Explore the Thinking behind our investment approach

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.

With ESG and climate-focused investing becoming ever more prominent, increased SEC regulations around climate disclosures will hopefully help to increase corporate transparency and separate the legitimate from the greenwashed. Jeff recently attended the CERES Banking for Net-Zero Alliance Conference in NYC, where he had the opportunity to sit down with Tom Steyer, former Democratic Presidential Candidate and Co-Executive Chair of Galvanize Climate Solutions, to talk about the proposed SEC regulations, transition finance, and the Inflation Reduction Act. Mr. Steyer is a huge supporter of transparency, data, and information, seeing them as the 21st Century ways to solve 21st Century problems. And while he understands that the transition to a green economy needs to happen fast, he also realizes that it needs to be practical. Hear more of what he has to say in this concise 5-minute interview with Jeff.

“Let me say this. It is very premature to be thinking about pausing. So people, when they hear lags, they think about a pause. It is very premature, in my view, to be thinking about or talking about pausing rate hikes. We have a ways to go.” ~Fed Chairman Jay Powell, FOMC Press Conference, 11/2/2022 “Restoring price stability is of paramount importance because it is the foundation of sustained economic and financial stability. Price stability is not an either/or, it’s a must-have.” ~NY Fed President John Williams, 11/16/2022 “Pausing is off the table right now, it’s not even part of the discussion. Right now the discussion is, rightly, in slowing the pace.” ~SF Fed President Mary Daly, 11/16/2022 _______________________________________ Markets and Macro Update After a difficult September that saw the S&P 500 Index fall over 9%, the S&P rallied over 8% [1] in October on still-unrealized hopes for a monetary policy pivot from the Federal Reserve. On November 2nd, the Fed decided to hike the Fed Funds rate by another 75 bp. In the press conference that followed, Fed Chair Powell reiterated that controlling inflation is their top priority as long as the labor market remains strong and that they are nowhere near the long-anticipated “pivot.” Though Powell indicated the pace may slow down in coming months, as 75 bp per meeting is a very aggressive pace, the Committee gave little guidance on the terminal level of rates where they would feel comfortable pausing. They instead will monitor the inflation and labor market data to drive their decisions. Following the Fed meeting, on November 10th, both core and headline CPI surprised the market, coming in lower than expected. Headline CPI rose 7.7% year-over-year (compared to a forecast of 7.9%) and Core CPI, which excludes food and energy, rose 6.3% vs an expected 6.5%. [2] This inflation release sparked a massive stock rally. The S&P rose 5.5% in one day, its biggest one-day gain in years. The 2-Year US Treasury yield dropped more than 20 bp in a single day as the market quickly started pricing in a more dovish Fed that will bring inflation under control sometime in the first half of next year and perhaps begin cutting rates back to “normal” before 2023 is over. Sounds fantastic right? Unfortunately, we don’t expect that it will play out quite so simply. Despite the “will-they-or-won’t-they-pivot” roller coaster of the past several months, our view has remained largely unchanged through the Fed meeting and the CPI print. Powell’s press conference comments, and more recent comments by other Fed presidents including the two above, indicate that not much in the Fed’s thinking has changed either. While CPI was lower than expected, the underlying constituents paint a less optimistic picture. More than half of the downside surprise resulted from the health insurance index, which plummeted for technical reasons that don’t reflect real world price declines and dragged CPI down by 0.11%. Importantly, this health insurance adjustment is not used in calculated Core PCE, the Fed’s preferred measure of inflation. Services CPI is stickier than goods CPI, which makes it more of a concern to the Fed. It was up by 7.2% in October, slightly less than September’s 7.4%, remaining near the worst level since August 1982. It is possible, though far from certain, that CPI has peaked for the cycle but there is still a long way to go until the Fed’s 2% target is reached. Meanwhile, the labor market remains very strong. JOLTS job openings were at 10.7 million in September, higher than the 9.8 million expected. [3] More jobs were added to the economy than expected, according to both the ADP Employment Change [4] report and the Non-Farm Payroll [5] report for October [6]. The unemployment rate rose slightly from 3.5% to 3.7%, still near historic lows. While reports of layoffs have increased in recent weeks, particularly within the tech sector, we don’t expect that to materially impact the broader labor market enough to change the Fed’s course in the near term. Not all of the layoffs will affect US-based workers and there remains significant unmet demand for labor from other sectors of the economy. Our base case scenario continues to be that the Fed does what it is telling us it is going to do, namely, to continue to raise rates (and hold them at higher levels) until inflation is under control, at least as long as the labor market remains tight. We also realize that the breakneck pace of rate hikes in an overleveraged and geopolitically treacherous world can (and likely will) result in “something breaking” that could force the Fed to loosen policy in response. Neither the base case nor the “pivoting in response to crisis” case is positive for risk assets like stocks, so we are remaining underweight to equities until our outlook meaningfully changes. COP27 COP27 kicked off last week on November 6th in Sharm El-Sheikh Egypt marking 30 years since the United Nations Framework Convention on Climate Change (UNFCCC) was adopted and seven years since the Paris Agreement was signed at COP21. The “Conference of the Parties” or “COP” brings together the governments that have signed the UNFCCC, the Kyoto Protocol, or the Paris Agreement in order to jointly address climate change and its impacts. Since 2015, under the legally binding Paris Agreement treaty, most countries have committed to undertaking three tasks: 1) Keeping 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. To get all 194 countries to sign onto the legally binding Paris Agreement, it was written in a way that allowed for a “bottom-up” approach where individual countries decide what actions they will take. For example, on the topic of climate mitigation each country set its own emissions reduction targets and timeline, to be revised and raised every five years. Member counties have had to submit and periodically update a National Adaptation Plan, detailing approaches to reduce physical vulnerability and to add durability and resilience to critical and public infrastructure. Now that the groundwork of setting goals and a system to measure our progress has been achieved, COP27 has the task of focusing largely on compliance and enforcement of what has already been established and trying to bring global focus to climate issues at a time when inflation, recession, an energy crisis, and war are all vying for resources and solutions. COP27 Goals and challenges [6] COP26 was the first test of the Paris ratchet mechanism, which was designed to increase the level of emission reduction for every country, every five years. Because emissions cuts promised ahead of COP26 remained insufficient to limit global warming to the agreed upon levels, the summit ended with “The Glasgow Climate Pact” calling for countries to put forward strengthened targets this year. While COP27 was not originally a major milestone on the Paris Agreement calendar, the unfinished business of Glasgow means it will now be a critical test of whether the international process can respond to the increasing urgency of the situation. Another major challenge that will be faced by COP27 is the issue of COP26’s failure to deliver on promises of regular climate finance. Developing countries are hoping developed countries will honor their commitments to provide $100 billion in climate finance annually from 2020 to 2025. So far, they have not. Grading COP Progress The Global Stocktake (GST) is the mechanism to assess the world’s collective progress towards fulfilling the Paris Agreement, happening in a five-year cycle. COP27 will host one of three Technical Dialogues as part of the 2021-23 GST.[6] The outcomes of the GST are intended to inform member countries, negotiations, and enhance international cooperation for climate action with the aim of increasing ambition. Unfortunately, as it stands the expectation of the results for COP27 are not expected to be favorable.