Explore the Thinking behind our investment approach

Written by Adam Bernstein As we’ve discussed in our recent market outlook commentary, traditional economic indicators such as shrinking GDP, stubbornly high inflation, and rising interest rates mislead 70% of economists who expected a U.S. recession in 2023. Now that we are three months into 2024, where are these indicators? And what has changed about the outlook? January inflation data came out above expectations across the board. Core CPI (Consumer Price Index) YoY came in at 3.9% vs an expected 3.7%.[1] CPI is like checking a grocery list to see how much the typical household basket of goods (clothes, rent, etc.) costs over time. It helps explain how our everyday living expenses are changing. Core PPI (Producer Price Index) YoY came in at 2.0% vs an expected 1.6%.[2] PPI reflects how much producers are paying for goods and services, which can impact future consumer prices. Core PCE (Personal Consumption Expenditures) YoY came in at 2.8%,[3] matching some expectations, but at the high end of the predicted spectrum. This is like taking a broader look at everything people spend money on, not just a fixed basket. It considers things like healthcare and services, giving a more complete picture of consumer spending and inflation, and making it the Fed’s preferred indicator. These hot inflation prints alongside accelerating wage growth data that came in at 4.5% for January vs its December reading of 4.3% have not made the Fed’s decision about whether to cut rates any easier. Overall, a few bad prints are no reason to panic. These data points on their own likely won’t change the Fed’s rate cut trajectory. As of the time of writing, the futures market is pricing in a 62.5% likelihood that rate cuts start in June, and that jumps up to a 78% likelihood by September.[4] Although the Fed futures curve still predicts three rate cuts in 2024, this seems too high, given how stable liquidity conditions have been. There has been an expectation shift among investors that quantitative tightening (QT) in aggregate will last longer than initially expected, past 2024 and into 2025, but at a slower pace so as not to repeat the liquidity crunch conditions of the 2018-2019 QT cycle. This opinion is supported by the Federal Open Market Committee’s (FOMC) January meeting minutes released last week. Despite these hot inflation prints and QT expansion talks, the long-term disinflation forces appear to still be intact. Overshoots in December GDP data have stabilized, the Zillow Rent Index is back at pre-pandemic levels, supply chain pressures have normalized, and quit rates have reverted to pre-pandemic levels, hopefully signaling that wage growth will follow.[5] But it is becoming more evident every month that the path to sustained lower inflation will not be a straight line. The main driver of these surprises in the January data was a result of the strong equity market rally and climate change. The uptick in portfolio-management services inflation component of PCE and the increase in dividend income, a component of personal income, were both a direct result of the stock market rally. As equity markets go up, the fees generated by asset-based portfolio management services increase, and as companies announce stock repurchase programs on the back of strong profits, fewer outstanding shares increase earnings per share and dividends per share. This feedback loop of stock growth supporting inflation makes it difficult to meaningfully cut down inflation while this market rally continues. These data points add credibility to our argument that to effectively push inflation down to 2%, equity markets must sell-off. Owner-equivalent rent (OER) and healthcare services are the other significant factors propping inflation. OER, which measures the cost of living in owner-occupied homes, had its most significant increase in a year. A possible explanation for this surprise can be attributed to a change in how it was calculated. “In January the proportion of OER weighted toward single-family homes increased by approximately 5%”.[6] Another explanation could be that OER isn’t directly measured. Instead, it relies on estimations and assumptions, which can introduce inaccuracies in the short term. The healthcare inflation upward adjustment can be attributed to the 3.2% annual cost-of-living adjustment for Social Security recipients. Going forward, geopolitical and climate risks make the path to sustained 2% inflation more difficult. Looking at these trends and data outlays through the lens of climate risk has helped our team maintain a stickier and higher inflation forecast than the market, which has benefited our portfolio positioning by allowing us to keep fixed income durations short. Looking at the graph below, the goods (orange) and services (purple) components of Core CPI, you can see that coming out of the pandemic, we had just about eliminated goods inflation, and we need only content now with services inflation. This has been the narrative for most of 2023, but as you can see, the Global Supply Chain Pressure Index (Black) has started to show pressure building again, a trend highly correlated with good inflation. Should we begin to see a re-acceleration in goods inflation, the Fed would find it nearly impossible to cut rates. Source: Bloomberg Climate risk is affecting these inflation data points. Global warming is intensifying the effects of the current El Niño, leading to a drought crisis in some of the most critical global shipping lanes. This crisis is being felt acutely in Panama, where severe drought, exacerbated by an intense El Niño event, has significantly impacted the Panama Canal. Reduced water levels have forced authorities to drastically cut ship crossings by over a third from a pre-drought capacity. This has resulted in a 20% decrease in cargo volume compared to the previous year’s fourth quarter and is estimated to cost the canal between $500 million and $700 million in revenue losses for 2024. Seeking alternatives, major shipping companies like Maersk are forced to reroute their vessels through longer passages, such as the Suez Canal (taking approximately 41 days to reach the East Coast of the US compared to the Panama Canal’s 35 days) or even longer detours, like sailing around Cape Horn at the tip of South America. This situation highlights the growing vulnerabilities of global infrastructure to climate change. Food inflation is also on the rise. While some crops benefit from a warmer climate (i.e., Higher rainfall in California benefits avocados and almonds), many staple crops such as palm oil, sugar, wheat, rice, and corn will face more challenging conditions and falling crop yields. Sixty percent of global food production occurs in just five countries: China, the United States, India, Brazil, and Argentina, and rice, wheat, corn, and soy make up almost half of the calories of an average global diet. Given all of the above factors, one can see how climate risks can quickly create an inflationary environment. Finally, energy prices have been one of the only deflationary components of CPI in 2023 and into 2024. In the intermediate term, non-Organization of the Petroleum Exporting Countries (OPEC) countries dominate medium-term capacity expansion plans for traditional energy projects. The relatively substantial increases from non-OPEC producers and the projected slowdown in demand for oil increase the spare capacity for oil in the intermediate term, keeping energy prices in check. Many investors need to pay more attention to the underestimated risks tied to a sustained rise in commodity price inflation. Capital limitations and the depletion of resources are poised to propel prices upward in the years ahead, contrary to the trends of the past decade. Consequently, investors still need to embrace this shift’s potential implications fully. We think the “end of oil” will be a function of price-related demand destruction, not technology-driven obsolescence (even though the cost curves for renewable power will help). Clearly it is in the interest of a fiduciary investor to consider climate risk when analyzing the macro environment and making investment decisions.

