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By Jessica Skolnick, CFA and Adam BernsteinMacro and Markets UpdateAs we pass the halfway point of the final quarter of 2023, we find ourselves in another risk-on rally fueled by hopes of an imminent soft landing accompanied by sooner-than-expected rate cuts by the Federal Reserve. The sentiment is a sharp reversal from where we were last month when we published our last commentary. The S&P 500 lost ground in August, September, and October,1 the longest monthly losing streak since early 2020. The 10-year Treasury yield had risen in each of the previous 6 months through the end of October and briefly touched the key 5% level on October 19th.2 Markets seemed to be accepting the Fed’s message of higher-for-longer rates and processing the implications of that on asset prices.The FOMC meeting on November 1st turned the market’s frown upside down, though we are not sure anything has really changed. As expected, the Fed left the Fed Funds rate stable at 5.25%-5.50% and released a statement upgrading economic growth from “solid” to “strong”, acknowledging moderation in a still-strong labor market and indicating that the rise in long-term rates exerted some financial tightening in addition to their monetary policy tightening effects.3 Fed Chair Jerome Powell made it clear in the post-meeting press conference that rate cuts are not part of the discussion, since inflation remains above the Fed’s 2% target: “The Committee is not thinking about rate cuts right now at all. We are not talking about rate cuts.”4The market glossed over Powell’s statements and immediately began pricing in additional rate cuts in 2024, widening the gap between the Fed’s dot plot and market forecasts even further. The median dot plot projection for year-end 2024 is 5.125% (implying one rate cut), while the market’s forecast is just 4.41%, indicating nearly four rate cuts in the next 13 months!5 Stock and bond markets did what they have done every time a phantom pivot has been priced in. The 10-year fell from 4.93% on the morning of the Fed meeting to 4.64% on November 13th, and the yield curve inversion between the 2-year and 10-year Treasury more than doubled from 15 bp to 40 bp, while the S&P 500 rallied nearly 5% over this same timeframe.Meanwhile, nothing much has changed in the underlying data or in the Fed speak following the meeting. The labor market has weakened slightly but remains strong by historical metrics. Job openings were at 9.5 million in September, compared to a 5 million average in the decade preceding the Covid pandemic.6 The September non-farm payroll report was a bit weaker than expected, primarily due to ongoing labor strikes rather than layoffs or other signs of reduced labor demand. October Consumer Price Inflation moderated to 3.2%, but the core measure remained elevated at 4.0%,7 twice the Fed’s target, and the November University of Michigan survey showed short and long-term inflation rose to the highest levels in over a decade.8The Fed may stay in an extended pause given the precipitous fall in long-term rates, little indication of a growth slowdown and falling inflation that remains above target, but the catalysts for actual rate cuts are absent. Premature rate cuts against a solid economic backdrop risk a reacceleration in inflation that the Fed wants to avoid. A hard landing scenario in which rate cuts are necessary would not support the risk-on sentiment currently present in the market.ESG Update – Divergent Energy ViewsInternational Energy Agency:The International Energy Agency (IEA) just released its 2023 World Energy Outlook report that predicts, for the first time, that global oil demand will reach its peak this decade. The predicted peak for oil, which also extends to cover coal and natural gas, does not mean a rapid plunge is imminent, but the IEA forecasts a downward slopping plateau over several years.9Source: IEA, BloombergThe IEA prediction hinges on a few key assumptions:1) The economics of the energy transition are gaining momentum. The Levelized Cost of Electricity (LCOE) is a metric used to estimate the average cost of generating one unit of electricity. It is a useful measure for comparing the cost-effectiveness of different energy sources or technologies. It depends on the asset and location but generally, solar, on-shore/off-shore wind, and geothermal energy production have cheaper LCOE pricing than traditional energy sources, such as coal and gas, and this trend is accelerating.2) Demand for oil in petrochemicals, aviation, and shipping will likely continue to increase until at least 2050, but this increase in demand will be more than offset by the lower oil demand for transport as the growth in electric vehicles continues to rise.103) China is expected to represent about 40% of global oil demand in 2023.11 Said another way, China holds the key to shifting global energy demand. China’s oil demand is facing structural decline, due to record growth in the installation of new low-carbon energy sources.Organization of Petroleum Exporting Countries (OPEC):OPEC predicted in their 2023 annual outlook that oil demand will continue to grow for decades, reaching 116 million barrels a day in 2045. This prediction represents a 16% increase in demand and 6 million barrels a day more than previously predicted. To reach these numbers, OPEC has India