Explore the Thinking behind our investment approach

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.

In recognition of Black History Month, we would like to honor Adasina Social Capital Founder and CEO Rachel Robasciotti as a leading voice in racial and social justice investing. Rachel stands among a group of accomplished women shaping capital markets as a female manager and minority firm owner. “Social Justice movements are often early indicators of risk in public markets” ~ Rachael Robasciotti[1] Rachel has built Adasina Social Capital to create large-scale, systemic change in four interlocking areas, using community sourced research and impact goals. By partnering with social justice organizations within communities identified as most impacted by racial, gender, economic, and climate injustice, Rachel and her team have developed the Adasina Social Justice Investment Criteria, a data-driven set of standards that guide their investment strategies to reflect social justice values and advance progressive movements for change.[1] Beyond their signature social investment criteria, Adasina mobilizes investors to drive long-term impact through campaigns and education, ensuring that values-aligned investors are working in solidarity with one another and, more importantly, with impacted communities. By combining financial experience with community-based wisdom, Adasina serves as a dynamic resource for financial and social justice activists to learn, spread awareness of, and take actionable steps towards building a more regenerative world. For clients seeking a bridge between financial markets and social justice movements, the Adasina U.S. Large Cap SMA is now available exclusively through Gitterman Asset Management. We are committed at Gitterman to moving the needle up from 1.4% of assets owned by women and minority led firms within the $82 trillion US asset management industry.[2] Thank you, Rachel for opening the way towards large-scale, systemic change and bringing a much-needed voice to the public markets.

Writing this commentary from the third week of January, it feels like we could dust off some older blogs or commentaries to reuse because the pattern we saw play out in between Federal Reserve meetings throughout 2022 is happening once again. Through January 17th, the S&P 500 is up 4.0% [1] year-to-date. International equities are performing even better. The MSCI EAFE Index and MSCI Emerging Markets Index have both returned 7.5% [2] so far this year. Interest rates across the US Treasury curve have fallen and the Barclays US Aggregate Bond Index has consequently rallied 2.6% [3] year-to-date. What gives? Following a difficult 2022 and a risk-off December, what changed when the clock struck midnight on January 1st and ushered in 2023? In our opinion, not a whole lot aside from the same rejection of Fed messaging that we saw multiple times last year in between FOMC meetings. At the December FOMC press conference, Fed Chair Jerome Powell insisted that rates were likely to top 5% and stay there without any rate cuts planned for 2023, barring unforeseen calamity. But the market has chosen to disagree, as shown in the two figures below [4]: Source: Bloomberg The first chart shows the current market forecast for the Fed Funds rate for the next year. It shows that the market expects the Fed Funds rate to peak below 5% at the May meeting and then it expects the Fed to begin cutting rates in July. The second chart takes a longer view and shows the market Fed Funds rate forecast against the Fed’s December dot plot out until 2026. The dot plot is the Fed’s own forecast, and each dot represents one Fed member. The light blue line is the market forecast at the time of the last Fed meeting and the darker blue line what the market was expecting as of Jan 11th. Despite the dot plot moving higher at that meeting and the Fed’s messaging growing more hawkish, the market forecast has actually fallen lower and the disconnect has grown. Whether you believe the market forecasts or not, they matter a lot to shorter term market movements. Assets are almost always valued with the discount rate (or the risk-free rate) being a key input. As rate expectations fall, valuations across all asset classes should rise, which is what we have seen so far this year. Unfortunately, we still think the market is getting this one wrong and the January rally is likely to be short lived, for the following reasons: Fed credibility: After insisting that inflation was transitory throughout 2021 and then falling sharply behind the curve in 2022, the Fed is aware it has a credibility problem. We are choosing to take the Fed’s communications at face value in the absence of a compelling argument that we shouldn’t. At the December FOMC press conference, Chair Powell said that the labor market remained very strong, fighting inflation was the Fed’s top priority, and that rates would remain elevated as long as necessary to achieve price stability. The labor market: The labor market remains in disequilibrium despite some recent layoffs in the tech and financial sectors. Whatever the cause, death and disability among the working age population are on the rise and there is a structural shortage of workers as a result. The WHO estimates that there have been 14.8 million excess deaths globally in 2020 and 2021 [5] and insurers reported a 40% increase in working age deaths in 2021 [6]. The labor force participation rate remains stubbornly below the pre-pandemic norm at just 