by Adam Bernstein, ESG/Impact Analyst At the start of 2023, investors and economists anticipated a challenging year for markets, and according to Bloomberg, 70% of economists polled expected a U.S. recession. Contrary to these predictions, it was an excellent year for the stock market and the economy. Q4 and the full year (2023) Gross Domestic Product (GDP) growth came in above analyst expectations, showing a robust increase at an annual rate of 3.3% for the quarter and 3.1% for the year.[1] Inflation has also gracefully descended towards the Fed’s 2% target. These developments have bolstered confidence in the Federal Reserve’s ability to engineer a soft landing, a cyclical slowdown in economic growth that avoids recession. The positive surprise in GDP was fueled by a quarterly uptick in inventories and an enhanced trade balance. Notably, personal spending growth continued to be the key driver, accelerating throughout the quarter, and culminating in a significant surge during the holiday season. While many economists have tempered their recession forecasts for 2024, doubts linger, and both a recession and soft-landing scenario remain a close call amongst forecasting communities. So why was Wall Street so wrong about its recession call in 2023? [2] I’ll start with a short explainer of some capital dynamics leading into 2023. Quantitative Easing (Q.E.) and zero-interest rate (ZIRP) policies, which were remnants of the 2008 financial crisis, artificially propped up unprofitable businesses and fueled unproductive investments. As measured by the Consumer Price Index (CPI), consumer price inflation averaged just 1.6% from January 2009 to December 2019, but inflation was not absent from the economy. It shifted to assets owned mainly by the wealthy, a group with the lowest marginal propensity to spend additional wealth. Due to a weak labor market and low wage growth, there was an absence of significant fiscal stimulus among lower/middle-income households, who traditionally have a high propensity to spend. As a result, consumer demand did not put substantial upward pressure on the prices of goods and services in the pre-pandemic era. In the pandemic, massive fiscal stimulus was directed into households and at consumers who had a high propensity to spend at historically significant volumes, and over a short time frame. This turbocharged any existing excesses and put pressure on prices. The S&P 500 gained 94% from its April 2020 low through the peak in December 2021, and home prices rose 45% from early 2020 through June 2022. This dynamic, coupled with pandemic supply chain disruptions caused demand to outpace supply, leading to further price hikes and the onset of our current inflation problems. In 2023, inflation proved easier to tame than expected, thanks to the unwinding of pandemic-related supply shocks and the Fed’s successful anchoring of inflation expectations. We’ve seen a notable reduction in Headline CPI inflation rates, which came down from their peak of 9.1% to 3.3%.[1] This occurred without causing a severe economic downturn or materially increased unemployment rates, giving markets cause to celebrate. Two key factors shaped this outcome: 1) Pandemic-induced supply chain disruptions and labor shortages gradually eased, naturally decreasing inflationary pressures, and avoiding harsh economic contractions. 2) The Federal Reserve’s commitment to a 2% inflation target and quick action prevented a wage-price spiral. Reducing supply bottlenecks has been the primary driver of disinflation success in 2023, but future gains will have to come from the hard-to-battle services inflation. A robust CPI print for December underscored the challenges to achieving a sustained return to 2% inflation. While a decline in shelter costs (the most significant component of services inflation) is anticipated, planned price increases in other core service sectors (healthcare and utilities) are poised to support inflation. Taking all of this into consideration, when we look at inflation, we expect it to continue coming down unless there’s some shock. Right now, both JPMorgan and Bloomberg’s macro strategists forecast core CPIs getting near 2% by December. Threats to this view include a successful effort by producers to reduce inventory levels, which will mitigate the deflationary pressures observed in core goods over the past six months. Other risks include heightened geopolitical tensions and extreme weather patterns that can disrupt significant trade routes. For instance, closures of the Panama Canal and Suez Canal due to droughts triggered by El Niño could wreak havoc on global supply chains. Similarly, an escalation of conflict in the Middle East could disrupt trade flows through the Strait of Hormuz. Another area Wall Street misjudged was the resiliency of the consumer. Consumer spending defied expectations, remaining robust thanks to a strong labor market and positive wage adjustments. The labor market was much sturdier than anticipated, with unemployment reaching a 50-year low despite concerns about job losses due to quantitative tightening. Personal consumption expenditures in Q4 accounted for nearly 68% of GDP, the most significant component of its growth. Recent data also indicates an encouraging improvement in consumer sentiment, with a 13% increase in January 2024, compared to the previous month, and a 21.4% rise in the prior year.[1] The significant role of consumer spending in shaping economic direction underscores the importance of understanding consumer trends. Our view of consumers is that they don’t stop spending just because it’s prudent to stop spending; they stop when they are forced to, making consumer debt monitoring important in understanding spending. Total household debt in the U.S. reached a record high of $17.29 trillion in the third quarter of 2023, representing a 4.8% increase over the previous year. Credit card debt alone surged by 16.7% for the one-year period ending September 30, 2023, surpassing $1 trillion for the first time ever. Despite these concerning figures, household debt service payments for 2023 only represented, on average, less than 10% of disposable personal income. For reference, 2008 debt service payments were ~13% of disposable income. With wage growth and personal savings at 4.1% and 3.7% in December, the 4.8% growth in household debt seems manageable.[3] During 2023, the net worth of all U.S. households rose by $11.8 trillion or 8.1%, a sizable increase in wealth that will help households continue to spend and feel better about borrowing money.[4] Consumer strength seems to have more runway, but an uptick in corporate layoffs could shift this picture quickly. In the latest labor reports for December, the robustness of the labor market persisted, with hiring picking up pace even after seasonal adjustments. The ratio of job openings to unemployed workers remained stable at 1.4, indicating a healthy demand for labor. Despite this, the quits rate is expected to stay relatively low at 2.2% below pre-pandemic levels, which could help alleviate wage and inflation concerns by reducing labor-market churn. The steady quits rate suggests that despite the high number of job openings, there may be less urgency for businesses to fill positions left vacant by departing employees, especially with recent productivity gains. As measured by the Employment Cost Index (ECI), wage inflation came slightly below expectations in the fourth quarter, consistent with inflation that’s primarily been receding faster than anticipated. These labor stats are still above the typical pace seen in the years before the pandemic, but as they cool, the Fed can feel more comfortable considering rate cuts. Despite economic worries, business spending held up well, driven by government subsidies for strategic industries like semiconductors and clean energy. Overall, 2023 presented a picture of surprising economic resilience and adaptability, defying many of Wall Street’s pessimistic forecasts. There has been a notable increase in concern regarding the sustainability of U.S. fiscal policy. This heightened unease is partially attributed to the extraordinary fiscal measures implemented during the pandemic, which led to a federal debt-to-GDP ratio of 98%, nearing levels observed after World War II. According to a June report by the Congressional Budget Office, projections indicate a continuous upward trajectory of the debt ratio in the forthcoming decades. With interest-rate expectations having shifted higher since then, the fiscal outlook looks even more troubling now, begging the question, can the U.S. afford higher rates for longer? What does all this mean for our outlooks and portfolio positioning? The Fed and the market are betting on an economic slowdown in 2024, but to differing degrees. The market has already priced in most potential gains from the Fed’s dovish stance, leaving little room for upside should anything but the prescribed rate cuts materialize. Moreover, the inverted yield curve and historically poor central bank track record in achieving soft landings suggest potential dangers. Therefore, investors should remain cautious while the Fed’s pivot toward dovishness has temporarily calmed markets and brought major indexes back to all-time highs. Maintaining agile portfolio positioning that can weather both dovish and hawkish scenarios is crucial, given the uncertainties surrounding the future trajectory of inflation and the Fed’s response. Our base case remains that the Fed will ultimately be unable to keep rates higher for longer because something will break, causing the excesses in the system to unwind. The labor market and consumers have so far remained surprisingly resilient, partially due