more than doubling its consumption, and China increasing oil demand by 26%.12Big U.S. Oil:13U.S. supermajors are also taking a dissenting stance. ExxonMobil’s recent venture into acquiring shale producer Pioneer Natural Resources and Chevron’s latest deal to absorb Hess mark a substantial consolidation within the Big Oil landscape, a scale not witnessed in two decades. These corporate unions seem to challenge the International Energy Agency’s (IEA) prognosis of a shrinking demand for oil, or, at the very least, position these expanded U.S. giants strategically as the enduring producers poised to meet the anticipated demand lingering into the mid-century. By reaffirming their commitment to oil, U.S. corporations are accentuating the growing gap with their European counterparts, who are cautiously tiptoeing into the realm of clean energy initiatives.Supermajors grapple with marketing a declining product but strive to be among the last standing. Anticipating reduced demand, they focus on being low-cost providers, making these deals viable even in a shrinking market. The production cost curve in commodities implies that if your cost of production is low enough, your risk is minimal. Businesses who operate in the oil & gas sector are used to earning certain return profiles. Renewables, however, tend to be both lower return and lower risk, which is a big reason why oil companies do not see the logic in diversifying much into clean energy. Another way these oil giants might look to play on the energy transition is to invest in heavy metal mining, a business with more similar risk/return metrics. “Exxon Mobil Corp. plans to become one of the biggest suppliers of lithium for electric vehicles, marking the oil giant’s first major foray outside of fossil fuels in decades. Exxon aims to produce its first lithium by 2027 and ramp up output to the equivalent of 1 million electric vehicles annually by 2030.”14 Consolidations do not guarantee faith in the growth of an industry, true confidence lies in investing in a sectors riskier market’s. Limited appetite is evident, even among those predicting prolonged oil demand.Gitterman’s In-House ViewWe were experiencing rising global energy demand and declining supply, which manifested in surging prices, grid failures, and rolling blackouts around the world, even before the Covid pandemic and the Russia-Ukraine War. In most places where we are producing oil (OPEC, Russia, US, Brazil), the amount we are producing is dropping. We have already depleted the best oil fields and well depletion math only accelerates as we go to lesser fields. Oil demand will likely peak in the short-term, but global energy demand is still accelerating and has grown by about 2% per year since 1973. The best way to limit the effects of a warming climate to levels that sidestep the worst physical effects is to decarbonize our energy generation mix.In the intermediate term, non-OPEC+ countries dominate medium-term capacity expansion plans, led by the United States, Brazil, and Guyana. The relatively strong increases from non-OPEC+ producers, together with the projected slowdown in demand increases the spare capacity for oil in the intermediate term, keeping energy prices in check. Many investors are overlooking the underestimated risks tied to a sustained rise in commodity price inflation. Capital limitations and the depletion of resources are poised to propel prices upward in the years ahead, contrary to the trends of the past decade. Consequently, investors remain hesitant to fully embrace the potential implications of this shift. We think the “end of oil” will be a function of price-related demand destruction, not technology-driven obsolescence (even though the cost curves for renewable power will help). Before we get there, we are likely to see marginal producers bought by lower cost providers with scale until it is harder and more expensive to transport traditional energy around the grid than renewable sources.And a reminder to please join us for our next installment of our ESG Practice Playbook series with RIA Channel, specifically designed to train advisors on integrating ESG strategies with their existing practice. Join us for this complimentary 3-hour interactive program that will cover topics such as:Improving client reporting with better climate data and portfolio analyticsImpact of climate change on client portfoliosInvesting in the transition to a more sustainable economyImportance of investing in nature-based solutionsWater investing trends and opportunitiesValues-based innovation: Today’s superpower for engaged advisorsWednesday, November 29, 202312:00 PM – 3:00 PM ET3 CFP / IWI / CFA CE credits availableOn-Demand Replay will also be offeredRegister Here