62.3% and the unemployment rate of 3.6% [7] is near multi-decade lows. A big enough slowdown will eventually cause unemployment to increase but it will take much longer than in prior slowdowns to do so given the missing workers. Inflation: It is true that we have seen some relief on the inflation front, but not nearly enough yet. Headline CPI fell from 9.1% in June 2022 to 6.5% in December 2022 [8] but is still well above the Fed’s 2% target. While the earlier drivers of inflation like durable goods and energy have started to turn negative, inflation in services is up 7.5% year-over-year in December, the highest since 1982. This is concerning because services inflation is more closely tied to wages and tends to be stickier. Inflation also remains vulnerable to upside surprises if energy or commodity prices increase as China reopens. The market expects inflation to return to the 2% level by year-end, which we think is unlikely given longer term inflationary forces like the trend towards re-shoring/” friend-shoring”, climate change and the worker shortage discussed above. All of this has been a long-winded way to say that our view hasn’t changed much since our last commentary. We aren’t ruling out the possibility that the market is correct, and we (and the Fed) are wrong, but we just don’t see the evidence to support that yet. In our view, the Fed will only pause or pivot before inflation is fully under control if “something breaks” and rate hikes push us into a hard landing or worse, hardly a good situation for risk assets. So, we’re remaining defensive with our exposure to equities and credit, which will face challenges in either scenario. We are also maintaining our underweight to duration (ie interest rate risk) in our bond portfolios because we don’t believe the full extent of rate hikes are priced in. We’re closely monitoring the inflation and employment situation, as well as messaging from the Fed, for any indications that it is time to update our rate outlook. Market Update Economic and market conditions remained challenging into the fourth quarter of 2022, concluding a year dominated by surging inflation, Russia’s brutal invasion of Ukraine, and aggressive monetary tightening. Both stocks and bonds suffered large losses, making 2022 the worst year for a balanced portfolio since 2008 with the average 60/40 portfolio down 16.0% [9] and the S&P 500 down 18.1%. [10] Energy stocks were the year’s clear winners with the sector up 64.3% [11] as rising oil and natural gas prices sparked by OPEC production cuts and ripples from Russia’s attack on Ukraine contributed to big gains for the sector. Defensive sectors such as consumer staples (-0.80%), healthcare (-2.04%), utilities (1.47%) broadly lived up to their name, protecting against some of the year’s steep declines [12]. The S&P Midcap 400 outperformed the large cap S&P 500 by about 5% and the small cap Russell 2000 lagged the S&P 500 by about 2%. Generally, smaller cap stocks tend to be more volatile, both on the upside and downside, than larger cap stocks. So, the relative performance of mid and smaller cap stocks this year was strong given the large drop in the market that occurred. One likely reason for this was the dollar’s strength, a bigger headwind for U.S. multinational companies because large cap stocks tend to have a bigger global footprint than smaller cap stocks. It was a terrible 12-months for growth stocks, which had their worst calendar year in over a decade as value took back the leadership role. Prior to last year, the growth index had consistently outperformed the value index since 2008. In 2020 and 2021, tech stocks drove big gains pumping up growth and leading to some of the widest performance gaps for style investing on record. But these valuations quickly evaporated in the face of rising interest rates. Growth oriented sectors such as technology (-27.7%) communication services (-37.6%) and consumer discretionary (-36.3%) performed worst this year with notable stock blowups in Amazon (-49%), Tesla (-68%), and Meta (-66%) [13]. Regionally, developed markets outperformed the US despite the stronger dollar and impact of the war in Ukraine on Europe. The MSCI EAFE Index lost 13.9% compared to the S&P 500’s loss of 18.1% [14]. A milder winter and lower energy prices than had been expected boosted European returns in the fourth quarter. The MSCI Emerging Markets Index underperformed the US, losing 19.9% in 2022 [15], dragged down by an underperforming China but helped somewhat by outperformance from commodity-exporting Latin American countries. The Fed’s aggressive interest-rate increases drove yields higher across the bond market, but especially among short-term bonds. The U.S. Treasury 10-year note climbed from 1.5% at the end of 2021 to a high of 4.25% for the year in October, its highest level since 2008, and finished the year at 3.8% [16]. The 2-year Treasury rose from just 0.7% at the beginning of the year to 4.3% at the end of 2022 [17]. This yield curve inversion can be a sign of investor pessimism about the economy, and persistent inversions like we saw last year almost always result in recession. Ultrashort bonds and floating-rate debt offered the only bright spots for bond investors. Ultrashort bonds were kept afloat by their very short maturities, which make them less sensitive to changes in interest rates. Overall, the Bloomberg US Aggregate Bond Index lost 13% in 2022, the worst performance since the inception of the index in 1976 [18].

