Written by Jessica Skolnick, CFA and Adam Bernstein, ESG / Impact Analyst

For the last several weeks, markets have been in a holding pattern awaiting clarity on the direction of future Federal Reserve decisions and, more imminently, a resolution to the debt ceiling limit debate. Treasury Secretary Janet Yellen announced last month that due to lower-than-expected tax receipts, the US government could run out of money as early as June 1^st and has urged Congress to negotiate an increase prior to June to avoid the possibility of default. Failing to raise the limit would have unknown and potentially catastrophic consequences on markets and the economy.

Congress has played chicken with the full faith and credit of the US government enough times that, so far, markets are generally taking this risk in stride. Yields have skyrocketed on Treasury bills maturing in June and credit default swap (CDS) premiums on US Treasury debt have widened but volatility has otherwise been muted. Equity markets have been rangebound for several weeks on light volume. While the consensus is that Congress will ultimately raise the limit as it has always done in the past, there is a nagging worry that this time may be different, and it appears that nobody wants to make any sudden moves until we see how it plays out.

The Federal Reserve met on May 3^rd and as expected, raised rates by 25 basis points to an upper limit of 5.25%. They removed language from their statement that said “additional policy firming may be appropriate” but stopped short of saying that a decision to pause at the next meeting had been made. Fed Chair Jerome Powell communicated in his press conference that the Fed will monitor ongoing stress in the banking system, incoming data on inflation and the labor market and the lagged effects of both Fed tightening and the credit tightening from banks to inform future rate decisions.

As of May 17^th, the market is pricing in a likely pause at the June meeting and then at least two rate cuts between now and the end of 2023,[1] in direct contradiction to Powell’s communication at the press conference: “We on the committee have a view that inflation is going to come down not so quickly. It will take some time. And in that world, if the forecast is broadly right, it would not be appropriate to cut rates. We won’t cut rates.”[2]

This disconnect in forecasts poses a real downside risk to equity markets, which have thus far brushed off the longer term impact of the Fed’s aggressive rate hikes by penciling them in as temporary. If and when the market accepts that rates will not reverse to the abnormally low levels, there is a risk that equity valuations could drop as corporations will need to refinance debt at higher rates, compressing margins and hindering their ability to buy back shares.

Recent inflation data indicates that the slowing trend seen over the last year may be stalling out above the Fed’s comfort zone and that more rate hikes may be needed. First quarter Core PCE, the Fed’s preferred inflation gauge, came in higher than expected at 4.9%[3] and well above the Fed’s 2% target. Overall CPI fell to 4.9% in April but the core figure, which excludes volatile food and energy, was 5.5% and has been stuck in a 5.5% to 5.7% range for several months. Rather than seeing the moderation in housing costs that the Fed had anticipated would soften inflation this year, rent of primary residence rose 8.8% year-over-year and owner’s equivalent rent rose 8.1%. Energy prices dropping 5.1% year-over-year and a large adjustment to health insurance CPI have pushed down prices.[4]  As those effects fade, there’s risk that inflation will reaccelerate and the Fed will have to become more hawkish.

The other side of the Fed’s mandate is to ensure full employment. If the economy experiences a hard landing and unemployment increases, they may be forced to cut rates even if inflation is above target. Despite headlines about layoffs in the Tech sector and some softening in recent employment data, we still have a very strong labor market relative to pre-pandemic norms. The March JOLTS survey showed 9.6 million job openings,[5] lower than expected but still well above the number of unemployed people, which at 5.7 million [6] is at the lowest level in 22 years. Weekly jobless claims have risen, most recently to 264,000,[7] but are still within the range considered normal prior to the pandemic. The most recent Bureau of Labor Statistics survey for April showed that the unemployment rate fell to 3.4%, the lowest level since 1969, while average hourly earnings accelerated to 0.5% month-over-month, the strongest gain in over a year.[8] Given the ongoing stress in the banking system, we are not ruling out the possibility of a significant reversal of fortunes in the job market that would necessitate rate cuts, though that scenario would be much more negative for equity markets than what is currently priced in.

The Energy System, the War in Ukraine, and the Energy Crisis

Before the COVID pandemic and the Russian-Ukraine War we were already experiencing issues with surging global energy demand and declining supply, which had manifested in surging prices, grid failures, and rolling blackouts around the world.  Oil and gas discoveries have not matched our annual consumption since 1975, with current findings only meeting 15-20% of our needs. While there may be potential for future supply, conventional energy sources are unreliable. Consequently, we need to explore a new energy mix to meet growing demands.

Oil production everywhere except Russia, the US, OPEC nations, and Brazil was in decline regardless of price, and there seems to be no material proven oil reserves left besides these regions. While it is possible that we may yet uncover new untapped supply, relying upon conventional energy generation sources alone is tenuous at best. The world will need a new energy mix to meet our evolving demand.  Climate investors and activists would like us to transition from traditional fuels to 100% renewable energy.  But renewables are not without their problems; intermittency, cost of energy storage, dispatchability, raw material supply chains.  The technology required to realize a net-zero compliant energy mix, to make renewables the lion’s share of the energy supply, is not yet commercially available.  In the meantime, we must find ways of being more efficient with the solutions that work today with the current infrastructure because climate change is not only a massive issue to solve but a time sensitive one.

Energy independence moved to the top of the developed world’s priority list once the Russia-Ukraine War began last year. The turmoil caused by the war prompted a drive to export US oil and gas to European allies. This occurred concurrently with President Biden’s efforts to pass the Inflation Reduction Act, sending the market a series of mixed signals.[9]  The war helped make the case for and hasten the usage of renewable energy in many developed countries since renewable energy was a power source everyone has abundantly within their own borders.  But this quick shift away from Russian oil also made it clear that the world was not yet ready to run entirely on renewable energy sources, especially when accounting for the price individuals pay for energy. The faster we transition our energy generation sources from fossil fuels to renewables, the more expensive it will be for everyday citizens (though this can be mitigated by appropriate government subsidies and infrastructure). The politics around who should shoulder this price is where we get into political gridlock. To aid Americans having to pay higher price at the pump and our European allies, the Biden Administration decided to release oil from the Strategic Petroleum Reserves (SPR), which is now at extremely low levels. The strategy worked at first. Energy prices slid back down as China and other economies came out of their pandemic restrictions and supply chains normalized.  But in possible retaliation, OPEC+ announced surprise output cuts on April 2^nd of 1.2 million barrels per day sending prices up immediately.

More recently the Biden administration’s approval of The Willow Project, a $600 million oil project in Alaska encompassing 200 oil wells sent more mixed messages to the market. As a recent Guardian article stated, “Biden may have promised there would be no drilling on federal lands during his campaign, but the reality has been very different given the tricky political landscape.  All members of Alaska’s congressional delegation, including newly elected Democrat Mary Peltola, called for Willow to be approved, citing thousands of new jobs.”  Biden himself appears to share this view – in his recent State of the Union speech, the president said, “we’re going to need oil for at least another decade, before adding and beyond that.”[10]

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