By Jessica Skolnick, CFA and Adam Bernstein Macro Update Recent record-breaking wildfires have caused a reexamination of wildfire suppression policies in place in North America for over 150 years.[i] Rather than allow smaller fires to burn periodically as Indigenous populations had done historically, we have instead focused on extinguishing fires whenever possible, particularly when they threaten lives or property. The unintended consequence of this practice has been increased fuel for wildfires in the form of underbrush and dead trees. Alongside climate change, this excess fuel appears to be resulting in more catastrophic fires that are much harder to contain. Business cycles can be thought of as smaller periodic fires that prevent excess fuel from accumulating. Historically, recessions have corrected boom time malinvestments of capital, where capital is allocated to less productive endeavors, followed by opportunities to reinvest capital more productively in the aftermath. When we take a zero-tolerance approach to economic downturns, we build risk in the system and become less productive over time. Compared to the volatile 1970s and 1980s, the economy in the 1990s and early 2000s was characterized by relative price stability and short and shallow recessions. The Federal Reserve believed it had cracked the code on managing the business cycle, until the 2008 financial crisis shattered that notion. The interconnected nature of our financial system had turned a bursting housing bubble into a systemic global crisis. The Fed’s response, long term monetary stimulus in the form of Quantitative Easing (“QE”) and zero-interest rate policy (“ZIRP”), was akin to shifting from a policy of allowing smaller controlled fires to one of wildfire suppression. Even if well-intentioned, ZIRP and QE prevented the normal ebb and flow of the business cycle because the risks of a correction were now seen as too large, and the negative consequences of high inflation and unproductive investment were hidden from view. Consumer price inflation, as measured by the Consumer Price Index (CPI), averaged just 1.6% from January 2009 to December 2019,[ii] but inflation was not absent from the economy. It had simply shifted to assets, which are mostly owned by the people who have the lowest marginal propensity to spend additional wealth, the most affluent. It was a different story for those without existing wealth. Over the same 2009 to 2019 timeframe, average hourly earnings grew just 2.4% annually[iii] and the broadest measure of unemployment, U-6, did not return to its pre-crisis levels until 2017.[iv] Due to the weak labor market and absence of significant fiscal stimulus to households, consumer demand did not put upward pressure on prices of goods and services. Against this ZIRP/QE backdrop, excesses and malinvestments began to build. Companies with fundamentally unprofitable business models were subsidized by cheap debt and venture capital funds flush with money chasing returns. Corporations borrowed at ultra-low rates and spent the proceeds on stock buybacks rather than investing more productively in their businesses. Nonresidential construction spending grew at 9.5% from the bottom in 2011 to late 2019,[v] nearly quadrupling the 2.4% GDP growth over this same period.[vi] Office construction spending grew 16.4% annualized[vii] and appeared overbuilt even prior to the post-pandemic shift to remote work. The 2020 response to the Covid pandemic was akin to pouring gasoline on the forest floor. Unlike the post-GFC response, Congress worked alongside the Fed to provide fiscal stimulus directly to households in the form of loan moratoriums, direct payments, PPP loans, enhanced unemployment benefits and more. This put money directly into the hands of consumers, increasing demand for goods at the same time pandemic related supply chain disruptions were constraining supply. The predictable result was a sharp rise in prices as measured by CPI. The inflation genie was out of the bottle. Meanwhile, the Fed embarked on more ZIRP along with massive QE that saw its balance sheet grow from $4 trillion to $8.5 trillion in just 26 months,[viii] a larger increase than all the post-GFC QE combined in a much shorter time frame. This turbocharged the excesses that had already been building up in the prior decade. This new ZIRP/QE period produced asset inflation that dwarfed the prior increases. The S&P 500 gained 94% from its April 2020 low through the peak in December 2021[ix] and home prices rose 45% from early 2020 through June 2022[x]. Following a brief dip at the start of the pandemic, nonresidential construction rose 13.5% annualized from January 2021 to August 2023.[xi] Even office construction spending has returned to its pre-pandemic level[xii] despite record office vacancies.[xiii] The spike in inflation became undeniable to the Fed, which began hiking rates in March 2022 and began quantitative tightening (“QT”) in June 2022, reducing the size of its balance sheet by allowing Treasuries and MBS to mature. The labor market has remained resilient due partially to structural changes in the labor force resulting from the pandemic and economic growth has remained strong so far despite the Fed’s tightening attempts. As a result, rates have risen higher and more quickly than most anticipated at the start. Meanwhile, inflation remains above target while base effects and adjustments are becoming less favorable. In recent months, the conversation has shifted from how high the Fed will raise rates before cutting to how long rates will remain high. The market’s expectation of a much higher for longer environment was one factor in pushing interest rates higher in the third quarter. Regardless of whether the Fed is done hiking, the likelihood of returning to the easy money days of ZIRP and QE in the absence of more significant economic pain is low. A best-case soft-landing scenario involves inflation returning to 2% and remaining in that range as the Fed lowers rates to the