By Jessica Skolnick, CFA and Adam Bernstein
Macro Update: The Powell Pivot
On December 1st, less than 2 weeks prior to the December 13th FOMC meeting, Federal Reserve Chair Jerome Powell said in a speech that “it would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease.” In that same speech, he described labor market conditions as remaining “very strong” with high wage growth while characterizing the most recent 3.5% core inflation print as being well above their 2% objective.
Between that speech and the FOMC press conference, November’s job and inflation reports came out stronger-than-expected. Unemployment unexpectedly fell from 3.9% to 3.7%, with rising labor force participation and higher than expected month-over-month wage growth.[1] November CPI rose slightly more than expected month over month, with the headline and core figures coming in at 3.1% and 4.0% respectively.[2] The rates market had, from October 31st through December 12th, priced out all expected rate hikes and added two anticipated rate cuts to the 2024 forecast.[3] It seemed due for a reality check by the Fed.
However, despite the data, the FOMC all but declared victory over inflation. Compared to the September statement, updated Summary of Economic Projections (SEP) lowered the median expected year-end Fed Funds target rate from 5.125% to 4.625%, equivalent to an additional two rate cuts in 2024. Expected GDP growth, PCE inflation, and core PCE inflation in 2024 were all reduced by ten basis points.[4]
We really cannot figure out what the FOMC members saw in the data in those 12 days to make themselves that much more confident in the soft-landing narrative. While inflation may continue to trend down, we are not seeing certainty that it will in the data. Core services inflation accelerated slightly on an annual basis with upward pressure from 4% wage growth, while large year-over-year declines in energy and goods (and the healthcare adjustment) are aging out of the data. Recent attacks on commercial vessels by Iranian-backed militants in Yemen, and the decision by many companies to pause shipping in the Red Sea as a result, only illustrate that our supply chain remains vulnerable to geopolitics.
Powell has gambled that the economy will soon hit a sharp growth slowdown accompanied by disinflation and rising joblessness. The market responded by pricing in nearly 2 additional rate cuts in the week following the meeting.[5] Since early November, intermediate and long Treasury yields have plummeted, with the 10-year falling from near-5% to below 4% and the inversion between the 2-year and 10-year growing from -15bp on October 31 to -51bp on December 18th.[6] All the good news from the Fed (and then some) for 2024 has been priced in. The Fed has functionally pulled forward most of the gains that would be realized next year, assuming their rate cut forecasts even materialize. Meanwhile, the fundamental issue of buying an inverted yield curve that is paying you to not take duration risk, has worsened.
While we cannot know for sure what drove the Fed’s abrupt shift in tone, we can ask what happens if things do not go according to the Fed’s plan. What happens if growth does not slow, inflation rebounds, or unemployment remains low and the Fed cannot meet its own forecast of 3 rate cuts, let alone the market’s expectation of twice that? In that scenario, long-term rates would have to give back their recent gains while rates on the short end would remain elevated for longer. Stronger than expected growth, labor demand and inflation have been defining features of this two year long tightening cycle. While we do not have a crystal ball, absent an unanticipated shock to the economy, our base case is for those trends to continue.
The Fed’s abrupt tone shift made on thing clear: rather than a pause, the Fed wants us to see this as a pivot. Plateaus like the one we find ourselves in now, between rate hikes and rate cuts, are usually supportive for stocks and bonds alike. Historically, it is only when the yield curve inversion normalizes, and the Fed begins cutting rates that stocks sell off and long-duration high-quality fixed income outperforms. While we hope the Fed has called it right that inflation will trend lower and reach target without significant pain in the economy or markets, history also tells us that central banks have an awful track record at achieving soft landings. Market participants hoping for rate hikes may want to be more careful about what they wish for.
ESG Update: Setting the Scene at COP28
COP28 kicked off on November 30th in Dubai, United Arab Emirates, 31 years since the adoption of the United Nations Framework Convention on Climate Change (UNFCCC), and eight years since the signing of the Paris Agreement at COP21. The “Conference of the Parties” or “COP” brings together all the governments that have signed the UNFCCC, the Kyoto Protocol, or the Paris Agreement to jointly address climate change and its impacts.
