Explore the Thinking behind our investment approach

Globally, trillions of dollars in sustainable infrastructure investment will likely be needed to provide clean, safe, and high-quality water, energy, and food to the world’s population in the coming years. While we have not found many institutional quality managers in the infrastructure space with expertise in climate and ESG analysis, KBI Global Investments (KBIGI) have stood out to us as a longstanding specialist in this field. Exposure to listed infrastructure often comes in the form of investments such as MLPs, which primarily invest in traditional midstream energy, and are not aligned with the goals of Gitterman Asset Management’s SMART Climate Portfolios, but we have found KBIGI to be of interest in that they are an institutional global manager with an experienced team of ESG and climate focused infrastructure investors. In 2000, KBIGI was one of the earliest investors to recognize the alpha potential of investing in solutions to water scarcity and provisions for renewable sources of energy. Their continued focus on secular investment themes has enabled them to build intellectual capital within the environmental sectors that they leverage across their platform. KBI invests in listed infrastructure, which offers many potential benefits to investors, including diversification across sectors and geographies at lower costs compared to many private alternatives, while investing in sectors that are uncommon in traditional infrastructure strategies. Specifically, KBI invests in three themes: energy solutions, water, and agribusiness, and the cornerstone of their strategy is the sustainable nature of infrastructure investments. Their portfolio delivers material and diverse exposure to water and clean energy infrastructure, food storage, transportation, and farmland. This infrastructure need is well recognized by U.S. lawmakers with the passage of the Inflation Reduction Act, which will ultimately unlock hundreds of billions of dollars in incentives and tax credits for e-vehicles, renewables, and sustainable infrastructure. [1] The KBIGI team has been managing specialized sustainable infrastructure investments in water and clean energy since as far back as 2001, and food since 2008. If you would like to learn more about KBIGI, and how we incorporate them into our UMA and thematic SMA solutions, we would look forward to speaking with you. As a reminder, each quarter, Gitterman Asset Management’s Investment team, led by our Director of Investments, Jessica Skolnick, CFA, produces a quarterly 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 highlight the most important current events and economic indicators influencing our view on the economy, markets, and sustainability issues.

Most of us follow the markets and interest rates on a day-to-day basis, and this takes up a lot of time and attention because they tend to have a more short-term and immediate impact on markets. Yet, climate change by comparison is often viewed as a slower moving issue that we don’t know when or where will strike next. Despite the increasing storms, fires, floods, and droughts we are currently experiencing, we still hear a lot about 2050 or 2100 being the time of major impact, and so we tend to ignore many of the day-to-day factors that happen and brush them off. Yet, behind the scenes, rating agencies are not operating with this mindset. Over the last several years, companies like MSCI, Moody’s, Sustainalytics, and ICE have spent serious amounts of money analyzing climate data and acquiring risk data companies. As examples, Moody’s now owns climate data and risk analysis leader Four Twenty Seven, while ICE recently acquired risQ and Level 11 Analytics. The cost of climate risk pricing in the markets has already begun, which is why we coined the term The Great Repricing, meaning the gap between the data that is available to measure risk and the time it takes for the markets to price in this risk. We believe that RIGHT NOW is the time to evaluate portfolios to eliminate climate risk where possible. While it is sometimes difficult to get supply chain risk information on every company, we’ve included asset managers in our UMAs and thematic SMAs like Wellington Management, who’s partnership with Woodwell Climate Research Center enables them to better predict the frequency and intensity of climate change events and offer increased climate transparency to the equity markets. Through their longstanding relationship with Woodwell Climate Research Center, Wellington is expanding the intersection between the capital markets and climate change. They are also sharing this research with issuers to encourage them to develop a strategy towards carbon-reduction targets. Many people still have very different opinions and beliefs about climate change, but at this point, from a financial point of view, it really doesn’t matter what we think about it. Nearly all reinsurers at this point are thinking about climate change as a fact, and nearly all rating agencies and more asset managers are doing the same: pricing in risk, knowing that the markets generally move very slowly and then all at once.