neutral rate of approximately 2.5%. Even this environment would be more restrictive than what we experienced for most of the last 15 years. Interest expense will increase with refinancings of corporate, real estate and other debt, impacting profit margins and driving unprofitable or marginally profitable enterprises into default. Normalized rates alone may be enough of a spark to light the fire. Unfortunately, our base case is that the Fed will ultimately be unable to keep rates higher for longer because something will likely break first, causing the excesses in the system to unwind. We have detailed many of these potential catalysts in prior commentaries and blogs. Right now, we are keeping a close eye on the following: Unrealized losses on bank balance sheets due to interest rate increases were $558 billion in Q2 2023.[xiv] Most of these losses are on bonds intended to be held to maturity but could pose issues if banks are forced to sell bonds for liquidity purposes. The Fed created the Bank Term Funding Program (“BTFP”) in March 2023 following the failure of several regional banks, but this program only applies to bonds owned as of March 12, 2023, and interest rates have continued to move higher. China’s property market, especially following the recent defaults of Evergrande and Country Garden, two of the largest property developers. Commercial real estate. Low transaction volume and banks’ ability to “extend and pretend” by offering loan extensions and modifications have delayed a reckoning. Unpaid principal balances with CMBS special servicers rose from $5.5 billion in summer 2022 to $12.7 billion in 2023 while office values fell by 12.7%.[xv] The residential housing market, where a combination of high mortgage rates and near-record prices have led to the worst affordability on record.[xvi] A recent report concluded that home prices in 99% of the US are unaffordable for the average income earner.[xvii] Rising geopolitical risks and the resulting trend towards deglobalization and onshoring/friend-shoring. Political dysfunction in the US. After narrowly avoiding a debt default over the summer, we are approaching another potential government shutdown next month. Until such a breakdown occurs (or a soft landing is assured), we expect upward pressure on rates to continue as higher for longer rates get priced in, particularly on the long end. This has been the primary driver of the bond market selloff in 2022 and 2023 so far. Credit spreads have only recently begun to widen, and we expect widening to continue to reflect the increased credit risk present in a higher rate world. This risk-off shift may halt the upward pressure on rates and ultimately spread to equities, which look particularly vulnerable given elevated valuations and the opportunity to earn 5% risk free on cash. In a soft-landing, we would expect the above dynamic to be more orderly than in a “something breaks” scenario. In the latter, the Fed would likely respond by rapidly cutting rates as inflation concerns move to the back burner. Traditional safe haven investments like long-duration high-quality bonds would outperform while risk assets would experience drawdowns. For now, though, our portfolios remain overweight short-duration high-quality fixed income and cash with an underweight to equities and minimized exposure to the riskiest sectors of both asset classes (emerging markets, high yield debt, etc.). Market Update Resilience seems to be the best way to describe the US economy and stock market this year. Despite the S&P 500[xviii] losing 3.3% in Q3, it remains up 13.0% year-to-date.[xix] Large-cap growth stocks have outperformed, returning +25.0%[xx] for the year but losing 5.4% in Q3 as equity markets began to price the real cost of prevailing interest rates and tighter liquidity conditions. Over the past year and a half, the Fed raised the effective federal funds rate by a cumulative 5.25% to combat inflation which led to a cascade of knock-on effects that until recently have, for most of 2023, primarily impacted the bond market while leaving stocks unscathed. The historic magnitude and pace of the hikes caused the deepest yield curve inversion of the 2-year and 10-year Treasury yield curve since the early 1980s, which is one of our most accurate recession indicators. The most acute effect of rising rates so far has been the bear market it has caused in long-duration bonds. The US Treasury market has lost about a quarter of its value since yields bottomed out in 2020 and Bank of America has declared this the biggest treasury bond bear market in history. The hiking campaign has hit long-term Treasuries the hardest. TLT, an ETF tracking 20+ year Treasuries, has lost 47%[xxi] since the start of the hiking cycle. Since the peak of the S&P 500 in December 2021, the index has been in a rolling bear market and failing to make new highs. We have seen a series of 6-16% corrections as the market tries to balance between sticky inflation prints, a robust jobs market, and the Fed tightening. The S&P lost 25% through late 2022[xxii] but enthusiasm over AI sparked by the release of ChatGPT beta in early 2023 alongside the Fed’s lifeline to banks in the form of the BTFP reversed the market downtrend. The AI frenzy resulted in one of the most concentrated bull markets in history. In July, a surging 10-year treasury yield and rising rates, with