Commentary by Jessica Skolnick, CFA, Director of Investments and Adam Bernstein, ESG/IMPACT Analyst
For over a year, we have been managing our portfolios defensively and writing about the myriad risks and headwinds we see facing the market. A defensive posture was easy to maintain in 2022. Fed rate hikes spooked equity markets and risk assets in general. 2023 has been a much different story. Against a backdrop of higher interest rates, stubborn inflation and bank turmoil, the S&P has rallied over 14% year-to-date. So, what gives? Are we wrong, or just early?
On the macro front, we have been more right than wrong over the last 18 months. We believed that inflation would stay higher than expected for longer, due to a tight labor market and pressure to maintain corporate profit margins. Stickier inflation would then force the Fed to raise rates higher and keep them there for longer than the market expected. We expected higher rates along with the shift to remote work and oversupply to impact commercial real estate. We have also been cautious on the China growth thesis given their property market issues and the increased polarization of the economic world that accelerated with the Russia-Ukraine War.
So, we believe we are early but not wrong. The market is currently priced for perfection – a soft landing (or no landing) scenario where the inflation genie goes quietly back into the bottle and the Fed can begin cutting rates early next year without the economic turmoil usually associated with rate cutting cycles. Refinancing risk would not be a major problem in such an environment, because rates would be lower, and earnings forecasts can stay rosy without a recession in the cards. Unfortunately, we see too many risks on the horizon for this to be our base case:
- The rate hikes that have occurred have not been priced into equity markets. One year ago, the Fed futures market expected a slow hiking cycle that would peak at 3%. Today, the upper bound is 5.25% and the revised dot plot from the June meeting suggests 2 more hikes (and no cuts) in store for the remainder of 2023. And yet the S&P 500 is up over 16% from this time last year.
- The drop in headline inflation has been driven primarily by a 11.7% drop in energy CPI. Core CPI and Core PCE have been stuck at elevated levels higher than the Fed’s target all year. The Fed had expected housing costs to fall as we moved through the year but asking rents have risen to new highs in recent months, baking in future inflationary pressure.
- Commercial real estate (CRE) has only begun to turn over in the office space. Low transaction volume along with expectations for lower rates ahead have only delayed the reckoning. We expect stress to spread to multifamily as well, which at 40% of the CMBS market is about twice as large as offices. There are nearly 800,000 units slated for completion in 2023, compared to less than 500,000 in 2022, against a backdrop of weakening demand.
- While the Fed’s Bank Term Funding Program (BTFP) has calmed the immediate stress, the drivers of the banking turmoil in March (higher rates, lower deposits, and CRE stress) have only worsened in the intervening months. The Fed bank stress tests, which will be released on June 28th, will provide more insight into the state of the banking system.
- The year-to-date rally in the S&P 500 has been concentrated in a handful of large tech names and has pushed valuations to levels not justified in the current rate environment. The earnings yield on the S&P 500 is just 4.8% lower than the yield-to-worst on the Bloomberg US Credit Index and most short-term Treasuries. In other words, investors in the stock market at these levels are not being paid any premium to compensate for the risk.
ESG Update: The Return of El Niño and its Investment Implications
If you’d been able to peel yourself away from the stock charts of the magnificent seven (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) at any point in the last couple of weeks, you would have noticed that we have been inundated by headlines of blazing Canadian forest fires, record air pollution levels in the eastern US, record temperatures around the world, droughts in Arizona, and record breaking forest fires in California. This pick-up in intensity of climate disasters is no coincidence. On June 8th, the scientists at the NOAA Climate Center (a division of the national weather service) announced their first El Niño advisory in four years, noting that we have officially entered our next El Niño phase. An El Niño is abnormal warming of the sea surface temperatures in the central and eastern tropical Pacific Ocean. It is part of a larger climate cycle called the El Niño-Southern Oscillation (ENSO) that occurs on average every 2-7 years. The shift to a warming phase in our natural climate cycle can create material investment risks for an already hot world:
India is particularly vulnerable. In 2017, heat-exposed work produced about 50% of GDP, representing 30% of GDP growth, and employed about 75% of the labor force.
Solar panels, batteries, and power grids lose efficiency through heat. It is estimated that grid technologies experience “load shedding” of 0.1-0.5% loss of power per 1-degree Celsius increase. Planned outages due to heightened fire risk caused California’s utilities provider PG&E to go bankrupt.
While some crops benefit from a warmer climate (higher rainfall in California benefits avocados and almonds, for example), many staple crops such as palm oil, sugar, wheat, rice, and corn will face more challenging conditions and falling crop yields. Sixty of global food production occurs in just five countries: China, the United States, India, Brazil, and Argentina. Rice, wheat, corn, and soy make up almost half of the calories of an average global diet.
This El Niño is occurring on top of an ongoing long-term warming trend and could potentially be the costliest El Niño cycle in history. When you look at current climate events through this lens it is no wonder, we saw a raft of large insurance companies abandon certain states this month. Most recently, Farmers insurance Group became the latest of fifteen insurance companies to stop writing new business in Florida over the past 18 months. We are currently a world grappling with war, inflation, recession risk, restrictive monetary policy, and an El Niño has now come at exactly the wrong time.
“According to Bloomberg Economics modeling, previous El Niños resulted in a marked impact on global inflation, adding 3.9 percentage points to non-energy commodity prices and 3.5 points to oil. They also hit growth to gross domestic product, especially in Brazil, Australia, India, and other vulnerable countries.” We already know that climate change, the transformation of our global energy system, and the spending we need to make progress on these two critical issues are extremely inflationary. Amplified by the inflationary pressures of an El Nino we see persistent stressor on an already sticky core services inflation number. Powell’s work is not done and likely will not be, due in some respects, to these underlying themes.
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_______________________________________________ Bloomberg, as of 6/20/2023  Bloomberg, as of 6/20/2023  Bloomberg, Bureau of Labor Statistics, as of May 2023  Zillow Observed Rent Index, as of April 2023 https://www.zillow.com/research/april-2023-rent-report-32595/  Cohen & Steers, as of March 2023 The commercial real estate debt market: Separating fact from fiction – Cohen & Steers (cohenandsteers.com)  Fannie Mae 2023 Multifamily Outlook, January 2023, https://multifamily.fanniemae.com/news-insights/multifamily-market-commentary/2023-multifamily-market-outlook-turbulence-ahead  Bloomberg, as of 6/21/2023  https://www.weather.gov/news/230706-ElNino https://www.mckinsey.com/~/media/mckinsey/business%20functions/sustainability/our%20insights/will%20the%20worlds%20breadbaskets%20become%20less%20reliable/mgi-will-the-worlds-breadbaskets-become-less-reliable.pdf https://www.mckinsey.com/~/media/mckinsey/business%20functions/sustainability/our%20insights/will%20the%20worlds%20breadbaskets%20become%20less%20reliable/mgi-will-the-worlds-breadbaskets-become-less-reliable.pdf https://www.mckinsey.com/~/media/mckinsey/business%20functions/sustainability/our%20insights/will%20the%20worlds%20breadbaskets%20become%20less%20reliable/mgi-will-the-worlds-breadbaskets-become-less-reliable.pdf  https://www.wsj.com/articles/home-insurers-curb-new-policies-in-risky-areas-nationally-c93abac0  https://www.bloomberg.com/graphics/2023-el-nino-climate-change-extreme-weather/#xj4y7vzkg