Our investment thesis since early 2022 has been that the Federal Reserve will continue to raise rates and keep them at a high level until either inflation returns to target or “something breaks” in the form of a major financial crisis. The failures of regional banks Silvergate, Silicon Valley Bank (SVB) and Signature Bank earlier this month may be a warning sign that something has broken, though it is still too early to tell. All three of the banks had exposure to crypto or venture capital. Silvergate’s failure is most directly related to the crypto industry and fallout from the collapse of FTX. SVB and Signature Bank found themselves under pressure from depositor withdrawals that were first caused by weakness in the VC or crypto industries and then exacerbated by panic-driven bank runs. Most of the deposits at these banks were above the FDIC insurance limit and depositors were reasonably concerned they could lose access to cash. The banks were forced to sell low-yielding long-term Treasuries and/or Agency MBS that were valued below par as a result of higher interest rates in order to raise cash to meet those withdrawals. SVB was placed into receivership by FDIC on Friday March 10th and Signature Bank followed over the weekend. The FDIC, Treasury and the Federal Reserve issued a joint statement on March 12th detailing a plan to limit contagion to other regional banks. Depositors at the failed banks were made whole above and beyond the FDIC insurance limits. The cost of this will be borne by FDIC and its member banks, not the government or taxpayers. A new facility was created that would allow other banks to borrow from the Fed against the par value of the Treasuries and Agency MBS on their balance sheet to meet withdrawals rather than be forced to sell those bonds and risk falling into a similar spiral as SVB and Signature. If the issue with regional banks is limited to a simple mismatch between the duration of their assets (Treasuries/MBS) and their liabilities (deposits), the depositor guarantee and new Fed lending facility may be enough to contain the damage and prevent contagion. If depositors are assured they will not lose access to their funds and banks are able to access liquidity to meet withdrawals, then future bank runs become a lot less likely. In that case, the Fed may continue to hike rates at the March 22nd FOMC meeting given inflation levels that remain above target. The new program will not solve the problem, however, if the issue runs deeper than a duration mismatch. One of the systemic risks we have been focused on is the commercial real estate (CRE) market, particularly offices, multifamily and retail. Unlike single-family residential mortgages, CRE loans tend to be leveraged at variable rates and are more vulnerable to the steeply rising interest rates we have seen in the last year. Adding to the risk, the cultural shift towards remote work has resulted in rising vacancy rates in offices across the country, particularly in New York and California. Reports of defaults involving major asset managers like Blackstone and PIMCO have been hitting the headlines in recent weeks. According to a recent Bloomberg article,[1] the banking industry’s exposure to CRE rose dramatically during the pandemic from approximately $4.5 trillion in 2021 to $5.3 trillion today. Large banks have only about 6% of their assets in CRE loans but smaller and foreign banks have over 20% of their assets in CRE as of March 1st.[2] Signature Bank issued more CRE mortgages against New York City buildings than any other bank since 2020 and had about a third of its assets in real estate loans as of the end of 2022.[3] SVB was a California-domiciled bank, as is First Republic, another regional bank that has come under pressure. There has been no official indication that CRE distress contributed to the bank failures but we are watching developments in this space closely. Complicating matters, the financial instability that began with regional banks in the US has spread to Credit Suisse Groupe AG (CS). CS has been struggling since the blow up of its client Archegos in 2021 and we have discussed its issues in prior commentaries. As of this writing, its stock is trading at an all time low and its credit default swaps (which represent the cost of insuring its bonds against default) are trading at record highs. Unlike the failed regional banks, CS is a systemically important financial institution whose woes are not primarily about rising rates. The situation is rapidly evolving but a failure of CS would almost certainly meet the definition of “something breaking”. Lessons from SVB Collapse for Bond Investors The near-term cause of the SVB collapse was that the bank was forced to sell Treasuries and Agency MBS at prices well below par in order to meet withdrawals, even though those bonds would have matured at higher values had they been held to maturity. Their experience is a lesson to bond investors as well as other banks. Investors who get their fixed income exposure through pooled investment vehicles like mutual funds or ETFs are subject to a similar risk if rate volatility causes other investors in the vehicle to redeem their funds and the portfolio managers are forced to sell bonds at a discount to raise cash. This is not a risk for investors who own