a backdrop of re-accelerating economic growth have again forced investors to price the possibility of a hard landing. As of the end of Q3, the “Magnificent Seven” stocks (Apple, Microsoft, Alphabet, Meta, Tesla, Amazon, Nvidia) that have been driving year-to-date returns made up ~27% of the S&P 500 and were responsible for 84% of the index’s YTD return. The top five performing GICS subsectors are largely made up of the AI ecosystem: semiconductors (Nvidia +197%), interactive media services (Meta +149%), systems software (Microsoft +32%), technology hardware (Apple +32%), and broadline retail (Amazon +51%) were responsible for 85% of the index’s YTD return. In Q3 the Magnificent Seven outperformed the S&P 500’s performance of -3.3%, losing 1.0% combined,[xxiii] though the correlation of these stocks to overall S&P 500 performance fell from 0.9 in Q2 to 0.5 in Q3,[xxiv] an indication that the concentrated nature of the year-to-date rally may be breaking down. One of the most significant trend reversals from 2022 is the performance of the Utility sector. In 2022, Utilities lived up to their defensive reputation, returning 1.4% while the overall S&P 500 Index lost 18%. This year, Utilities have declined 14.0% compared to the S&P 500’s gain of 13.1%.[xxv] With stable and predictable annual earnings and dividends, utilities are viewed as a bond proxy. Rising bond yields make their dividend yields less attractive. The negative yield spread between utilities’ dividends and US Treasuries have been a major headwind. As of the end of the quarter the utility index yield stood at 4.0%, about 60 basis points below the 10-year US Treasury yield.[xxvi] This is the first time that this spread has been negative in 14 years. If the market is right in predicting the end of rate hikes and the beginning of rate cuts is nigh, it might prove to be a great buying opportunity for utilities. The other major area of distress this year has been the banks. The acute phase of turmoil for regional banks may have passed, but lenders are still contending with increased competition for deposits and higher funding costs, two factors that could persist if interest rates remain higher for longer. If the market predicted rate cuts do not materialize, the current 2024 analyst consensus on margins and revenue might prove too optimistic. In 2007 the average cost of deposits for a bank hovered around 3.7% and the total percentage of high-cost CD deposits for customers looking for better yield equaled 38% of total deposits. In Q3 average deposit costs were 2.3% and CDs made up only 20% of total deposits.[xxvii] Costs can still rise for banks from here as investors look to realize improved yields and put more pressure on their profitability. Global and international markets have underperformed in the US so far this year with the MSCI ACWI Index losing 3.6% in Q3 but remaining up 10.0% year-to-date. Developed international markets represented by the MSCI EAFE Index lost 4.9% for the quarter and are up just 6.6% year-to-date while the MSCI Emerging Markets Index lost 3.7% in Q3 and is up just 1.3% for the year. China and Hong Kong, the largest components of the EM index, lost 8.6% and 17.1% respectively in the quarter, dragging down the headline index. The MSCI EM ex-China Index has performed much better, with a year-to-date total return of 5.7%.[xxviii] As touched upon in our macro update, we have continued to favor a defensive approach for both equity and fixed income sleeves of our portfolios because our base case scenario is a hard landing caused by interest rates that remain higher for longer due to the resilience of the labor market and the hard to battle services inflation component of CPI. Even if the Federal Reserve manages to stick a soft landing in the near term, higher rates for longer will likely cause US equities to remain range bound. Bloomberg’s S&P 500 fair value model suggests current valuations already incorporate the potential for easier policy to emerge, leaving substantial positive earnings surprises as the only likely candidate for S&P 500 outperformance. The S&P 500 is expected to report a year-over-year decline in earnings of -0.3% for the third quarter, which would make it the fourth straight quarter that the index has reported a decline in earnings.[xxix] For the S&P 500 to retake its all-time high, the Fed would have to successfully beat core inflation back down to 2% or below and lower interest rates at a pace commensurate with the Fed futures curve without a deterioration in profit margins. On the fixed income side of the portfolio, we favor boring high-quality short-term Treasury and Agency MBS allocations. There are two primary sources of risk in fixed income: duration (risk that the price of a fixed-income security will change due to shifts in interest rates) and credit (the risk of the issuer defaulting on its financial obligations). A yield curve inversion in the 2-year/10-year portion of the Treasury curve functionally means that an investor is getting paid a higher yield to own a 2-year Treasury that has less risk than a 10-year Treasury (debt ceiling debates aside, Treasuries are not considered to carry credit risk). With the yield curve having been inverted since March 2022, an investor could have gotten up to 107 basis points of extra yield,[xxx] depending when purchased, on the 2-year treasury vs. the 