Explore the Thinking behind our investment approach

Commentary by Jessica Skolnick, CFA, Director of Investments and Adam Bernstein, ESG/IMPACT Analyst For over a year, we have been managing our portfolios defensively and writing about the myriad risks and headwinds we see facing the market. A defensive posture was easy to maintain in 2022. Fed rate hikes spooked equity markets and risk assets in general. 2023 has been a much different story. Against a backdrop of higher interest rates, stubborn inflation and bank turmoil, the S&P has rallied over 14% year-to-date.[1] So, what gives? Are we wrong, or just early? On the macro front, we have been more right than wrong over the last 18 months. We believed that inflation would stay higher than expected for longer, due to a tight labor market and pressure to maintain corporate profit margins. Stickier inflation would then force the Fed to raise rates higher and keep them there for longer than the market expected. We expected higher rates along with the shift to remote work and oversupply to impact commercial real estate. We have also been cautious on the China growth thesis given their property market issues and the increased polarization of the economic world that accelerated with the Russia-Ukraine War. So, we believe we are early but not wrong. The market is currently priced for perfection – a soft landing (or no landing) scenario where the inflation genie goes quietly back into the bottle and the Fed can begin cutting rates early next year without the economic turmoil usually associated with rate cutting cycles. Refinancing risk would not be a major problem in such an environment, because rates would be lower, and earnings forecasts can stay rosy without a recession in the cards. Unfortunately, we see too many risks on the horizon for this to be our base case: The rate hikes that have occurred have not been priced into equity markets. One year ago, the Fed futures market expected a slow hiking cycle that would peak at 3%. Today, the upper bound is 5.25% and the revised dot plot from the June meeting suggests 2 more hikes (and no cuts) in store for the remainder of 2023. And yet the S&P 500 is up over 16% from this time last year.[2] The drop in headline inflation has been driven primarily by a 11.7% drop in energy CPI. Core CPI and Core PCE have been stuck at elevated levels higher than the Fed’s target all year.[3] The Fed had expected housing costs to fall as we moved through the year but asking rents have risen to new highs in recent months, baking in future inflationary pressure.[4] Commercial real estate (CRE) has only begun to turn over in the office space. Low transaction volume along with expectations for lower rates ahead have only delayed the reckoning. We expect stress to spread to multifamily as well, which at 40% of the CMBS market is about twice as large as offices.[5] There are nearly 800,000 units slated for completion in 2023, compared to less than 500,000 in 2022, against a backdrop of weakening demand.[6] While the Fed’s Bank Term Funding Program (BTFP) has calmed the immediate stress, the drivers of the banking turmoil in March (higher rates, lower deposits, and CRE stress) have only worsened in the intervening months. The Fed bank stress tests, which will be released on June 28th, will provide more insight into the state of the banking system. The year-to-date rally in the S&P 500 has been concentrated in a handful of large tech names and has pushed valuations to levels not justified in the current rate environment. The earnings yield on the S&P 500 is just 4.8% lower than the yield-to-worst on the Bloomberg US Credit Index and most short-term Treasuries.[7] In other words, investors in the stock market at these levels are not being paid any premium to compensate for the risk. ESG Update: The Return of El Niño and its Investment Implications If you’d been able to peel yourself away from the stock charts of the magnificent seven (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) at any point in the last couple of weeks, you would have noticed that we have been inundated by headlines of blazing Canadian forest fires, record air pollution levels in the eastern US, record temperatures around the world, droughts in Arizona, and record breaking forest fires in California. This pick-up in intensity of climate disasters is no coincidence. On June 8th, the scientists at the NOAA Climate Center (a division of the national weather service) announced their first El Niño advisory in four years, noting that we have officially entered our next El Niño phase. An El Niño is abnormal warming of the sea surface temperatures in the central and eastern tropical Pacific Ocean. It is part of a larger climate cycle called the El Niño-Southern Oscillation (ENSO) that occurs on average every 2-7 years. The shift to a warming phase in our natural climate cycle can create material investment risks for an already hot world:[8] Emerging markets India is particularly vulnerable. In 2017, heat-exposed work produced about 50% of GDP, representing 30% of GDP growth, and employed about 75% of the labor force.[9] Energy grids Solar panels, batteries, and power grids lose efficiency through heat. It is estimated that grid technologies experience “load shedding” of 0.1-0.5% loss of power per 1-degree Celsius increase. Planned outages due to heightened fire risk caused California’s utilities provider PG&E to go bankrupt.