bonds directly, as in a separately managed account (SMA). Rate increases can cause the value of a bond to decline on paper but, barring default, those bonds will pay back at par if held to maturity. For clients with sufficient investable assets to meet minimums, an SMA can reduce the risk of locking in paper losses on bonds as a result of the decisions of other investors. SVB and ESG SVB is a case study on the outcome of four major decisions: 1) The effects of mismanagement; senior management made the mistake of investing short-term deposits into long-term fixed rate assets at a significantly higher proportion than the average bank. 2) Interest rate hikes occurred quickly and at a significant enough magnitude to elevate short-term rates dramatically and invert the yield curve. This effectively made SVB insolvent when it was forced to sell its longer duration yet lower yielding bonds to meet withdrawals. 3) Legislators and politicians relaxed core banking regulations by rolling back Dodd-Frank protections in 2018. To lessen the regulatory burden on banks with balance sheets of less than $250B.[4] The original provisions of Dodd-Frank may have stopped SVB from enacting such as aggressive deposit investment strategy. 4) The misuse of ESG scores to accelerate investment in SVB. Silicon Valley Bank was scored highly by most of the major ESG data providers and unofficially known as the “climate” bank by founders due to its involvement in financing renewable energy projects and climate technology start-ups. The details underlying SVB’s topline rating contradict its reputation as an ESG leader. Using MSCI data, SVB was an industry laggard on environmental scores. It was in the bottom quartile of consumer banks for financing environment impact, a data point that considers the bank’s credit policy as it relates to agriculture, biodiversity, fossil fuel, mining, and ESG risk management. SVB also scored in the bottom quartile for consumer banks in Access to Finance, which evaluated their efforts to expand financial services to historically underserved markets. MSCI notes that “the bank lags its industry peers in adopting ESG risk management policies and systems. We found limited evidence of sector-specific environmental credit policies and ESG due diligence and risk escalation processes.”[5] It appears that the topline scores and SVB’s inclusion in major indexes were enough to dupe mainly US ESG investors. According to Morningstar Direct, the US ESG fund universe (after controlling for domicile and share-class duplication) includes 628 funds, of which 49 or 7.8% held SVB as of January. The average weight for SVB among US ESG funds was 0.36% and included passive and active managers. The ESG globally domiciled fund universe includes 8,393 funds (after controlling for share-class duplication), of which 265 funds or 3.15% held SVB as of January with an average weight of 0.35%. Globally the overall fund universe includes 117,954 funds, of which 1,557 funds or 0.98% held SVB at an average weight of 0.24%. Idiosyncratic stock events such as this one highlights the risks of investing in broadly labeled and generic ESG funds. As this banking crisis continues Credit Suisse Group AG (CS) seems to be the next major bank struggling with liquidity issues. We are happy to state that only 2 US ESG funds hold CS (at an average 0.03% weight) and 48 globally domiciled ESG funds hold CS (at an average 0.39% weight). A vast majority of the CS ownership within ESG funds is held in passive index funds.[6]

From a climate investing perspective, water is an essential theme. Floods, droughts, and hydrological cycles are several of the ultimate expressions of climate change, driving water scarcity, influencing population movement, and increasing the need for investment in water sustainability. As a cornerstone of all human survival, we view water as a major component of any well-researched ESG portfolio. In our research we find that there are several water strategies within the investment universe to consider. Water Asset Management has recently been recognized by eVestment as the number one ranked strategy in the Global Equity ESG-Focused universe since its 17-year inception in April 2006. According to Matt Diserio, President and Co-founder of Water Asset Management, they are “one of only 22 (out of about 466) global ESG funds that have consistently been a top quartile performer for the 1yr, 3yr, and 10yr periods by eVestment.” [1] The rankings were based on performance, down market capture and sharpe ratio. As a thematic manager in our Mix & Match SMA Suite, Water Asset Management’s Global Water Equity, LP strategy provides concentrated exposure to significant macro themes in the global water sector. Their approach combines top-down water macro theme identification and rigorous bottom-up company analysis to drive stock selection. The opportunity set includes over two hundred water focused companies globally with a sizeable number of small and mid-cap names, which allow for pure expressions of key water themes. We believe it is important to keep asking clients what they are interested in. Water offers an intuitive topic of conversation with tangible impacts and opportunities for suitable clients to enhance diversification and participate in a long-term secular trend.