10-year treasury with a fraction of the duration risk. We are also not seeing the usual negative correlation between duration and equity markets that you see in the risk-off environments that we are in, at least not yet. Recent equity market selloffs have been accompanied by rising rates and falling bond prices rather than the typical hedging dynamic that high-quality long-duration bonds have historically provided. When the curve normalizes and we start getting paid for taking duration risk again, we will likely go further out on the curve. Climate and ESG Update The focus this quarter will be on the underperformance of the renewable energy trade but, first, let us break down some of the major sustainable finance themes: energy efficiency, electric vehicles, semiconductors, climate solutions, renewable energy producers, net-zero, energy storage, social justice and water. Of these themes, energy efficiency (59.3%), semiconductors (37.5%), climate solutions (19.3%), and electric vehicles (18.6%) have outperformed the S&P 500 this year. The themes that have struggled the most have been renewable energy producers (-22.8%),[xviii] energy storage (-10.4%),[xxix] and water (-0.3%).[xxxi] Let us unpack what went wrong. By “the renewable energy” trade, we really mean renewable power generation and distribution firms (utilities that create energy from solar, wind, hydro, geothermal, biomass, and nuclear energy). The valuations of these firms were pushed to extremes by investors in 2020 due to anticipation for the passage of the Infrastructure Investment and Jobs Acts as well as the Inflation Reduction Act (IRA) which were subsequently passed in 2021 and 2022, and for good reason. The IRA bill alone is expected to drive ~$3.5trillion in cumulative capital investment in new energy supply infrastructure over the next decade. The Act has the greatest impact on investment in wind power and solar PV, whose investment will nearly double from $177 billion to $321 billion by 2030. And let’s not forget the tens of billions of dollars in grants, tax credits, and loan programs to develop manufacturing and supply chains for clean energy components, batteries, electric vehicles, and critical minerals.[xxxii] There have been two fundamental shifts in the market since 2020 that have shifted the operating environment for these types of companies: Many renewable energy producers and distributors cannot self-fund renewable energy projects due to the significant upfront capital requirements and long payback periods. These costs can be substantial and are typically beyond what a company can finance solely from their own equity or retained earnings. This means that, on average, renewable energy companies take on more debt than traditional energy companies, whose business models are more tied to the price of energy. For this reason, most renewable energy firms rely on project finance, a specific form of financing that focuses on the project’s cash flows and assets rather than the creditworthiness of the project sponsor. The downside to relying on project finance loans to fund growth is that they are fixed rate loans and extremely sensitive to interest rate changes and discounts to future cash flows. When interest rates shot up, it immediately ate into the profitability of renewable projects making many planned and current solar plants, wind farms, and small modular reactors unprofitable without a precipitous increase in the price of traditional energy. This re-rating of risk came at a time when valuations were elevated, and a number of hedge funds started shorting renewable energy stocks.[xxxiii] The Utilities sector is a major component of the renewable energy themes that have underperformed this year. Negative yield spreads for utilities vs. US 10-year treasury bonds have been a major headwind for the entire utility sector. The S&P 500 Water index (~40% utilities) and the Renewable Energy producers index (~94% utility) allocate about 40% and 95% respectively to the Utilities sector, which has been the worst performing sector this year.[xxxiv] Regulated utilities make money by providing essential services to customers, like electricity or water. The key to their profitability is the rate base, which is the total value of their assets minus depreciation. They are allowed to earn a reasonable rate of return on this rate base that is determined by regulators. Here is the interesting part: utility profitability (ROE) is not directly tied to energy prices or sales. Even if energy prices or sales fluctuate, the utility’s profits remain stable because they are determined by the negotiated rate base. So, the utilities do not become more profitable when they sell more energy, and they do not become less profitable when prices drop. In plain terms, rate-based (assets) expansion, not sales, is what drives earnings. Authorized returns for utilities generally move directionally with long-term bond yields, but with several quarters of lags. Regulators may try to hold down authorized returns amid surging customer bills stemming from high commodity prices, inflation, and interest rates, which has been the case this year. These short-term headwinds for the sector should shift into tailwinds as utility regulators approve rate base increases and IRA incentives continue to cause higher capex spending and help green companies do well in the long term.