Last week, at the final FOMC meeting of 2022, the Federal Reserve raised rates by 0.50% (to a range of 4.25% – 4.50%) as expected while unexpectedly increasing its dot plot forecast of where it believes rates will be in 2023 and beyond. Notably, the expectation for the Fed funds rate at the end of 2023 was raised to 5.1%, a big increase from the 4.6% expected at the September meeting. The Fed also revised its estimate for 2023 GDP growth down to just 0.5% and increased its inflation expectations.[1] In the press conference following the meeting, Fed Chairman Jerome Powell clarified that the dot plot implied no rate cuts at all in 2023, throwing cold water on those hoping for an imminent pivot. The initial market reaction was disbelief. The Fed’s surprising hawkishness was enough to halt the stock market rally that had begun in October but was not enough to trigger a serious selloff or a repricing of forward rate expectations. In fact, Treasury rates were flat or fell slightly from the time of the meeting through the end of the week. The skepticism was understandable. November CPI did show encouraging signs of slowing, coming in at 7.1% compared to 7.7% in October.[2] Layoffs from the tech and financial sectors have started to hit the headlines. In a normal market environment, the Fed skeptics would be correct to question such a hawkish path but, as has been the theme of this decade, nothing about this situation is normal. Out of everything that makes this time different, the labor market is the most crucial to understand. In a normal rate hiking cycle, high inflation causes the Fed to raise interest rates to slow demand, which reduces inflation. Higher interest rates also increase costs to businesses and ultimately result in rising unemployment and recession. The Fed’s challenge is to manage the tradeoff between keeping inflation in check while minimizing the pain inflicted on regular people. But now the Fed finds itself in a unique position. It is hiking rates against the backdrop of a structural labor shortage that is both exerting upward pressure on inflation (via rising wages) and providing the Fed more leeway to raise rates before the impact on workers becomes politically untenable. Powell explicitly addressed the labor shortage in last week’s press conference. He described it as structural rather than cyclical and estimated that around 3.5 million workers are “missing” from the labor force, attributing the gap to early retirements, reduced migration and half a million excess deaths among workers since the start of the pandemic. We agree with all of the above but would add Long Covid disability, the opioid crisis, and childcare issues to the list of labor shortage causes that are unlikely to resolve in the short-term. Whatever the drivers of the labor shortage, what are the implications for Fed policy and, by extension, the market and economic outlook for next year? Quite simply, the Fed can (and may be forced to) raise rates to a higher level and keep them there for longer than it has in the past before seeing a negative impact on workers. If a recession begins, corporate layoffs may not be at the same scale as in prior recessions as companies have been struggling to hire workers for a couple of years. There is no glut of boom time workers to lay off, aside from the tech sector, since over hiring hasn’t been possible. Managers who learned from experience may hoard the workers they do have while cutting costs elsewhere. Unlike prior hiking cycles, the brunt of the pain of rate hikes looks like it will fall on corporate profit margins and risk asset valuations rather than on average Americans, at least until the labor market normalizes. We don’t expect a pivot from the Fed until after the unemployment rate begins to increase and expect equity returns to be weak or negative for some time past that point. We are also preparing for another leg down in the bond market as interest rates price in the Fed’s new dot plot and corporate bonds begin to price in rising default risk from a near-certain 2023 recession. We are maintaining a very defensive stance in our portfolios, which are underweight equity and overweight cash with a short duration high quality bond allocation. Finally, Some Good News: A Breakthrough in Nuclear Fusion What happened? On December 5th, U.S. scientists at the National Ignition Facility in California generated a nuclear fusion reaction that created a net energy gain, an important breakthrough in the search for a clean and affordable energy future. The experimental result is a massive nuclear energy breakthrough in a century-long quest to harness fusion energy. What is