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.

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