The first FOMC meeting of 2023 on February 1st didn’t deliver any major surprises or changes in messaging. The Fed decided to raise rates by 0.25% as expected and there were no revisions to the Statement of Economic Projections at this meeting. Fed Chair Powell’s tone at the press conference as the most notable departure from the prior meeting. While he has in the past scolded the markets for rallying on more dovish forecasts than the Fed’s own, this time he agreed to disagree with the market. The S&P spiked up about 4% following the meeting on these dovish “vibes” and did not return to its pre-meeting level until more than 2 weeks later. The substance of Powell’s comments hadn’t changed much from the last meeting. The Fed’s message is simple: there is some disinflation in goods (which may be transitory, especially if energy costs rise), expected but not yet materialized future disinflation in housing, and significant inflation in services with no signs of slowing. Services inflation is more likely to become entrenched than goods inflation and is more closely related to the labor market, which remains exceptionally strong. Powell ruled out the possibility of raising the Fed’s inflation target above 2% and recommitted to tightening policy until that goal is achieved. Data released since the meeting has supported the idea that the inflation fight is far from over. January Non-Farm Payrolls, released a couple of days after the FOMC meeting, showed blowout job growth of 517,000 compared to just 189,000 expected. Initial jobless claims have been below 200,000 for four consecutive weeks and, despite major layoff announcements from the tech sector, the December JOLTS survey showed layoffs and firings remained about 25% below the pre-pandemic trend. Inflation data has mostly surprised to the upside. January CPI rose 6.4% year-over-year compared to the market’s 6.2% expectation and PPI rose 6.0% year-over-year, well above the market’s 5.4% forecast.[1] Markets are forward looking and, until recently, they looked right past the blip of higher rates to the second half of the year when the Fed would be slashing rates against the backdrop of a soft landing. Data released in the last three weeks have shifted this forecast a little, but not enough. September rate cuts are still priced into the Fed Funds futures curve. The yield curve has moved higher, putting the 2-year Treasury at its highest level since 2007. It could rise further if the market prices in a Fed Funds rate above 5% for most or all of 2023. Conversely, the S&P 500 is still up over 4% year-to-date,[2] not reflecting the margin pressure companies would experience as higher wage and interest expenses run into the limits of their ability to raise prices. Such a rapid monetary tightening following over a decade of near-zero rates and endless QE isn’t without risk. Our thesis since last year has been that the Fed will raise rates and keep them elevated until either inflation is under control or “something breaks”. We’re seeing signs of weakness in commercial real estate, particularly offices, as the realities of remote work and higher rates collide with an oversaturated and leveraged market. Credit Suisse, a global systemically important bank, has seen its share price plunge to record lows amidst client outflows. Geopolitical tensions, particularly with Russia and China, have only escalated in 2023. Any of the above (or something else entirely) breaking could be the catalyst for future Fed rate cuts and would also put downward pressure on the risky assets that have rallied on hopes of looser policy. The math just doesn’t add up for us. Sustainable Investing in the Time of Surging Energy Prices If you are an ESG-centric financial advisor or investor investing in public equities over the past couple of years, you’ve probably noticed that you’ve been fighting an uphill battle. ESG large-cap funds tend to be underweight traditional energy, value stocks, financials, and commodity businesses. There are many different reasons any individual ESG fund might have these underweights. A manager may have decided to divest from extractive industries or companies that make their revenue selling or procuring hydrocarbons. Managers might limit their investable universe to stocks with specific minimum ESG scores or outcomes or decide to take a more thematic approach by investing businesses exposed to renewable energy and solutions that help consumers adapt to a changing climate. These sustainable investment approaches have different motivations but no one method is necessarily better than another. Still, they can create unintended macroeconomic risks when put together in a portfolio. For example, when energy and commodity prices rose in 2022 in the wake of the Ukraine War, Morningstar reported that “only 35% of sustainable funds outperformed the Russell 1000 index during the year, while nearly 60% of their peers did so.”[3] In our opinion, the energy and commodities underweight was the cause of the short-term underperformance. Despite a difficult 2022, this short-term volatility did not do much to change the long-term performance record of ESG funds against traditional funds. Morningstar also reports that “over the trailing three- or five-year period, an investor seeking long-term returns would have been better off in a sustainable fund than in one of its conventional peers. Of the 451 U.S. large blend funds an investor could have chosen in January 2018, 169 survived and beat the Russell 1000 Index, while 282 either closed or underperformed. Nearly 60% of the sustainable options succeeded, while only 35% of their conventional peers did.”[3] It seems that the most important decision investors could have made over the past couple of years was not the choice of ESG managers vs. traditional managers, but to understand how each manager’s ESG approach integrated with the rest of their portfolio. For example, if you had an ESG large-cap manager structurally underweight value stocks and energy stocks, it would have been a great investment decision to pair that manager with a fund that thematically invests in water and sustainable infrastructure. The companies those funds would invest in would balance out the macroeconomic biases of the first manager by loading up on utilities, grid operators, and diversified energy businesses. Understanding how one ESG integration method offsets or enhances another while also tracking toward overall portfolio sustainability goals is what we believe is the best way to invest sustainably in the current market environment.

Deepen Your Client Relationships and Elevate Your Expertise Climate change and other social and environmental risks necessitate integration into investment management decisions, regardless of political perspectives. However, navigating the sustainable investment landscape is not easy for financial advisors. You need easy-to-implement, compliant solutions that protect your time and can be personalized to client needs. Our customizable, scalable solutions include core portfolios alongside standalone thematic strategies that complement your existing offerings.