During Climate Week NYC, we hosted a mainstage panel at The Nest Climate Campus at the Javits Center titled Women Leaders in the Era of Climate Change. Jeff sat down with Marina Severinovsky, Head of Sustainability, North America at Schroders, Ariane Mahler, CIO at Veridien Global Investors, Heather Beatty, CEO at Scopefour Capital, and Rebecca Carland, CIO at Builders Asset Management to talk about how they each lead in their respective organizations and seek to create value for stakeholders in an era of unprecedented change. We believe that the unique challenges of our time are calling for more female leaders at the nexus of climate adaptation, innovation, and regulation. The panel was widely viewed as one of the most engaging of the entire Nest Climate Campus event, and we hope you also find it to be interesting and informative! With this in mind, we also wanted to remind you that each quarter, our investment team, led by our Director of Investments, Jessica Skolnick, CFA, produces a market outlook to address the latest macroeconomic trends and sustainability issues facing investors and advisory firms today. We invite you to join us as we shift focus this quarter to the underperformance of renewable energy in the wake of the Infrastructure Investment and Jobs Act and the Inflation Reduction Act (IRA).

Written by Jessica Skolnick, CFA and Adam Bernstein, ESG / Impact Analyst Our macro updates are usually focused on the “will they or won’t they?” decisions of the Federal Reserve and the market and economic impacts of those decisions. With no FOMC meeting on the calendar for August, this month we will focus on the recent volatility in long term rates, over which the Fed has much less control than it does on the shorter end of the curve. Interest Rates One of the key discussion themes at our Investment Committee meeting in the past several months has been whether it makes sense to lengthen the duration of our fixed income portfolios. As detailed in our prior blogs and commentary, we are bearish on the stock market and longer duration high quality bonds have traditionally provided ballast in portfolios when equities decline because investors flock to the safety of government bonds in periods of turmoil. This increase in demand results in lower yields and higher prices, with the biggest price increases in the longest duration bonds. In that way, longer term bonds can hedge equity market risk by moving up when markets move down. Despite this historical relationship, our Investment Committee has continued to keep our bonds short duration and high quality. While we believe we are eventually going to experience a reckoning in the stock market, we do not know when it will occur. Meanwhile, the yield curve has been deeply inverted for months. The yield differential between the 2-year Treasury and the 10-year Treasury peaked at over 108 bp[1] in March and again in July. Usually, reaching for a higher yield in bonds means taking on more duration or credit risk but today’s inverted yield curve means that investors can obtain a higher yield on bonds that have less risk. Without a compelling reason to give up yield in exchange for more risk, we maintained our positioning. After the last several weeks, we are very happy with that decision. The 10-year Treasury has risen from a near-term low of 3.75% on July 19th to close at 4.34% on August 21st, the highest level since 2007,[2] wiping out the year-to-date gains on the Bloomberg US Treasury Index. The move higher was driven by a growing acceptance that the Federal Reserve may keep rates higher for longer due to inflation that remains persistently above target and an economy expanding faster than anticipated. The catalyst was Fitch’s July downgrade of US sovereign debt exacerbated by the Treasury’s announcement that it would be increasing longer-term debt issuance through the end of the year. Despite the recent run-up in rates, we are still cautious about adding duration to our portfolios. The yield curve inversion narrowed to about 67 bp[3] as of August 21st, but remains significantly inverted relative to history. We also believe that the 10-year Treasury could move higher still. On August 18th, the Atlanta Fed revised its expected GDP estimate for Q3 up to a whopping 5.8%,[4] and we expect CPI to stabilize or move higher as a result of reduced base effects, a new health insurance adjustment in September and a potential reacceleration in energy and food prices. A 10-year Treasury rate above 5% seems crazy in the context of post-financial crisis QE and zero interest rate policy but is unexceptional when compared to most of history. ESG Update: The Return of El Niño and its Investment Implications In our latest blog we detailed some investment implications associated with El Niño climate patterns and a warming world. An El Niño is the abnormal warming of the sea surface temperatures in the central and eastern tropical Pacific Ocean. It’s part of a larger climate cycle called the El Niño-Southern Oscillation (ENSO) that occurs on average every 2-7 years. In the blog we discussed why El Niños have historically dragged down GDP production and raised inflation forecasts. Generally, El Niños are inflationary because they increase food and energy prices along the following transmission mechanisms: They negatively affect countries where heat-exposed work makes up a large percentage of GDP. Extreme heat overloads energy grids which cause “load shedding” and blackouts that increase energy demand and energy prices. Many critical crops like corn have a higher