[10] Crop loss While some crops benefit from a warmer climate (higher rainfall in California benefits avocados and almonds, for example), many staple crops such as palm oil, sugar, wheat, rice, and corn will face more challenging conditions and falling crop yields. Sixty of global food production occurs in just five countries: China, the United States, India, Brazil, and Argentina. Rice, wheat, corn, and soy make up almost half of the calories of an average global diet.[11] This El Niño is occurring on top of an ongoing long-term warming trend and could potentially be the costliest El Niño cycle in history. When you look at current climate events through this lens it is no wonder, we saw a raft of large insurance companies abandon certain states this month. Most recently, Farmers insurance Group became the latest of fifteen insurance companies to stop writing new business in Florida over the past 18 months.[3] We are currently a world grappling with war, inflation, recession risk, restrictive monetary policy, and an El Niño has now come at exactly the wrong time. “According to Bloomberg Economics modeling, previous El Niños resulted in a marked impact on global inflation, adding 3.9 percentage points to non-energy commodity prices and 3.5 points to oil. They also hit growth to gross domestic product, especially in Brazil, Australia, India, and other vulnerable countries.”[12] We already know that climate change, the transformation of our global energy system, and the spending we need to make progress on these two critical issues are extremely inflationary. Amplified by the inflationary pressures of an El Nino we see persistent stressor on an already sticky core services inflation number. Powell’s work is not done and likely will not be, due in some respects, to these underlying themes.[13]

Since 2020, we’ve been discussing what we call The Great Repricing: the gap between the physical risk from climate change and the time it takes for the markets to price in this risk. As climate-related disasters increasingly inflict significant losses, insurance companies continue to face challenges in providing affordable coverage. In 2021, the rise in climate-related disasters led to $145 billion in damages and resulted in higher home insurance premiums for 90% of homeowners.1 The devastating wildfires in California have led to premium hikes, tougher eligibility requirements, and have now compelled insurance giants Allstate and State Farm to pull out of the California Homeowners Insurance Market. The annual cost of U.S. flood damage has more than quadrupled since the 1980s,2 and this will only grow given climate-driven extreme rain, more intense hurricanes, and rising seas. Many local governments have expressed concern that helping people relocate could decimate their tax bases. See what Jeff had to say about all of this in this recent interview: Since 2020, we have been sharing our understanding of the potential impact of these climate trends, and incorporating a variety of investment metrics, including climate repricing risk, into our model portfolio construction process. Learn more about our Climate Unified Managed Accounts today. And for more information about The Great Repricing, download our white paper and watch Jeff’s TV show on Fintech.tv.

Increasingly, investors consider climate risk to be investment risk. So, what can you do to better manage risk and adapt to a world where climate may be an important consideration when pricing and valuating assets? Save the date for this year’s annual Climate & Capital Conference, hosted at the New York Stock Exchange during Climate Week NYC, and join thought leaders from the investment, business, and climate communities to discuss practical solutions to address climate challenges. Topics will include: Climate adaptation and mitigation Innovations in climate technology and data Regulatory updates, and much more This event will take place at the iconic New York Stock Exchange and broadcast simultaneously via livestream on Wednesday, September 20th, 2023. More info and detailed agenda to be released soon!

Did you miss our recent webinar? Climate change and other social and environmental risks are increasingly necessary integrations into investment management decisions. Yet navigating the sustainable investment landscape isn’t always easy for advisors that are new to the space. In this webinar, Jeff Gitterman and Penelope Jackson expand on several trends related to climate policy and offer ways to incorporate climate investing into your practice. Topics include: How does climate adaptation, innovation, and regulation impact pricing in the capital markets? What new technologies and improvements are in development to address a variety of climate solutions? How can your practice take advantage of these trends with the Gitterman Climate UMA? Our Unified Managed Accounts have the potential to simplify the investment management process on several fronts, while also providing many other attractive features that are not available in other investment products, such as: Strategies that incorporate physical climate risk and adaptation alongside ESG integration Market leading tax overlay capabilities, including customized transition management Access to institutional and boutique managers not normally accessible in a UMA Watch Replay Passcode: KjeN4B+& As we continue to bring innovative ideas to the marketplace, look for news of our future events!

