory backlash (for example, diesel vehicle manufacturers). In the last few days, we’ve seen Volkswagen agree to a multi-billion settlement in the US. Fines like that cannot but hurt the firms concerned. If only we had such effective laws here – instead of the “crony capitalism” we so often end up with. Other manufacturers, such as Fiat, are at risk of getting sucked into this whirlpool.

While most of the Exponential Investor coverage has focused on road transport, the already-stressed shipping industry is also currently under additional pressure, due to air pollution controls on ship diesel. This comes specifically from fuel desulphurisation rules, designed to clean up port cities. That means a brutal crackdown on fuel quality.

We also have to consider indirectly-affected investments. These may include holdings of inner-city property. There is already some evidence that such premises are softening in value, as commercial tenants reject city-centre locations. Likewise, in just the last few weeks, Cornwall Council has announced that it will be subjecting houses on the busiest roads to compulsory purchase. (No, I don’t understand why it’s moving the residents, not the cars.) However, these indirect plays are likely to be much shorter-term – as a clean-up is now all but inevitable.

So, why is the backlash happening at present?

Not only does the disease burden affect quality of life, it’s also economically devastating. The costs are only now becoming clear. For example, premature birth is eye-wateringly expensive – $51k per baby. Furthermore, it is linked to lifelong care costs – premature babies are less fit, healthy and resilient than their full-term counterparts. Therefore, there is a strong public health economics benefit to reducing the incidence of preterm birth. With an obvious link to pollution now apparent, there’s a clear economic incentive to act.

Similarly, Alzheimer’s disease is a fiscally-important condition. It can shorten people’s lives, cutting off their ability to earn and pay taxes. However, by far the most important economic impact of Alzheimer’s is its huge care cost. Often people with dementia spend many years – even decades – dependent on the state for care. Anything that can be done to reduce the incidence of Alzheimer’s is likely to pay off handsomely for politicians. The recent Budget brought us Philip Hammond’s short-lived raid on the self-employed – partly to deal with spiralling care costs. Part of that pressure has come from diesel-induced dementia.

For residents of London in some boroughs, pollution is seen as the number one political issue. A major clampdown on air pollution generally, and diesel vehicles specifically, is almost certain to sweep the UK. Chris Grayling has made it very clear that drivers should be put off buying diesel cars, pending an economic slapping. A costly diesel scrappage scheme is also potentially in the offing. This is partly to ensure that the much-needed Heathrow expansion can proceed. Without these drastic measures, the UK’s forthcoming beating from the EU for inaction on air quality could end up being considerably worse than it otherwise may be.

On a city level, there is an increasing backlash against air pollution. Sadiq Khan’s T-charge is starting in October. He’s now on about (finally) restricting traffic near schools. Many other EU cities are currently looking at an outright diesel ban. It’s not necessary to catalogue these places individually; this is a global trend against diesel – with Europe at the tip of the spear. If this kind of crackdown is not a leading indicator for price falls in the sector, I don’t know what is. Globally, even more extreme measures on general air pollution are in the offing – with China having scrapped a swathe of half-built power stations. That’s a pretty extreme cost to bear, in the name of air quality.

The writing’s on the wall for diesel, and you need to amend your portfolio accordingly. Make sure you don’t have any stocks that are exposed to the risks of a major backlash against the fuel. More generally, you should look at cleaning out polluting stocks from your portfolio.

Don’t say you weren’t warned.

Finally, I have to declare a personal interest in this matter. I have a genetic variant in a gene called APOE4, linked to a risk of Alzheimer’s disease. Recent research has shown that people with my variant have a considerably elevated risk, if they are living in a polluted environment. As a bumpkin, that’s something that I fortunately don’t have to contend with. However, I regularly work in polluted areas, meaning my personal exposure is still probably very high. I can’t pretend I’m not worried about this, and I have seriously looked at changing my career to get away from air pollution.

If you can manage to type a few words between coughing fits, we’d love to hear from you. Send your views, asthma inhalers and samples of your antibiotic-resistant bacteria to andrew@southbankresearch.com.

Best,

Andrew Lockley
Exponential Investor

PS. I recently argued that the writing is on the wall for polluting investments. Now, multiple major cities are now moving towards a diesel ban: Paris, Mexico City, Madrid and Athens. It’s almost certain that other cities will follow suit…

Category: Commodities

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