likelihood of failing if temperatures get too high, which pushes up food prices. The types of inflationary El Niño forces summarized here and detailed in our last blog are all related to the heating effect of the climate cycle, but warm temperatures are not the most direct way El Niños affect the global economy. The knock-on effects of a warmer climate cycle include droughts and sea level shifts which have a more direct impact on people and property. Droughts can damage crops, livestock, and infrastructure, while sea level changes can inundate coastal areas and displace people. Warming, on the other hand, is a more gradual process and its impacts are less immediate. The COVID pandemic was the first time we realized how fragile our “just-in-time” delivery model was. Today, supply chains have returned to normal operations and, as a result, goods inflation has normalized. But pandemic shutdowns are not the only way goods inflation can be shocked and supply chain routes can fail. “An increasing amount of climate-driven extreme weather events are taking their toll on the world’s major shipping routes.”[5] Collectively, there are seven international trade choke points where ~53% of global GDP passes through annually. The following are the estimated percentages of global GDP that pass individually through the seven international trade choke points: Strait of Hormuz: 20% Strait of Malacca: 12% Suez Canal: 10% Panama Canal: 5% Bab el-Mandeb Strait: 3% Bosphorus and Dardanelles: 2% Strait of Gibraltar: 1% [6] “The low sea levels around the Suez Canal prompted by drought conditions have caused Maersk to load approximately 2,000 containers fewer than usual on the same vessel. Typically, container ships might need to comply with a maximum depth of 50 feet on the Panama Canal. Current restrictions require ships to adhere to 44 feet of draft, forcing container ships to either weigh less or transport fewer goods.”[7] This is an example of how climate change is adding acute risk to the consensus core goods inflation projections and interest rate decisions of the Fed. Today, investors are focused squarely on services inflation because goods inflation has already retreated to below the desired ~2% level while services inflation stubbornly stands at 6.1%, as of the August CPI reading.[8] Most of the major investment houses we speak with believe that continued normalizing supply chain pressures are a reliable leading indicator of core goods prices and will continue to depress goods inflation. They also believe that services inflation is in a downtrend and, as a result, Powell’s inflation checklist is close to being complete, making the July hike the final hike of the cycle. Given what we know about El Niño inflationary pressures, and specifically the potential for them to cause goods inflation spikes, we remain unconvinced by this market narrative. In May 2021, the Ever-Given ran aground blocking trade in the Suez Canal from both directions. The Suez Canal facilitates almost $10 billion of goods daily so the six-day blockage is estimated to have resulted in $60 billion of disrupted trade and the subsequent trapping of ~$700 million in cargo.[9] The Ever-Given event has demonstrated that while a blockage of any global maritime chokepoint for any reason can have a significant influence on goods inflation, El Niño conditions and climate change make these types of economic destructive events more likely and will continue to limit the growth of economies that rely heavily on global exports.

Climate Week NYC is “the largest annual climate event of its kind, bringing together some 400 events and activities across the City of New York – in person, hybrid and online. The event takes place every year in partnership with the United Nations General Assembly and is run in coordination with the United Nations and the City of New York.”[1] The Nest Climate Campus at The Javits Center is one of the leading event partners of Climate Week NYC, and was created to establish a unified central destination in the city for people to convene.[2] Jeff recently sat down with Britton Jones, Founder and CEO of The Nest Climate Campus, to talk more about the event, which will attract thousands of people to The Javits Center from September 19th – 21st.

We are pleased to offer you a complimentary livestream invitation to our annual Climate & Capital Conference on Wednesday, September 20th, hosted at the New York Stock Exchange during Climate Week NYC. This year’s conference will be centered around three interconnected themes: adaptation, innovation, and regulation (“AIR”). Over the next decade, we believe that industry professionals will face increasing exposure to both known and emerging risks, including physical climate risk, biodiversity loss, large-scale human migration, and changing regulatory frameworks. Advances in environmental technologies and new ideas for improving the effectiveness of government policies are likely to shift the landscape even further. The 2023 Climate & Capital Conference will provide attendees with practical tools to navigate climate-related challenges and opportunities. The conference will include a series of panels, fireside chats, and interactive discussions with industry leaders around strategies for both mitigating risk and fostering innovation to reduce emissions and build resilience for the world’s most vulnerable communities. Please see a full list of speakers and working agenda here Climate & Capital Conference New York Stock Exchange September 20, 2023 Register for Complimentary Livestream