Written by Jessica Skolnick, CFA and Adam Bernstein, ESG / Impact Analyst For the last several weeks, markets have been in a holding pattern awaiting clarity on the direction of future Federal Reserve decisions and, more imminently, a resolution to the debt ceiling limit debate. Treasury Secretary Janet Yellen announced last month that due to lower-than-expected tax receipts, the US government could run out of money as early as June 1st and has urged Congress to negotiate an increase prior to June to avoid the possibility of default. Failing to raise the limit would have unknown and potentially catastrophic consequences on markets and the economy. Congress has played chicken with the full faith and credit of the US government enough times that, so far, markets are generally taking this risk in stride. Yields have skyrocketed on Treasury bills maturing in June and credit default swap (CDS) premiums on US Treasury debt have widened but volatility has otherwise been muted. Equity markets have been rangebound for several weeks on light volume. While the consensus is that Congress will ultimately raise the limit as it has always done in the past, there is a nagging worry that this time may be different, and it appears that nobody wants to make any sudden moves until we see how it plays out. The Federal Reserve met on May 3rd and as expected, raised rates by 25 basis points to an upper limit of 5.25%. They removed language from their statement that said “additional policy firming may be appropriate” but stopped short of saying that a decision to pause at the next meeting had been made. Fed Chair Jerome Powell communicated in his press conference that the Fed will monitor ongoing stress in the banking system, incoming data on inflation and the labor market and the lagged effects of both Fed tightening and the credit tightening from banks to inform future rate decisions. As of May 17th, the market is pricing in a likely pause at the June meeting and then at least two rate cuts between now and the end of 2023,[1] in direct contradiction to Powell’s communication at the press conference: “We on the committee have a view that inflation is going to come down not so quickly. It will take some time. And in that world, if the forecast is broadly right, it would not be appropriate to cut rates. We won’t cut rates.”[2] This disconnect in forecasts poses a real downside risk to equity markets, which have thus far brushed off the longer term impact of the Fed’s aggressive rate hikes by penciling them in as temporary. If and when the market accepts that rates will not reverse to the abnormally low levels, there is a risk that equity valuations could drop as corporations will need to refinance debt at higher rates, compressing margins and hindering their ability to buy back shares. Recent inflation data indicates that the slowing trend seen over the last year may be stalling out above the Fed’s comfort zone and that more rate hikes may be needed. First quarter Core PCE, the Fed’s preferred inflation gauge, came in higher than expected at 4.9%[3] and well above the Fed’s 2% target. Overall CPI fell to 4.9% in April but the core figure, which excludes volatile food and energy, was 5.5% and has been stuck in a 5.5% to 5.7% range for several months. Rather than seeing the moderation in housing costs that the Fed had anticipated would soften inflation this year, rent of primary residence rose 8.8% year-over-year and owner’s equivalent rent rose 8.1%. Energy prices dropping 5.1% year-over-year and a large adjustment to health insurance CPI have pushed down prices.[4] As those effects fade, there’s risk that inflation will reaccelerate and the Fed will have to become more hawkish. The other side of the Fed’s mandate is to ensure full employment. If the economy experiences a hard landing and unemployment increases, they may be forced to cut rates even if inflation is above target. Despite headlines about layoffs in the Tech sector and some softening in recent employment data, we still have a very strong labor market relative to pre-pandemic norms. The March JOLTS survey showed 9.6 million job openings,[5] lower than expected but still well above the number of unemployed people, which at 5.7 million [6] is at the lowest level in 22 years. Weekly jobless claims have risen, most recently to 264,000,[7] but are still within the range considered normal prior to the pandemic. The most recent Bureau of Labor Statistics survey for April showed that the unemployment rate fell to 3.4%, the lowest level since 1969, while average hourly earnings accelerated to 0.5% month-over-month, the strongest gain in over a year.