A Sustainability Perspective on the Third Quarter of 2021
Is the Rally Over?
The stock market continued the remarkable rally that began way back in the spring of 2020 through early September, but as summer turned to fall it ran into turbulence. September ended up being the worst month for the markets since March of 2020. The S&P 500 was essentially flat for the quarter, gaining just 0.6%. Bonds also saw volatility but essentially treaded water. The Barclays US Aggregate Bond Index gained a mere 0.05% for the quarter. Stock markets in the rest of the world did worse than in the US, with the MSCI ACWI Ex-US benchmark (comprising all significant stock markets around the world) falling 3.0%.
Throughout the year-and-a-half rally, stocks were powered by the anticipation of rapid economic growth post-pandemic and by rock-bottom interest rates, courtesy of the Federal Reserve. Valuations rose ever higher while investors seemed to shrug off most bad news. The defiance of gravity at last came to an end in September. By that point stocks were trading at a massive premium to their historic valuations: 37 times earnings, according to the well-respected Case-Schiller index, compared with a historical average of 16 times. Yet growth indicators such as job creation were starting to disappoint – thanks in part to the Delta variant, “transitory” inflation stubbornly refused to go away; supply chain disruptions were causing shortages and price hikes across the globe, and the Democrats in Congress seemed unable to pass potentially transformative infrastructure bills. It’s not surprising that stocks had a rough end to the quarter.
Similarly, bonds started to react to the Federal Reserve signaling that it was going to start reducing its bond buying in the coming months (by “tapering” purchases) and the stubbornness of inflation. Both of these factors led to a small rise in government bond yields and, therefore, falling government bond prices over the quarter. The slightly positive return for the index is entirely due to inflation-linked government bonds and higher yielding corporate bonds, which are less sensitive to interest rates and inflation concerns.
What’s With All the Shortages and Why is Inflation Still So High?
The unprecedented global shutdown of 2020 led to all kinds of distortions in the global economy. Energy consumption fell sharply as travel suddenly stopped and city centers emptied out. Millions were suddenly jobless. Across the world, spending on services collapsed with restaurants, cinemas, museums, performance venues etc. closed and tourism halted. In contrast, spending on goods soared in wealthy countries as consumers wanting to make their enforced stays at home more pleasant turned to online shopping.
As the economy has re-opened, we have found that restarting such a complex global machine is not as easy as simply flipping a switch. Shortages and bottlenecks have afflicted one industry after another, from rental cars to semi-conductors to energy to container ports. This has led to a series of price spikes that the Federal Reserve has characterized as “transitory.”
There does not seem to a single explanation for these disruptions. In some cases - most obviously the travel and tourism sector - businesses of all sizes reacted to the sudden shutoff in demand by largely closing down. On re-opening it has taken time to restaff their operations, acquire new fleets of vehicles and so on. The energy sector has faced similar difficulties bringing its operations back online as did the North American lumber industry, which also saw a spike in demand due to the home improvement boom. The surge in demand for consumer electronics during the pandemic ate up the inventory of semiconductors that would normally have gone to the auto sector, which continues to hold back production in that industry. American consumers’ seemingly insatiable demand for electronics and other durable goods has strained capacity to the limit all along the supply chain, leading to extraordinary delays.
The US labor market has also been slow to return to normal. As of the end of September total employment was still 9 million below its pre-pandemic peak yet the job market seems tight, with wages rising at a pace well above their earlier trend and many employers reporting difficulty finding workers. Many on the right had been attributing the failure of workers to return to their jobs to the supplemental unemployment benefits included in the COVID relief plan, but those have now expired and the job market has not suddenly been blessed with a flood of workers. Commentators on the left have attributed workers’ seeming reluctance to return to work to unattractive wages and working conditions, as well as lingering fear of exposure to COVID. These factors do seem to be very real in the hospitality sector, where pressure to raise wages is the highest. An unusually high proportion of workers, 2.4%, quit their jobs in August, a clear indicator of both low job satisfaction and confidence in finding another job. This is hard to reconcile with food pantries reporting that demand is still well above where it was before the pandemic. All that seems clear is that the job market – especially for lower paying jobs – is not working properly.