to structural changes in the labor force resulting from the pandemic, and economic growth has remained strong so far despite the Fed’s tightening attempts. Some market catalysts we are watching include the $684 billion in unrealized losses on bank balance sheets, China’s property market instability, commercial real estate challenges, housing market struggles with high mortgage rates, rising geopolitical risks, deglobalization trends, and U.S. political dysfunction. Until such a breakdown occurs (or a soft landing is assured), we expect upward pressure on rates to continue as higher for longer rates get priced in, particularly at the long end of the curve. Credit spreads have only recently begun to widen, and we expect widening to continue to reflect the increased credit risk present in a higher-rate world. A risk-off shift may halt the upward pressure on rates and ultimately spread to equities, which look particularly vulnerable given the elevated valuations of a narrow bull market and the opportunity to earn 5% risk-free on cash and short-term bonds. To better understand the market rally in 2023 and how to position portfolios best this year, we looked at other times in history when the Fed paused hiking rates and then plateaued before eventually cutting. Before 1990, the Fed was all over the place, and there were no periods we could easily identify as being the typical Hike Rates -> Plateau -> Cut Rates pattern we are used to seeing today. But after 1990, apart from the early-mid 90s when the economy was robust, and the Fed was able to keep rates at a normal level for a few years, the pattern has been for risk-on markets during the plateau, followed by risk-off/recession around the time the Fed begins cutting rates. The average S&P 500 [5] return based on the last five rate plateau periods was 18.54%,[6] lasting an average of 10 months. The S&P, since the start of the plateau for this cycle, has only returned 8.69% [5] as of 1/30/24 over almost six months, meaning we might be able to expect another ~10% melt-up in markets over the next four months, if history is a guide, before the cycle turns. But we want to take only some of our direction from history, so when we combine this historical analysis with forward-looking expectations, we find that the S&P 500 is priced for perfection and hard to buy at the current valuation levels. Still, utilities and infrastructure assets are trading at significantly discounted valuations and are set to benefit from policy shifts like the Inflation Reduction Act (IRA) bill, the Chips and Science Act, the Infrastructure Investment Act, and the global trajectory towards a low-carbon economy. These trends have yet to fully bear fruit for investors, as 2023 was a slow year for renewable energy and infrastructure businesses, primarily attributable to elevated interest rates. As the economy, inflation, and rates normalize, these types of investments are set up to have long runways to perform. Climate and ESG Update This quarter, we will focus on unpacking the investment case of what we believe to be one of the most significant opportunities available to investors today: energy-system investments in the era of climate change. The basket of public and private investment opportunities that underlie this market segment represents a compelling opportunity due to several long-term trends converging on a concentrated basket of stocks with clear short-term catalysts. These trends include: Issues with existing infrastructure/ energy sources We were experiencing rising global energy demand and declining supply, which manifested in surging prices, grid failures, and rolling blackouts around the world, even before the COVID-19 pandemic and the Russia-Ukraine war. In most places where we produce oil (Organization of the Petroleum Exporting Countries, OPEC, Russia, U.S., Brazil), the amount we produce is dropping. We have already depleted the best oil fields, and well-depleting math only accelerates as we go to lesser fields. Oil demand will likely peak in the short term, but global energy demand is still accelerating and has grown by about 2% yearly since 1973. Currently, non-OPEC+ countries dominate medium-term capacity expansion plans, led by the United States, Brazil, and Guyana. The relatively substantial supply increases from non-OPEC+ producers, and the projected slowdown in oil demand increase the spare capacity for oil, keeping energy prices in check. Due to this dynamic, many investors need to pay more attention to a sustained rise in commodity prices. Capital limitations and the depletion of resources are poised to propel prices upward in the years ahead, contrary to the past decade’s trends. We think the “end of oil” will result from price-related demand destruction, not technology-driven obsolescence. Before we get there, we will likely see marginal producers bought by lower-cost providers with scale until it is harder and more expensive to transport traditional energy around the grid than renewable sources. We are witnessing a system in transition that needs trillions of dollars of investment to serve our evolving needs. Valuations for the companies involved in this process are still very reasonable, and pose an opportunity to investors who are watching these trends unfold. On the flip side, investors who are not paying attention to these major shifts will have to content with stranded assets and asset abandonment risks for firms who will not be able to sell down inventories or operate their businesses in a warmer climate. The transition to a low-carbon economy COP28 took place in 2023, marking 31 years since the United Nations Framework Convention on Climate Change (UNFCCC) was adopted, and eight years since the Paris Agreement was signed at COP21. The “Conference of the Parties” (or “COP”) brings together all the governments that have signed the UNFCCC, the Kyoto Protocol, or the Paris Agreement to address climate change and its impacts jointly. The negotiated agreements and outcomes of this conference give investors and consumers insights into the direction of travel for most of the world’s developed and developing economies. COP represents one of the largest global organizational bodies that focuses on critical climate issues and its ability to mobilize diverse stakeholders to create specific industry action, making it one of the great investor roadmaps. Some of the significant outcomes of this year’s conference include a tripling of global renewables capacity by 2030 and double energy efficiency improvements. This suggests a substantial increase in global capital investment in the energy system, and projections are for an average of $4 trillion annually through 2050 to meet the goals. This marks a notable rise from the current level of investment at just over $2 trillion annually. By 2050, it’s envisioned that low-carbon sources will constitute approximately 70% of the world’s energy output, up from ~20% today. Advancements in energy storage, electrified transport, and alternative fuels for aviation and shipping are expected to persist, driven by ongoing technological innovation to reduce costs and enhance efficiency. While the transition towards a low-carbon economy offers investment prospects, it also serves as a critical lens to evaluate investment strategies and associated risks. Given the magnitude of this transition, capitalizing on it necessitates investors to develop insights into cost trajectories, technological trajectories, and the evolving dynamics within value-chain segments. Although the transition’s impact is most keenly felt in the power, infrastructure, technology, and utility sectors today, it is imperative to adopt a comprehensive portfolio perspective when navigating these shifts. Electrification of the grid Governments have tried to curtail energy demand, mainly through passing CAFÉ standards (efficiency standards) on vehicles, ride-sharing incentives, fuel taxes, investment in public transportation systems, and demand control of high energy usage appliances. Generally speaking, the global population grows by 0.9%, and the total energy demand grows by 1.4% annually. The energy mix has started to shift when you look at data from 1973 until 2019, noting increases in nuclear and natural gas, and renewables, while the total energy produced has also risen by about 2% per annum. One of the most significant changes to our energy system has been increased electricity generation (often powered by natural gas). To meet this growing demand, we need more production. There has been a revolution in renewable energy capacity added to the grid to solve this problem. Electrification emerged as a pivotal strategy to increase energy output, curtail emissions, and transition towards decarbonized energy supply chains, playing a crucial role in achieving net zero objectives. As various grid systems undergo electrification, the proportion of electricity in total final energy consumption is anticipated to surge, projecting a rise from 20% in 2022 to over 27% by 2030 in the Net Zero Emissions by 2050 (NZE) Scenario. While there has been a consistent upward trajectory in this proportion recently, aligning with the NZE Scenario demands a notable acceleration, necessitating a doubling pace to meet the 2030 milestone. The administration estimates that planned investment in clean energy and related sectors has exceeded $110 billion since the IRA passed. Bloomberg Intelligence compiled a group of the 36 top companies focused on boosting power efficiency for the grid and found that the group bested the S&P 500 index by 31% in 2023 and by 53% over the last four years. Energy consumption trends Consumer trends are substantially accelerating energy demand, reinforcing our