Since 2015, under the legally binding Paris Agreement treaty, most countries made three commitments:
1) Limiting 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
The Paris Agreement requires countries to set their own emission reduction targets, known as nationally determined contributions (NDCs). Still, there are no legally binding penalties if a country fails to meet its stated targets. Every five years, the negotiators of COP update the Global Stocktake (GST), the mechanism to assess the world’s collective progress towards fulfilling the Paris Agreement. The outcomes of the GST are meant to inform member-country negotiations and enhance international cooperation for climate action to increase ambition. While the agreement is legally binding, the outcomes of the GST are intended to inform future NDCs rather than impose legally binding requirements on individual countries. The goal is to regularly review and increase ambition in tackling climate change based on collective progress.
Our Take
This year’s conference was hosted by a petrostate, led by a fossil-fuel CEO, and loaded with over 2,000 oil/coal/gas lobbyists. We had understandably low expectations. The backdrop was also particularly challenging. The Ukraine-Russian war and the Israel-Hamas war have placed energy security and independence at the forefront for many nations. War has disrupted traditional energy supply chains, leading to record-breaking profits for many Western energy companies that have been able to pick up the slack. Unfortunately, this combination of national security concerns and excess profits has led companies to re-invest in more oil and gas development projects rather than putting forward a detailed CAPEX plan to transition away from fossil fuels.
The 2023 Climate Action 100 Net Zero Benchmark results showed that while 77% of companies now commit to net-zero and 87% have disclosed medium-term emission reduction targets, only 2% of companies have committed to phasing out CAPEX in carbon-intensive assets, and only 3% have disclosed sufficient details about how they plan to reach their targets. The geopolitical environment has led countries to increase fossil fuel subsidies rather than imposing windfall taxes on energy firms to help them fund their transitions. A 2023 International Monetary Fund analysis found that fossil fuel subsidies rose by $2 trillion over the past two years to a record $7 trillion globally.
But despite these difficulties, there is a silver lining: reaching consensus and winning hard-fought fossil fuel concessions here, under a United Arab Emirates (UAE) COP presidency, will have a much more profound impact on our global ability to limit emissions for one specific reason. Buy-in must happen from inside these producing countries, not outside of them. Luckily, 98 of the 198 countries who attend COP and have ratified the Paris Agreement are oil producers.
We are struggling to curb emissions today because our global economy and its continued growth rely heavily on the continued use and expansion of fossil fuels. This is changing, thanks in part to the progress of COP, the technological innovations in energy production and storage, the improving economics of renewables solutions, and the increasingly precarious economics of hydrocarbon production. But today, we are not there; we cannot flip on a switch and have the world’s energy grids run on renewable and nuclear energy.
We cannot distribute, store, or produce the required energy to meet demand. The economics are improving, but they would lead to higher energy bills across the globe if we tried switching everyone over to renewables today, disproportionately affecting low-income countries and zip codes.
Take, for example, the country of Iraq, a leading OPEC member state. With 99% of its exports, 85% of its federal budget and 42% of GDP tied directly to oil, Iraq has predictably rejected the language for a phase-down and a phase-out of fossil fuel. Imagine expecting Iraq to commit to rapidly eliminating the one resource it has, on which its entire economy currently depends, without offering it any viable transition path to a prosperous post-carbon future. COP has yet to show substantial progress on the Paris goals in large part because developed countries have yet to assure developing countries of a prosperous post-carbon future.
Even given all these headwinds, COP28 was still a historic breakthrough. It telegraphed an obvious direction of travel for the world to consumers, investors, countries, and companies alike. It has signaled the decade of peak oil has arrived, and that the energy system transformation is unstoppable. The biggest adversary we have from here is time, we are on track for a 2.7° Celsius level of warming by the end of the century if we continue along the business-as-usual track. This level of warming virtually guarantees that we will need to live with some of the worst climate change outcomes if we do not quickly find ways to transition these oil production economies and meaningfully lower emissions.
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[1] Bureau of Labor Statistics, Bloomberg, as of 11/30/2023 [2] Bureau of Labor Statistics, Bloomberg, as of 11/30/2023 [3] Bloomberg, World Interest Rate Probability – US Futures, as of 10/31/2023 and 12/12/2023 [4] Summary of Economic Projections, Board of Governors of the Federal Reserve System, as of 12/13/2023 [5] Bloomberg, World Interest Rate Probability – US Futures, as of 10/31/2023 and 12/18/2023 [6] Bloomberg, accessed on 12/18/2023___________________________________