https://www.nytimes.com/2021/10/14/opinion/workers-quitting-wages.html?searchResultPosition=4
Sudden shortages and supply chain disruptions have led to price spikes while labor shortages have led to higher wages in some sectors. As a result, inflation has remained stubbornly at multi-decade highs for months, reaching an annual rate of 5.4% in September. In the beginning it was easy to blame higher inflation on one-off events such as the temporary spike in used car prices but after several months it can no longer be explained away. Wage and price hikes seem to be spreading through the economy. The Federal Reserve repeatedly referred to high inflation as “transitory” in the spring but has seemingly dropped that language while bringing forward both the “tapering” in its market intervention to keep interest rates down (now expected in November) and its expected first rate-hike (3rd quarter of 2022). Treasury Secretary Janet Yellen has said she expects inflation to remain high well into the first of 2022 before subsiding as the post pandemic supply chain issues get resolved. Many economists wonder if the Fed is still behind the curve on inflation and will have to tighten monetary policy more aggressively. Bond yields have risen some in response to inflation concerns but nearly as much as they would have if investors were truly worried.
Even Celebrities Are Promoting Sustainable Investing
With the news that Prince Harry and Meghan Markle are partnering with Ethic - a larger competitor of White Pine, also specialized in sustainability - it’s clear that sustainable investing really is the hot new trend: https://www.nytimes.com/2021/10/12/business/dealbook/harry-meghan-ethical-investors.html?smid=url-share
Perhaps more momentous was the news that Harvard University has at last divested fossil fuel holdings from its $41 billion endowment. Harvard had been resisting intense pressure to take this step from activist students and alumni for over a decade. In its statement announcing the move Harvard cited its “fiduciary responsibility” to make long-term investment decisions and its belief that fossil fuel investments are not “prudent.” It is striking that Harvard has made purely financial arguments for this move and cited the Prudent Investor rule that governs the management of endowments rather than the moral case that activists have often made. Harvard’s argument is much more powerful because it is purely an investment argument. Instead of making the longstanding activist case that divesting from fossil fuels is simply the right thing to do and is therefore worth sacrificing some investment returns, Harvard is arguing the necessity of divesting in order to protect investment returns. While the Universities of Cambridge and Oxford and the University of California System had already taken this same step, Harvard’s move is likely to resonate because of the enormous size of its endowment and the institution’s prominence. In fact, less than two weeks later Boston University followed suit.
The widespread move toward sustainable investing continues to hurt the performance of fossil fuel stocks, which has fallen behind the recent rise in oil prices, in contrast to previous oil price rallies. Exxon Mobil’s market value is currently $260 billion, down from $400 billion in 2014, when oil prices were at the same level as now.
And here’s a satisfying quote:
“’Oil and gas has seen the worst returns of any sector over the past five years: the returns are volatile and investors feel ESG pressures,’ says Wil Van Loh, who runs Quantum Energy partners, which manages $18 billion, making it one of the few remaining big energy private-equity funds. ‘There’s been a huge retreat in available capital.’”
https://www.bloomberg.com/opinion/articles/2021-10-14/it-pays-to-not-pay-your-debts
On the regulatory front, US Securities and Exchange Commission Chair Gary Gensler announced that the SEC is working on rules that would require corporations to publicly disclose their climate change risk. The proposal is expected by the end of the year and would add mandatory disclosure of climate risks to the annual financial filings required for all publicly traded companies. The SEC is also taking aim at investment funds that engage in “greenwashing” by proposing to require that they disclose the data they use to determine that an investment is sustainable. This requirement would be very helpful since the flood of money into sustainable investing has – not surprisingly – been a big incentive to slap the “sustainable” label on all kinds of investment products.
Separately the Central Bank of Brazil announced that starting in July of 2022 the country’s large banks will be required to report on climate-related risks to their lending and investment portfolios, including not just environmental but also social and reputational risks related to climate change and the transition to a less carbon-intensive economy. Environmental, social and climate impacts must be considered in all financial products and services that banks offer. This move by one of the most respected Emerging Markets central banks puts Brazil at the forefront of climate change regulation in the financial sector.
What’s Next?
More of the same? Quite possibly. It seems that with the initial phase of the economy’s re-opening largely behind us, growth will likely be slower and perhaps more volatile. The IMF has recently reduced its forecast for global growth in 2022, citing the clogged global supply chains and the risks from very low levels of vaccination in developing countries. Inflation does not seem likely to return to the normal 2% range for at least six months.
Investors remain faced with stocks that are trading at expensive valuations and so are vulnerable to disappointment and bonds that continue to offer historically low yields despite inflation seemingly stuck in the 5% range. Earnings growth could continue to support the stock market and if Congress does manage to pass at least part of President Biden’s infrastructure proposals that could also be positive for stocks. Still, at this point the best argument for investing in the stock market is that with interest rates so low, there is no alternative. Be careful.
Urban Larson
Principal
Disclosure
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