need for more energy sources. Artificial intelligence (A.I.) operates at a high energy intensity, demanding considerably higher power consumption than typical cloud-computing operations. As a result, energy consumption by companies such as Meta, Amazon, Microsoft, and Google has tripled since 2018. Projections suggest that by 2030, the energy requirements of data centers alone could triple, accounting for 3% of global demand; however, this figure could escalate to 5% without substantial efficiency enhancements, as highlighted by an analysis conducted by Huawei. The shift towards electrification across various sectors is crucial to mitigating climate change. Bloomberg New Energy Finance (BNEF) estimates that by 2030, E.V.s will witness a power consumption growth comparable to data centers, which are anticipated to drive the bulk of the 60% surge in demand for communication technologies. A.I. holds promise in delivering significant climate benefits, such as predictive maintenance and real-time energy-consumption analysis. These gains will likely entail increased utilization of clean energy and companies that can lead the way in power optimization and electrification. Market buy-in opportunity The opportunity set investors have for investing in the energy system is split into a handful of industries: technology hardware, semiconductors, communications equipment, electrical components, utilities, data centers, and power producers accounts for a bulk of the opportunity. Of these industries, renewable energy generation companies are reeling from a painful run in which this sector has badly lagged the broader market due to high-rate sensitivity and resurgent oil and gas thanks to heightened geopolitical risk. Battered valuations in the clean energy sector make this a promising moment to buy into one of economic history’s biggest structural growth stories. The utility sector is a significant component of the renewable energy themes that have underperformed this year. Negative yield spreads for utilities vs. U.S. 10-year treasury bonds have been a significant headwind for the utility sector. Look at the S&P water index (~40% utilities) or the renewable energy producers index (~94% utility). You can see why renewable energy investors performed poorly this year, with the utility sector down (-14 %)5 in 2023. Regulated utilities make money by providing essential services to customers, like electricity or water. The key to their profitability is the rate base, which is the total value of their assets minus depreciation. They are allowed to earn a reasonable rate of return on this rate base. Regulators, such as public utility commissions, oversee and regulate these utilities, deciding how much profit they are allowed to make each year. Authorized utility returns generally move directionally with long-bond yields, but with several quarters of lags. If the market is correct on the path of interest rates, and energy prices remain in check, utilities may be poised for a breakout year. The other industries are more technology centric and growth oriented. These companies invest in critical components of a modern, sustainable energy system but are driven by different market factors than the utility and power portion for the energy grid opportunity set. While investors in wind and solar, exemplified by the S&P Global Clean Energy Index, saw declines of over 20% last year, electric grid technology and optimization companies, exemplified by the Nasdaq Clean Edge Smart Grid Infrastructure Index, saw gains of over 20% over the same period. These components can come together in a portfolio that is strategically aligned with the changing energy landscape, set to benefit from policy shifts like the IRA bill, CHIPS Act, and Infrastructure Investment Act, along with the global trajectory towards a low-carbon economy. Closing Thoughts Transforming our energy system is not just an environmental aspiration; it’s a race against time. Climate change sounds warnings through intensifying weather extremes, and scientists warn of looming tipping points, irreversible thresholds beyond which the Earth’s systems shift radically, potentially with catastrophic consequences. In 2023, the global climate witnessed unprecedented warming, with surface temperatures reaching record highs and numerous regions experiencing extreme weather events, including devastating wildfires in Canada and deadly heatwaves in various parts of the world. This heightened climate urgency underscored the discussions at the COP28 climate summit in Dubai. Despite the Earth’s discomforting temperature anomalies throughout the year, exacerbated by human-induced climate change and natural factors like a robust El Niño event, some scientists suggest that 2023 may be a precursor to even more pronounced warming trends in the coming years. The events of 2023 highlight the pressing need for comprehensive climate action and underscore the risks associated with continued greenhouse gas emissions.

By Jessica Skolnick, CFA and Adam Bernstein Macro Update: The Powell Pivot On December 1st, less than 2 weeks prior to the December 13th FOMC meeting, Federal Reserve Chair Jerome Powell said in a speech that “it would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease.” In that same speech, he described labor market conditions as remaining “very strong” with high wage growth while characterizing the most recent 3.5% core inflation print as being well above their 2% objective. Between that speech and the FOMC press conference, November’s job and inflation reports came out stronger-than-expected. Unemployment unexpectedly fell from 3.9% to 3.7%, with rising labor force participation and higher than expected month-over-month wage growth.[1] November CPI rose slightly more than expected month over month, with the headline and core figures coming in at 3.1% and 4.0% respectively.[2] The rates market had, from October 31st through December 12th, priced out all expected rate hikes and added two anticipated rate cuts to the 2024 forecast.[3] It seemed due for a reality check by the Fed. However, despite the data, the FOMC all but declared victory over inflation. Compared to the September statement, updated Summary of Economic Projections (SEP) lowered the median expected year-end Fed Funds target rate from 5.125% to 4.625%, equivalent to an additional two rate cuts in 2024. Expected GDP growth, PCE inflation, and core PCE inflation in 2024 were all reduced by ten basis points.[4] We really cannot figure out what the FOMC members saw in the data in those 12 days to make themselves that much more confident in the soft-landing narrative. While inflation may continue to trend down, we are not seeing certainty that it will in the data. Core services inflation accelerated slightly on an annual basis with upward pressure from 4% wage growth, while large year-over-year declines in energy and goods (and the healthcare adjustment) are aging out of the data. Recent attacks on commercial vessels by Iranian-backed militants in Yemen, and the decision by many companies to pause shipping in the Red Sea as a result, only illustrate that our supply chain remains vulnerable to geopolitics. Powell has gambled that the economy will soon hit a sharp growth slowdown accompanied by disinflation and rising joblessness. The market responded by pricing in nearly 2 additional rate cuts in the week following the meeting.[5] Since early November, intermediate and long Treasury yields have plummeted, with the 10-year falling from near-5% to below 4% and the inversion between the 2-year and 10-year growing from -15bp on October 31 to -51bp on December 18th.[6] All the good news from the Fed (and then some) for 2024 has been priced in. The Fed has functionally pulled forward most of the gains that would be realized next year, assuming their rate cut forecasts even materialize. Meanwhile, the fundamental issue of buying an inverted yield curve that is paying you to not take duration risk, has worsened. While we cannot know for sure what drove the Fed’s abrupt shift in tone, we can ask what happens if things do not go according to the Fed’s plan. What happens if growth does not slow, inflation rebounds, or unemployment remains low and the Fed cannot meet its own forecast of 3 rate cuts, let alone the market’s expectation of twice that? In that scenario, long-term rates would have to give back their recent gains while rates on the short end would remain elevated for longer. Stronger than expected growth, labor demand and inflation have been defining features of this two year long tightening cycle. While we do not have a crystal ball, absent an unanticipated shock to the economy, our base case is for those trends to continue. The Fed’s abrupt tone shift made on thing clear: rather than a pause, the Fed wants us to see this as a pivot. Plateaus like the one we find ourselves in now, between rate hikes and rate cuts, are usually supportive for stocks and bonds alike. Historically, it is only when the yield curve inversion normalizes, and the Fed begins cutting rates that stocks sell off and long-duration high-quality fixed income outperforms. While we hope the Fed has called it right that inflation will trend lower and reach target without significant pain in the economy or markets, history also tells us that central banks have an awful track record at achieving soft landings. Market participants hoping for rate hikes may want to be more careful about what they wish for. ESG Update: Setting the Scene at COP28 COP28 kicked off on November 30th in Dubai, United Arab Emirates, 31 years since the adoption of the United Nations Framework Convention on Climate Change (UNFCCC), and eight years since the signing of the Paris