[8] Given the ongoing stress in the banking system, we are not ruling out the possibility of a significant reversal of fortunes in the job market that would necessitate rate cuts, though that scenario would be much more negative for equity markets than what is currently priced in. The Energy System, the War in Ukraine, and the Energy Crisis Before the COVID pandemic and the Russian-Ukraine War we were already experiencing issues with surging global energy demand and declining supply, which had manifested in surging prices, grid failures, and rolling blackouts around the world. Oil and gas discoveries have not matched our annual consumption since 1975, with current findings only meeting 15-20% of our needs. While there may be potential for future supply, conventional energy sources are unreliable. Consequently, we need to explore a new energy mix to meet growing demands. Oil production everywhere except Russia, the US, OPEC nations, and Brazil was in decline regardless of price, and there seems to be no material proven oil reserves left besides these regions. While it is possible that we may yet uncover new untapped supply, relying upon conventional energy generation sources alone is tenuous at best. The world will need a new energy mix to meet our evolving demand. Climate investors and activists would like us to transition from traditional fuels to 100% renewable energy. But renewables are not without their problems; intermittency, cost of energy storage, dispatchability, raw material supply chains. The technology required to realize a net-zero compliant energy mix, to make renewables the lion’s share of the energy supply, is not yet commercially available. In the meantime, we must find ways of being more efficient with the solutions that work today with the current infrastructure because climate change is not only a massive issue to solve but a time sensitive one. Energy independence moved to the top of the developed world’s priority list once the Russia-Ukraine War began last year. The turmoil caused by the war prompted a drive to export US oil and gas to European allies. This occurred concurrently with President Biden’s efforts to pass the Inflation Reduction Act, sending the market a series of mixed signals.[9] The war helped make the case for and hasten the usage of renewable energy in many developed countries since renewable energy was a power source everyone has abundantly within their own borders. But this quick shift away from Russian oil also made it clear that the world was not yet ready to run entirely on renewable energy sources, especially when accounting for the price individuals pay for energy. The faster we transition our energy generation sources from fossil fuels to renewables, the more expensive it will be for everyday citizens (though this can be mitigated by appropriate government subsidies and infrastructure). The politics around who should shoulder this price is where we get into political gridlock. To aid Americans having to pay higher price at the pump and our European allies, the Biden Administration decided to release oil from the Strategic Petroleum Reserves (SPR), which is now at extremely low levels. The strategy worked at first. Energy prices slid back down as China and other economies came out of their pandemic restrictions and supply chains normalized. But in possible retaliation, OPEC+ announced surprise output cuts on April 2nd of 1.2 million barrels per day sending prices up immediately. More recently the Biden administration’s approval of The Willow Project, a $600 million oil project in Alaska encompassing 200 oil wells sent more mixed messages to the market. As a recent Guardian article stated, “Biden may have promised there would be no drilling on federal lands during his campaign, but the reality has been very different given the tricky political landscape. All members of Alaska’s congressional delegation, including newly elected Democrat Mary Peltola, called for Willow to be approved, citing thousands of new jobs.” Biden himself appears to share this view – in his recent State of the Union speech, the president said, “we’re going to need oil for at least another decade, before adding and beyond that.”[10]

By Jeff Gitterman In my travels to various conferences and my connection to many RIA firms, I keep hearing an increasingly familiar story. “The growth of my practice is shrinking due to market declines and the passing of my clients as they age, and it’s the first time in years that I have to market for new clients.” A firm’s future valuation can be impacted if these observations go unaddressed. 2022 brought a ten percent increase in RIA acquisitions,[1] yet declining asset growth at the firm level over the same timeframe reveals the advisor’s dilemma. The median age of an advisor is on the rise,[2] and sadly, as the clients of these advisors also continue to get older, their mortality rates will increase, while the retention of next generation heirs tends to be very poor.[3] I often hear from other advisors that either their technology platform or investment options don’t meet the needs of the heirs of their clients, who in general are much more interested in values-based investing.[4] Add in increasing complexity due to product proliferation, changes in technology, and regulatory overload, and it is clear that the present-day advisor faces numerous challenges retaining the next generation of clients. Unified Managed Accounts (UMAs) have the potential to simplify investment management and give time back to advisors, while also providing attractive features that next generation clients can find appealing enough to stick around. As examples, UMAs allow a client to own their own cost basis, which can be attractive to heirs inheriting a stepped-up basis, and are housed under a single contract to simplify the account opening process. Additionally, our UMAs offer values screens, ESG diligence, and a focus on the risk and opportunities inherent in the marketplace due to climate change, which is often an expressed interest to a variety of investors, and offer the potential to solve many of the above pain points.