nuclear fusion? Nuclear energy as we know it today comes from fission reactions, which split atoms to release energy. Nuclear fusion is the process of fusing two atoms into a single atom, which releases a tremendous amount of energy. Nuclear fusion is the reaction that fuels the stars in our universe, including our sun. Why is it important? Ever since the theory of nuclear fusion was understood in the 1930s, scientists and engineers have been trying to recreate and harness it. If nuclear fusion can be replicated at an industrial scale, it could provide virtually limitless clean, safe, and affordable energy to meet the world’s energy demand. Fusing atoms together in a controlled way releases nearly four million times more energy than a chemical reaction such as the burning of coal, oil or gas and four times as much as nuclear fission reactions. Fusion has the potential to provide the kind of baseload energy needed to provide electricity to our cities and our industries. Investment implications: There are about 35 companies currently working on some form of nuclear fusion. The U.S. government has invested in nuclear fusion programs since the 1950s, but all the money has gone towards national labs, universities, and the Primary International Research Project in France (ITER). This year marks the first time that the US government has invested directly in private sector fusion energy companies. Notable recent raises for companies seeking to commercialize fusion include Commonwealth Fusion Systems, TAE Technologies Inc. and Helion Energy Inc. Other fusion companies that have landed significant backing include Marvel Fusion GmbH, General Fusion, Tokamak Energy Ltd., and Zap Energy Inc. Perspective: “Whereas a giant pile of carbon-spewing coal might generate electricity for a matter of minutes, the same quantity of fusion fuel could run a power plant for years–with no carbon dioxide emissions.” – NPR Fusion offers an exciting new opportunity in energy generation. If commercialization can be achieved, this form of energy would solve the intermittent issues with renewable energy sources such as solar and wind and provide a base load energy source like hydrocarbons and nuclear energy without the health, safety, environmental, and raw material supply chain issues. But there is still a way to go. About 300 megajoules of energy were needed to fire the laser that was used in the fusion experiment, while the reaction showed a net gain of only about 1.1 megajoules (barely enough energy to boil a teakettle 3 times). The private fusion industry has seen almost $5 billion in investment, according to the industry trade group, the Fusion Industry Association, and more than half of that has been since the second quarter of 2021. It took 11 years and billions of dollars to set up and successfully execute this one laser test. So, we still have a long road ahead of us before commercialization can be reached. Using history as a guide, it took the world 37 years to split the atom, from that start of atomic research in 1895, until the first atom was split in 1932 at a laboratory in the UK. It then took another 28 years for the world to commercialize this process for use within the energy grid, with the first nuclear power plants going operational in 1957. While the promise of fusion to solve our most pressing energy and climate issues is unmatched, the uncertain timeline means that we must continue to invest in renewables and other emission reduction technologies.

In 2010, the Institute for Sustainable Infrastructure was formed through a collaboration of the American Society of Civil Engineers, the American Public Works Association, and the American Council of Engineering Companies, in response to the growing need for a consistent and consensus-based approach to sustainability in infrastructure. While historically, infrastructure in the United States (transportation, energy systems, water, waste, telecommunications, environmental systems, etc.) has generally been the purview of the public markets, a current shift is taking place that offers more opportunities for private investment in this space. Jeff recently spoke with Anthony Kane, CEO & President of the Institute for Sustainable Infrastructure, about emerging private opportunities for investing in infrastructure, which he says is taking place largely through public-private partnerships and green bonds. While the new Bipartisan Infrastructure Law and the Inflation Reduction Act are great steps in the right direction, Anthony says that $2.5 trillion of additional private funding will be needed to solve many of the current infrastructure issues over the next 10 years.