Agreement at COP21. The “Conference of the Parties” or “COP” brings together all the governments that have signed the UNFCCC, the Kyoto Protocol, or the Paris Agreement to jointly address climate change and its impacts. Since 2015, under the legally binding Paris Agreement treaty, most countries made three commitments: 1) Limiting the rise in global average temperature to below 2°C, but ideally 1.5°C 2) Strengthen the ability to adapt to climate change and build resilience 3) Align investment flows towards lower greenhouse gas emissions The Paris Agreement requires countries to set their own emission reduction targets, known as nationally determined contributions (NDCs). Still, there are no legally binding penalties if a country fails to meet its stated targets. Every five years, the negotiators of COP update the Global Stocktake (GST), the mechanism to assess the world’s collective progress towards fulfilling the Paris Agreement. The outcomes of the GST are meant to inform member-country negotiations and enhance international cooperation for climate action to increase ambition. While the agreement is legally binding, the outcomes of the GST are intended to inform future NDCs rather than impose legally binding requirements on individual countries. The goal is to regularly review and increase ambition in tackling climate change based on collective progress. Our Take This year’s conference was hosted by a petrostate, led by a fossil-fuel CEO, and loaded with over 2,000 oil/coal/gas lobbyists. We had understandably low expectations. The backdrop was also particularly challenging. The Ukraine-Russian war and the Israel-Hamas war have placed energy security and independence at the forefront for many nations. War has disrupted traditional energy supply chains, leading to record-breaking profits for many Western energy companies that have been able to pick up the slack. Unfortunately, this combination of national security concerns and excess profits has led companies to re-invest in more oil and gas development projects rather than putting forward a detailed CAPEX plan to transition away from fossil fuels. The 2023 Climate Action 100 Net Zero Benchmark results showed that while 77% of companies now commit to net-zero and 87% have disclosed medium-term emission reduction targets, only 2% of companies have committed to phasing out CAPEX in carbon-intensive assets, and only 3% have disclosed sufficient details about how they plan to reach their targets. The geopolitical environment has led countries to increase fossil fuel subsidies rather than imposing windfall taxes on energy firms to help them fund their transitions. A 2023 International Monetary Fund analysis found that fossil fuel subsidies rose by $2 trillion over the past two years to a record $7 trillion globally. But despite these difficulties, there is a silver lining: reaching consensus and winning hard-fought fossil fuel concessions here, under a United Arab Emirates (UAE) COP presidency, will have a much more profound impact on our global ability to limit emissions for one specific reason. Buy-in must happen from inside these producing countries, not outside of them. Luckily, 98 of the 198 countries who attend COP and have ratified the Paris Agreement are oil producers. We are struggling to curb emissions today because our global economy and its continued growth rely heavily on the continued use and expansion of fossil fuels. This is changing, thanks in part to the progress of COP, the technological innovations in energy production and storage, the improving economics of renewables solutions, and the increasingly precarious economics of hydrocarbon production. But today, we are not there; we cannot flip on a switch and have the world’s energy grids run on renewable and nuclear energy. We cannot distribute, store, or produce the required energy to meet demand. The economics are improving, but they would lead to higher energy bills across the globe if we tried switching everyone over to renewables today, disproportionately affecting low-income countries and zip codes. Take, for example, the country of Iraq, a leading OPEC member state. With 99% of its exports, 85% of its federal budget and 42% of GDP tied directly to oil, Iraq has predictably rejected the language for a phase-down and a phase-out of fossil fuel. Imagine expecting Iraq to commit to rapidly eliminating the one resource it has, on which its entire economy currently depends, without offering it any viable transition path to a prosperous post-carbon future. COP has yet to show substantial progress on the Paris goals in large part because developed countries have yet to assure developing countries of a prosperous post-carbon future. Even given all these headwinds, COP28 was still a historic breakthrough. It telegraphed an obvious direction of travel for the world to consumers, investors, countries, and companies alike. It has signaled the decade of peak oil has arrived, and that the energy system transformation is unstoppable. The biggest adversary we have from here is time, we are on track for a 2.7° Celsius level of warming by the end of the century if we continue along the business-as-usual track. This level of warming virtually guarantees that we will need to live with some of the worst climate change outcomes if we do not quickly find ways to transition these oil production economies and meaningfully lower emissions.

By Jessica Skolnick, CFA and Adam BernsteinMacro and Markets UpdateAs we pass the halfway point of the final quarter of 2023, we find ourselves in another risk-on rally fueled by hopes of an imminent soft landing accompanied by sooner-than-expected rate cuts by the Federal Reserve. The sentiment is a sharp reversal from where we were last month when we published our last commentary. The S&P 500 lost ground in August, September, and October,1 the longest monthly losing streak since early 2020. The 10-year Treasury yield had risen in each of the previous 6 months through the end of October and briefly touched the key 5% level on October 19th.2 Markets seemed to be accepting the Fed’s message of higher-for-longer rates and processing the implications of that on asset prices.The FOMC meeting on November 1st turned the market’s frown upside down, though we are not sure anything has really changed. As expected, the Fed left the Fed Funds rate stable at 5.25%-5.50% and released a statement upgrading economic growth from “solid” to “strong”, acknowledging moderation in a still-strong labor market and indicating that the rise in long-term rates exerted some financial tightening in addition to their monetary policy tightening effects.3 Fed Chair Jerome Powell made it clear in the post-meeting press conference that rate cuts are not part of the discussion, since inflation remains above the Fed’s 2% target: “The Committee is not thinking about rate cuts right now at all. We are not talking about rate cuts.”4The market glossed over Powell’s statements and immediately began pricing in additional rate cuts in 2024, widening the gap between the Fed’s dot plot and market forecasts even further. The median dot plot projection for year-end 2024 is 5.125% (implying one rate cut), while the market’s forecast is just 4.41%, indicating nearly four rate cuts in the next 13 months!5 Stock and bond markets did what they have done every time a phantom pivot has been priced in. The 10-year fell from 4.93% on the morning of the Fed meeting to 4.64% on November 13th, and the yield curve inversion between the 2-year and 10-year Treasury more than doubled from 15 bp to 40 bp, while the S&P 500 rallied nearly 5% over this same timeframe.Meanwhile, nothing much has changed in the underlying data or in the Fed speak following the meeting. The labor market has weakened slightly but remains strong by historical metrics. Job openings were at 9.5 million in September, compared to a 5 million average in the decade preceding the Covid pandemic.6 The September non-farm payroll report was a bit weaker than expected, primarily due to ongoing labor strikes rather than layoffs or other signs of reduced labor demand. October Consumer Price Inflation moderated to 3.2%, but the core measure remained elevated at 4.0%,7 twice the Fed’s target, and the November University of Michigan survey showed short and long-term inflation rose to the highest levels in over a decade.8The Fed may stay in an extended pause given the precipitous fall in long-term rates, little indication of a growth slowdown and falling inflation that remains above target, but the catalysts for actual rate cuts are absent. Premature rate cuts against a solid economic backdrop risk a reacceleration in inflation that the Fed wants to avoid. A hard landing scenario in which rate cuts are necessary would not support the risk-on sentiment currently present in the market.ESG Update – Divergent Energy ViewsInternational Energy Agency:The International Energy Agency (IEA) just released its 2023 World Energy Outlook report that predicts, for the first time, that global oil demand will reach its peak this decade. The predicted peak for oil, which also extends to cover coal and natural gas, does not mean a rapid plunge is imminent, but the IEA forecasts a downward slopping plateau over several years.9Source: IEA, BloombergThe IEA prediction hinges on a few key assumptions:1) The economics of the energy transition are gaining momentum. The Levelized Cost of Electricity (LCOE) is a metric used to estimate the average cost of generating one unit of electricity. It is a useful measure for comparing the cost-effectiveness of different energy sources or technologies. It depends on the asset and location but generally, solar, on-shore/off-shore wind, and