Explore the Thinking behind our investment approach

When evaluating ESG portfolios, a very important question to ask is if ESG data is being used as a process of evaluation, or is it being sold as a product? ESG as a product refers to the data that companies like MSCI, Sustainalytics, and Thomson Reuters put out. These data products overweight high-scoring companies and underweight low-scoring companies to populate the constituents of an investment. Alternatively, a widespread practice of asset managers today uses ESG as a process, because buying multiple data sets creates a 360-degree perspective of a company. And by this, we mean that they have a process of looking at as much data as they can and making buy and sell decisions using that data along with traditional financial metrics. What we really need to evaluate, and we have been saying this for years, is the scoring methodology behind the data, because different data providers may say very different things about any given company. Scores among data providers can vary greatly, as each company has its biases about what the data means. So, the scores are arbitrary to a degree, but the data itself is not arbitrary. As an example, many years ago, several data providers gave Pacific Gas & Electric (PG&E) one of the best topline ESG scores, certainly of any utility, because it was converting a high number of its clients to renewable energy. And yet, if you looked under the hood of those scores, PG&E had been self-disclosing for years that they had high risk of fires due to extensive droughts throughout California. So, managers that were using ESG as a process looked at all of that data and avoided owning PG&E, while managers that simply looked at PG&E’s topline data as a product owned the utility in droves. It is a lot of work, but any good manager, in our opinion, is engaging with ESG by process: buying and analyzing the data themselves and essentially throwing out the topline scores. When we look at ESG data, we analyze c-suite governance, such as board composition. Is the board diversified, with a cross-section of voices representing the customers that buy the product or service? Do they have an experienced compliance officer? Have lawsuits occurred due to controversies or lack of oversight? These are things we want to know. Where does employee satisfaction rank as a leadership priority? Wouldn’t you want to own companies that treat their employees well? And do you think a company that does so has an edge, especially in a world of low unemployment where attracting good employees is difficult? In terms of environmental factors, do you think there is a concern if a company is polluting local areas where their customers and employees live? Do you think this is relevant to the future of a company’s valuation? We view these insights as essential, and you won’t get this depth of information from a 10-K. ESG data sets are robust, and they are also evolving. It does take some work to bring them into an investment framework, but it is important to understand that clients are not picking companies because of ESG data. Asset managers pick companies because they have a theme that they are tracking. Let’s say that a manager wants to own 10% in airlines, and they have narrowed that search down based on financial metrics to three companies. But then, if they look at the ESG data of those three companies, they might find that one company has an edge over the other two because of factors such as better governance, treatment of employees, customer relations, etc. This kind of data complements traditional financial metrics when used as a process to help measure intangible risks. Think about companies like Google, Apple, Facebook, and Netflix. Are people really investing in these companies purely due to financial metrics? No. They are being bought because people understand that brand loyalty, especially with certain companies, is a huge factor in their investment. In conclusion, not all ESG approaches are alike. While ESG scores may vary across data providers, it is the materiality of the data beneath the scores that we find most compelling. As more of a company’s value is derived from intangible risks, clarifying the difference between ESG as a process and ESG as a product enables us to maintain higher fiduciary standards for our clients.

At Gitterman Asset Management, we refer to ESG as the GPS of Investing®. Just as we historically used fold out maps when we would take a road trip, we now have GPS systems, which update constantly and include numerous additional data sets to make our trips smoother, easier, and quicker. We now know more about road closures, traffic, and any of the other real-time issues and situations that might hinder our trip than ever before. To us, ESG is the same thing. Just as most financial professionals primarily used traditional financial metrics to evaluate companies, we now have access to a nearly unlimited amount of non-financial, but material, data sets to help with our investment decisions. ESG data sets are simply that—data sets. This information does not tell us what to buy or sell. It is simply additional information. And while environmental, social, and governance, or ESG, may not be the best name for this data, political attacks on ESG as “woke” investing come from a misunderstanding of what it actually is. We don’t know of anyone driving around today complaining that GPS is “woke” driving, do you? ESG data is not thematic or values-driven, and this needs to be made clear. It is simply additional due diligence about the companies we are looking to invest in. It has nothing to do with stock selection around sectors or themes, and it will not disappear, because no asset manager is going back on utilizing this data once they have started. They might stop talking about it, or referring to it as ESG, but they are not going to stop using the data itself. What has to be made clear to the general public is that questions about values and not wanting to own things like tobacco, guns, or fossil fuels, etc. are irrelevant to ESG. They are two different lines on the highway that do not meet. Now, could we use ESG data to evaluate companies within a theme? Absolutely, but ESG data does not tell us what themes to pick. The current and increasing political attacks on ESG are largely driven by the fossil fuel lobby as a well-orchestrated attack against the divestment from fossil fuels. Yet ESG has nothing to do with this, and the best thing our industry can do is to keep bringing this point home. If someone wants to attack divestment funds and say they are anti-trust, etc., then the focus of the conversation should be on divestment from fossil fuels as the elephant in the room and the argument. ESG data, by nature, does not say anything about owning or not owning fossil fuels, and it doesn’t tell us what to divest from. We can also get full ESG data sets on fossil fuel companies, and this data can be used to help us pick the most compelling companies to invest in. The fossil fuel industry is a part of nearly every product we use today. Our clothes, headphones, iPhones, microphones, and the Blistex that we put on all have petroleum in it. We can’t just stop producing petroleum tomorrow and have a livable world. Bipartisan discussions are what we need now to reduce emissions in a way that does not leave people behind and makes sense for everyone. Reducing ESG data sets to ideological arguments does little to make any of us better investors. Our planet is more fragile than we once thought it to be. Navigating a way forward with data, like a GPS system, may help us find a way home faster.

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.