geothermal energy production have cheaper LCOE pricing than traditional energy sources, such as coal and gas, and this trend is accelerating.2) Demand for oil in petrochemicals, aviation, and shipping will likely continue to increase until at least 2050, but this increase in demand will be more than offset by the lower oil demand for transport as the growth in electric vehicles continues to rise.103) China is expected to represent about 40% of global oil demand in 2023.11 Said another way, China holds the key to shifting global energy demand. China’s oil demand is facing structural decline, due to record growth in the installation of new low-carbon energy sources.Organization of Petroleum Exporting Countries (OPEC):OPEC predicted in their 2023 annual outlook that oil demand will continue to grow for decades, reaching 116 million barrels a day in 2045. This prediction represents a 16% increase in demand and 6 million barrels a day more than previously predicted. To reach these numbers, OPEC has India more than doubling its consumption, and China increasing oil demand by 26%.12Big U.S. Oil:13U.S. supermajors are also taking a dissenting stance. ExxonMobil’s recent venture into acquiring shale producer Pioneer Natural Resources and Chevron’s latest deal to absorb Hess mark a substantial consolidation within the Big Oil landscape, a scale not witnessed in two decades. These corporate unions seem to challenge the International Energy Agency’s (IEA) prognosis of a shrinking demand for oil, or, at the very least, position these expanded U.S. giants strategically as the enduring producers poised to meet the anticipated demand lingering into the mid-century. By reaffirming their commitment to oil, U.S. corporations are accentuating the growing gap with their European counterparts, who are cautiously tiptoeing into the realm of clean energy initiatives.Supermajors grapple with marketing a declining product but strive to be among the last standing. Anticipating reduced demand, they focus on being low-cost providers, making these deals viable even in a shrinking market. The production cost curve in commodities implies that if your cost of production is low enough, your risk is minimal. Businesses who operate in the oil & gas sector are used to earning certain return profiles. Renewables, however, tend to be both lower return and lower risk, which is a big reason why oil companies do not see the logic in diversifying much into clean energy. Another way these oil giants might look to play on the energy transition is to invest in heavy metal mining, a business with more similar risk/return metrics. “Exxon Mobil Corp. plans to become one of the biggest suppliers of lithium for electric vehicles, marking the oil giant’s first major foray outside of fossil fuels in decades. Exxon aims to produce its first lithium by 2027 and ramp up output to the equivalent of 1 million electric vehicles annually by 2030.”14 Consolidations do not guarantee faith in the growth of an industry, true confidence lies in investing in a sectors riskier market’s. Limited appetite is evident, even among those predicting prolonged oil demand.Gitterman’s In-House ViewWe were experiencing rising global energy demand and declining supply, which manifested in surging prices, grid failures, and rolling blackouts around the world, even before the Covid pandemic and the Russia-Ukraine War. In most places where we are producing oil (OPEC, Russia, US, Brazil), the amount we are producing is dropping. We have already depleted the best oil fields and well depletion math only accelerates as we go to lesser fields. Oil demand will likely peak in the short-term, but global energy demand is still accelerating and has grown by about 2% per year since 1973. The best way to limit the effects of a warming climate to levels that sidestep the worst physical effects is to decarbonize our energy generation mix.In the intermediate term, non-OPEC+ countries dominate medium-term capacity expansion plans, led by the United States, Brazil, and Guyana. The relatively strong increases from non-OPEC+ producers, together with the projected slowdown in demand increases the spare capacity for oil in the intermediate term, keeping energy prices in check. Many investors are overlooking the underestimated risks tied to a sustained rise in commodity price inflation. Capital limitations and the depletion of resources are poised to propel prices upward in the years ahead, contrary to the trends of the past decade. Consequently, investors remain hesitant to fully embrace the potential implications of this shift. We think the “end of oil” will be a function of price-related demand destruction, not technology-driven obsolescence (even though the cost curves for renewable power will help). Before we get there, we are likely to see marginal producers bought by lower cost providers with scale until it is harder and more expensive to transport traditional energy around the grid than renewable sources.And a reminder to please join us for our next installment of our ESG Practice Playbook series with RIA Channel, specifically designed to train advisors on integrating ESG strategies with their existing practice. Join us for this complimentary 3-hour interactive program that will cover topics such as:Improving client reporting with better climate data and portfolio analyticsImpact of climate change on client portfoliosInvesting in the transition to a more sustainable economyImportance of investing in nature-based solutionsWater investing trends and opportunitiesValues-based innovation: Today’s superpower for engaged advisorsWednesday, November 29, 202312:00 PM – 3:00 PM ET3 CFP / IWI / CFA CE credits availableOn-Demand Replay will also be offeredRegister Here

By Jessica Skolnick, CFA and Adam Bernstein Macro Update Recent record-breaking wildfires have caused a reexamination of wildfire suppression policies in place in North America for over 150 years.[i] Rather than allow smaller fires to burn periodically as Indigenous populations had done historically, we have instead focused on extinguishing fires whenever possible, particularly when they threaten lives or property. The unintended consequence of this practice has been increased fuel for wildfires in the form of underbrush and dead trees. Alongside climate change, this excess fuel appears to be resulting in more catastrophic fires that are much harder to contain. Business cycles can be thought of as smaller periodic fires that prevent excess fuel from accumulating. Historically, recessions have corrected boom time malinvestments of capital, where capital is allocated to less productive endeavors, followed by opportunities to reinvest capital more productively in the aftermath. When we take a zero-tolerance approach to economic downturns, we build risk in the system and become less productive over time. Compared to the volatile 1970s and 1980s, the economy in the 1990s and early 2000s was characterized by relative price stability and short and shallow recessions. The Federal Reserve believed it had cracked the code on managing the business cycle, until the 2008 financial crisis shattered that notion. The interconnected nature of our financial system had turned a bursting housing bubble into a systemic global crisis. The Fed’s response, long term monetary stimulus in the form of Quantitative Easing (“QE”) and zero-interest rate policy (“ZIRP”), was akin to shifting from a policy of allowing smaller controlled fires to one of wildfire suppression. Even if well-intentioned, ZIRP and QE prevented the normal ebb and flow of the business cycle because the risks of a correction were now seen as too large, and the negative consequences of high inflation and unproductive investment were hidden from view. Consumer price inflation, as measured by the Consumer Price Index (CPI), averaged just 1.6% from January 2009 to December 2019,[ii] but inflation was not absent from the economy. It had simply shifted to assets, which are mostly owned by the people who have the lowest marginal propensity to spend additional wealth, the most affluent. It was a different story for those without existing wealth. Over the same 2009 to 2019 timeframe, average hourly earnings grew just 2.4% annually[iii] and the broadest measure of unemployment, U-6, did not return to its pre-crisis levels until 2017.[iv] Due to the weak labor market and absence of significant fiscal stimulus to households, consumer demand did not put upward pressure on prices of goods and services. Against this ZIRP/QE backdrop, excesses and malinvestments began to build. Companies with fundamentally unprofitable business models were subsidized by cheap debt and venture capital funds flush with money chasing returns. Corporations borrowed at ultra-low rates and spent the proceeds on stock buybacks rather than investing more productively in their businesses. Nonresidential construction spending grew at 9.5% from the bottom in 2011 to late 2019,[v] nearly quadrupling the 2.4% GDP growth over this same period.[vi] Office construction spending grew 16.4% annualized[vii] and appeared overbuilt even prior to the post-pandemic shift to remote work. The 2020 response to the Covid pandemic was akin to pouring gasoline on the forest floor. Unlike the post-GFC response, Congress worked alongside the Fed to provide fiscal stimulus directly to households in the form of loan moratoriums, direct payments, PPP loans, enhanced unemployment benefits and more. This put money directly into the hands of consumers, increasing demand for goods at the same time pandemic related supply chain disruptions were constraining supply. The predictable result was a sharp rise in prices as measured by CPI. The inflation genie was out of the bottle. Meanwhile, the Fed embarked on more ZIRP along with massive QE that saw its balance sheet grow from $4 trillion to $8.5 trillion in just 26 months,[viii] a larger increase than all the post-GFC QE combined in a much shorter time frame. This turbocharged the excesses that had already been building up in the prior decade. This new ZIRP/QE period produced asset inflation that dwarfed the prior increases. The S&P 500 gained 94% from its April 2020 low through the peak in December 2021[ix] and home prices rose 45% from early 2020 through June 2022[x]. Following a brief dip at the start of the pandemic, nonresidential construction rose 13.5% annualized from January 2021 to August 2023.[xi] Even office construction spending has returned to its pre-pandemic level[xii] despite record office vacancies.[xiii] The spike in inflation became undeniable to the Fed, which began hiking rates in March 2022 and began quantitative tightening (“QT”) in June 2022, reducing the size of its balance sheet by allowing Treasuries and MBS to mature. The labor market has remained resilient due partially to structural changes in the labor force resulting from the pandemic and economic growth has remained strong so far despite the Fed’s tightening attempts. As a result, rates have risen higher and more quickly than most anticipated at the start. Meanwhile, inflation remains above target while base effects and adjustments are becoming less favorable. In recent months, the conversation has shifted from how high the Fed will raise rates before cutting to how long rates will remain high. The market’s expectation of a much higher for longer environment was one factor in pushing interest rates higher in the third quarter. Regardless of whether the Fed is done hiking, the likelihood of returning to the easy money days of ZIRP and QE in the absence of more significant economic pain is low. A best-case soft-landing scenario involves inflation returning to 2% and remaining in that range as the Fed lowers rates to the neutral rate of approximately 2.5%. Even this environment would be more restrictive than what we experienced for most of the last 15 years. Interest expense will increase with refinancings of corporate, real estate and other debt, impacting profit margins and driving unprofitable or marginally profitable enterprises into default. Normalized rates alone may be enough of a spark to light the fire. Unfortunately, our base case is that the Fed will ultimately be unable to keep rates higher for longer because something will likely break first, causing the excesses in the system to unwind. We have detailed many of these potential catalysts in prior commentaries and blogs. Right now, we are keeping a close eye on the following: Unrealized losses on bank balance sheets due to interest rate increases were $558 billion in Q2 2023.[xiv] Most of these losses are on bonds intended to be held to maturity but could pose issues if banks are forced to sell bonds for liquidity purposes. The Fed created the Bank Term Funding Program (“BTFP”) in March 2023 following the failure of several regional banks, but this program only applies to bonds owned as of March 12, 2023, and interest rates have continued to move higher. China’s property market, especially following the recent defaults of Evergrande and Country Garden, two of the largest property developers. Commercial real estate. Low transaction volume and banks’ ability to “extend and pretend” by offering loan extensions and modifications have delayed a reckoning. Unpaid principal balances with CMBS special servicers rose from $5.5 billion in summer 2022 to $12.7 billion in 2023 while office values fell by 12.7%.[xv] The residential housing market, where a combination of high mortgage rates and near-record prices have led to the worst affordability on record.[xvi] A recent report concluded that home prices in 99% of the US are unaffordable for the average income earner.[xvii] Rising geopolitical risks and the resulting trend towards deglobalization and onshoring/friend-shoring. Political dysfunction in the US. After narrowly avoiding a debt default over the summer, we are approaching another potential government shutdown next month. Until such a breakdown occurs (or a soft landing is assured), we expect upward pressure on rates to continue as higher for longer rates get priced in, particularly on the long end. This has been the primary driver of the bond market selloff in 2022 and 2023 so far. Credit spreads have only recently begun to widen, and we expect widening to continue to reflect the increased credit risk present in a higher rate world. This risk-off shift may halt the upward pressure on rates and ultimately spread to equities, which look particularly vulnerable given elevated valuations and the opportunity to earn 5% risk free on cash. In a soft-landing, we would expect the above dynamic to be more orderly than in a “something breaks” scenario. In the latter, the Fed would likely respond by rapidly cutting rates as inflation concerns move to the back burner. Traditional safe haven investments like long-duration high-quality bonds would outperform while risk assets would experience drawdowns. For now, though, our portfolios remain overweight short-duration high-quality fixed income and cash with an underweight to equities and minimized exposure to the riskiest sectors of both asset classes (emerging markets, high yield debt, etc.). Market Update Resilience seems to be the best way to describe the US economy and stock market this year. Despite the S&P 500[xviii] losing 3.3% in Q3, it remains up 13.0% year-to-date.[xix] Large-cap growth stocks have outperformed, returning +25.0%[xx] for the year but losing 5.4% in Q3 as equity markets began to price the real cost of prevailing interest rates and tighter liquidity conditions. Over the past year and a half, the Fed raised the effective federal funds rate by a cumulative 5.25% to combat inflation which led to a cascade of knock-on effects that until recently have, for most of 2023, primarily impacted the bond market while leaving stocks unscathed. The historic magnitude and pace of the hikes caused the deepest yield curve inversion of the 2-year and 10-year Treasury yield curve since the early 1980s, which is one of our most accurate recession indicators. The most acute effect of rising rates so far has been the bear market it has caused in long-duration bonds. The US Treasury market has lost about a quarter of its value since yields bottomed out in 2020 and Bank of America has declared this the biggest treasury bond bear market in history. The hiking campaign has hit long-term Treasuries the hardest. TLT, an ETF tracking 20+ year Treasuries, has lost 47%[xxi] since the start of the hiking cycle. Since the peak of the S&P 500 in December 2021, the index has been in a rolling bear market and failing to make new highs. We have seen a series of 6-16% corrections as the market tries to balance between sticky inflation prints, a robust jobs market, and the Fed tightening. The S&P lost 25% through late 2022[xxii] but enthusiasm over AI sparked by the release of ChatGPT beta in early 2023 alongside the Fed’s lifeline to banks in the form of the BTFP reversed the market downtrend. The AI frenzy resulted in one of the most concentrated bull markets in history. In July, a surging 10-year treasury yield and rising rates, with a backdrop of re-accelerating economic growth have again forced investors to price the possibility of a hard landing. As of the end of Q3, the “Magnificent Seven” stocks (Apple, Microsoft, Alphabet, Meta, Tesla, Amazon, Nvidia) that have been driving year-to-date returns made up ~27% of the S&P 500 and were responsible for 84% of the index’s YTD return. The top five performing GICS subsectors are largely made up of the AI ecosystem: semiconductors (Nvidia +197%), interactive media services (Meta +149%), systems software (Microsoft +32%), technology hardware (Apple +32%), and broadline retail (Amazon +51%) were responsible for 85% of the index’s YTD return. In Q3 the Magnificent Seven outperformed the S&P 500’s performance of -3.3%, losing 1.0% combined,[xxiii] though the correlation of these stocks to overall S&P 500 performance fell from 0.9 in Q2 to 0.5 in Q3,[xxiv] an indication that the concentrated nature of the year-to-date rally may be breaking down. One of the most significant trend reversals from 2022 is the performance of the Utility sector. In 2022, Utilities lived up to their defensive reputation, returning 1.4% while the overall S&P 500 Index lost 18%. This year, Utilities have declined 14.0% compared to the S&P 500’s gain of 13.1%.[xxv] With stable and predictable annual earnings and dividends, utilities are viewed as a bond proxy. Rising bond yields make their dividend yields less attractive. The negative yield spread between utilities’ dividends and US Treasuries have been a major headwind. As of the end of the quarter the utility index yield stood at 4.0%, about 60 basis points below the 10-year US Treasury yield.[xxvi] This is the first time that this spread has been negative in 14 years. If the market is right in predicting the end of rate hikes and the beginning of rate cuts is nigh, it might prove to be a great buying opportunity for utilities. The other major area of distress this year has been the banks. The acute phase of turmoil for regional banks may have passed, but lenders are still contending with increased competition for deposits and higher funding costs, two factors that could persist if interest rates remain higher for longer. If the market predicted rate cuts do not materialize, the current 2024 analyst consensus on margins and revenue might prove too optimistic. In 2007 the average cost of deposits for a bank hovered around 3.7% and the total percentage of high-cost CD deposits for customers looking for better yield equaled 38% of total deposits. In Q3 average deposit costs were 2.3% and CDs made up only 20% of total deposits.[xxvii] Costs can still rise for banks from here as investors look to realize improved yields and put more pressure on their profitability. Global and international markets have underperformed in the US so far this year with the MSCI ACWI Index losing 3.6% in Q3 but remaining up 10.0% year-to-date. Developed international markets represented by the MSCI EAFE Index lost 4.9% for the quarter and are up just 6.6% year-to-date while the MSCI Emerging Markets Index lost 3.7% in Q3 and is up just 1.3% for the year. China and Hong Kong, the largest components of the EM index, lost 8.6% and 17.1% respectively in the quarter, dragging down the headline index. The MSCI EM ex-China Index has performed much better, with a year-to-date total return of 5.7%.[xxviii] As touched upon in our macro update, we have continued to favor a defensive approach for both equity and fixed income sleeves of our portfolios because our base case scenario is a hard landing caused by interest rates that remain higher for longer due to the resilience of the labor market and the hard to battle services inflation component of CPI. Even if the Federal Reserve manages to stick a soft landing in the near term, higher rates for longer will likely cause US equities to remain range bound. Bloomberg’s S&P 500 fair value model suggests current valuations already incorporate the potential for easier policy to emerge, leaving substantial positive earnings surprises as the only likely candidate for S&P 500 outperformance. The S&P 500 is expected to report a year-over-year decline in earnings of -0.3% for the third quarter, which would make it the fourth straight quarter that the index has reported a decline in earnings.[xxix] For the S&P 500 to retake its all-time high, the Fed would have to successfully beat core inflation back down to 2% or below and lower interest rates at a pace commensurate with the Fed futures curve without a deterioration in profit margins. On the fixed income side of the portfolio, we favor boring high-quality short-term Treasury and Agency MBS allocations. There are two primary sources of risk in fixed income: duration (risk that the price of a fixed-income security will change due to shifts in interest rates) and credit (the risk of the issuer defaulting on its financial obligations). A yield curve inversion in the 2-year/10-year portion of the Treasury curve functionally means that an investor is getting paid a higher yield to own a 2-year Treasury that has less risk than a 10-year Treasury (debt ceiling debates aside, Treasuries are not considered to carry credit risk). With the yield curve having been inverted since March 2022, an investor could have gotten up to 107 basis points of extra yield,[xxx] depending when purchased, on the 2-year treasury vs. the 10-year treasury with a fraction of the duration risk. We are also not seeing the usual negative correlation between duration and equity markets that you see in the risk-off environments that we are in, at least not yet. Recent equity market selloffs have been accompanied by rising rates and falling bond prices rather than the typical hedging dynamic that high-quality long-duration bonds have historically provided. When the curve normalizes and we start getting paid for taking duration risk again, we will likely go further out on the curve. Climate and ESG Update The focus this quarter will be on the underperformance of the renewable energy trade but, first, let us break down some of the major sustainable finance themes: energy efficiency, electric vehicles, semiconductors, climate solutions, renewable energy producers, net-zero, energy storage, social justice and water. Of these themes, energy efficiency (59.3%), semiconductors (37.5%), climate solutions (19.3%), and electric vehicles (18.6%) have outperformed the S&P 500 this year. The themes that have struggled the most have been renewable energy producers (-22.8%),[xviii] energy storage (-10.4%),[xxix] and water (-0.3%).[xxxi] Let us unpack what went wrong. By “the renewable energy” trade, we really mean renewable power generation and distribution firms (utilities that create energy from solar, wind, hydro, geothermal, biomass, and nuclear energy). The valuations of these firms were pushed to extremes by investors in 2020 due to anticipation for the passage of the Infrastructure Investment and Jobs Acts as well as the Inflation Reduction Act (IRA) which were subsequently passed in 2021 and 2022, and for good reason. The IRA bill alone is expected to drive ~$3.5trillion in cumulative capital investment in new energy supply infrastructure over the next decade. The Act has the greatest impact on investment in wind power and solar PV, whose investment will nearly double from $177 billion to $321 billion by 2030. And let’s not forget the tens of billions of dollars in grants, tax credits, and loan programs to develop manufacturing and supply chains for clean energy components, batteries, electric vehicles, and critical minerals.[xxxii] There have been two fundamental shifts in the market since 2020 that have shifted the operating environment for these types of companies: Many renewable energy producers and distributors cannot self-fund renewable energy projects due to the significant upfront capital requirements and long payback periods. These costs can be substantial and are typically beyond what a company can finance solely from their own equity or retained earnings. This means that, on average, renewable energy companies take on more debt than traditional energy companies, whose business models are more tied to the price of energy. For this reason, most renewable energy firms rely on project finance, a specific form of financing that focuses on the project’s cash flows and assets rather than the creditworthiness of the project sponsor. The downside to relying on project finance loans to fund growth is that they are fixed rate loans and extremely sensitive to interest rate changes and discounts to future cash flows. When interest rates shot up, it immediately ate into the profitability of renewable projects making many planned and current solar plants, wind farms, and small modular reactors unprofitable without a precipitous increase in the price of traditional energy. This re-rating of risk came at a time when valuations were elevated, and a number of hedge funds started shorting renewable energy stocks.[xxxiii] The Utilities sector is a major component of the renewable energy themes that have underperformed this year. Negative yield spreads for utilities vs. US 10-year treasury bonds have been a major headwind for the entire utility sector. The S&P 500 Water index (~40% utilities) and the Renewable Energy producers index (~94% utility) allocate about 40% and 95% respectively to the Utilities sector, which has been the worst performing sector this year.[xxxiv] Regulated utilities make money by providing essential services to customers, like electricity or water. The key to their profitability is the rate base, which is the total value of their assets minus depreciation. They are allowed to earn a reasonable rate of return on this rate base that is determined by regulators. Here is the interesting part: utility profitability (ROE) is not directly tied to energy prices or sales. Even if energy prices or sales fluctuate, the utility’s profits remain stable because they are determined by the negotiated rate base. So, the utilities do not become more profitable when they sell more energy, and they do not become less profitable when prices drop. In plain terms, rate-based (assets) expansion, not sales, is what drives earnings. Authorized returns for utilities generally move directionally with long-term bond yields, but with several quarters of lags. Regulators may try to hold down authorized returns amid surging customer bills stemming from high commodity prices, inflation, and interest rates, which has been the case this year. These short-term headwinds for the sector should shift into tailwinds as utility regulators approve rate base increases and IRA incentives continue to cause higher capex spending and help green companies do well in the long term.

During Climate Week NYC, we hosted a mainstage panel at The Nest Climate Campus at the Javits Center titled Women Leaders in the Era of Climate Change. Jeff sat down with Marina Severinovsky, Head of Sustainability, North America at Schroders, Ariane Mahler, CIO at Veridien Global Investors, Heather Beatty, CEO at Scopefour Capital, and Rebecca Carland, CIO at Builders Asset Management to talk about how they each lead in their respective organizations and seek to create value for stakeholders in an era of unprecedented change. We believe that the unique challenges of our time are calling for more female leaders at the nexus of climate adaptation, innovation, and regulation. The panel was widely viewed as one of the most engaging of the entire Nest Climate Campus event, and we hope you also find it to be interesting and informative! With this in mind, we also wanted to remind you that each quarter, our investment team, led by our Director of Investments, Jessica Skolnick, CFA, produces a market outlook to address the latest macroeconomic trends and sustainability issues facing investors and advisory firms today. We invite you to join us as we shift focus this quarter to the underperformance of renewable energy in the wake of the Infrastructure Investment and Jobs Act and the Inflation Reduction Act (IRA).