Are Happy Days Here Again?
The first quarter of the year saw the rally in equities continue even as interest rates in the US moved steadily higher. The S&P 500 gained 6.17% while the global MSCI All Country World Index rose 3.5%. At the same time bonds sold off. The benchmark yield on ten-year US Treasury bonds rose from 0.92% to 1.74% over the quarter, significantly higher than the record lows posted in the depths of the pandemic sell-off but still very low by historical standards.
Despite the drama of former President Trump’s followers’ chaotic and violent insurrection on January 6th the stock market moved steadily higher through the quarter. The Biden administration’s massive COVID relief package with its $1400 stimulus checks was a key driver. The rapid acceleration of vaccine distribution raised expectations of an earlier than anticipated re-opening of the US economy. Corporate earnings were strong while employment continued to recover. President Biden’s announcement of his very ambitious infrastructure plan at the end of the quarter gave further hope to the market of boom times ahead.
In contrast to the exuberance of equity investors, bond investors continued to sell. Between the three COVID Relief packages the Federal government is pumping $4 trillion into an economy which is already gaining steam. On top of that the Federal budget deficit has been setting records since the 2017 tax cuts and government debt is approaching 100% of GDP. The bond market saw growing risks of both higher inflation and an oversupply of US government bonds and pushed interest rates higher accordingly.
The worries of the bond market occasionally gave pause to equities investors during the quarter, but growth expectations proved more powerful than fears of inflation and higher levels of debt. The stock market absorbed a near doubling of interest rates with only a few hiccups.
Some Crazy Things Have Been Happening in the Markets. Should Investors Be Worried?
Even as the improving outlook has continued to drive a rally in the stock market, some recent events have borne the surreal hallmarks of a financial bubble. Early in the quarter the GameStop episode captured the public’s attention. GameStop, a chain of stores selling video games, was widely viewed as an overvalued company in structural decline by investment professionals, and several hedge funds took short positions in the stock. Pandemic bound retail investors motivated by animus towards hedge funds (who among us doesn’t dislike hedge fund managers??) and armed with stimulus checks and trading apps on their smart phones banded together to drive the price up. The resulting speculative frenzy drove the stock up several hundred percent and a number of hedge funds posted huge losses, with one having to be bailed out by its peers. Late in the quarter Archegos Capital, a hedge fund practically no one had heard of that was run as a family office, blew up even more spectacularly, causing founder Bill Hwang’s $20 billion fortune to evaporate in a mere 48 hours. (https://www.bloomberg.com/news/features/2021-04-08/how-bill-hwang-of-archegos-capital-lost-20-billion-in-two-days). In the meantime, Bitcoin – which has zero intrinsic value and is not backed by any financial institution – continued to rise to unforeseen new heights. The most common type of IPO was not a hot tech company but a SPAC (Special Purpose Acquisition Company), which is essentially a blank check given to its founders by investors who want to benefit from whatever the founders eventually acquire with the money .
Taken together all of these market events are reminiscent of the proverbial shoeshine man giving stock tips that made some savvy investors nervous in the run up to the 1929 crash or of the ever more complicated mortgage-backed securities that helped to trigger the 2008 financial crisis. But yet. GameStop and the retail investors had the last laugh: the company took advantage of the run up in its stock price to issue new shares and pay down its debt. With management accelerating the company’s move to the internet from brick-and-mortar retail its stock price is still up 600% year to date as of this writing. The dramatic collapse of Archegos wiped out a fortune and led to multi-billion-dollar losses at some of its lenders (notably Credit Suisse) but was easily absorbed by the markets. Bitcoin and other cybercurrencies are beginning to gain some credibility with central banks and may yet become useful as a medium of exchange. As for SPACs, it is at least very clear what investors are getting into and the SEC has warned of tougher oversight ahead on both these vehicles and the kinds of derivatives that got Archegos in trouble.
On the one hand that high levels of liquidity and low interest rates are continuing to support market exuberance. On the other hand, investment fundamentals won out in the cases of both GameStop and Archegos and the investors who got it wrong lost large sums of money with minimal disruption to the broader market, while the banks had enough capital to take absorb their losses. In a truly speculative market Archegos in particular could have triggered panic selling. This outcome – as well as the fact that the SEC appears to be getting tougher - should be broadly reassuring to investors, although complacency is never appropriate.
Sustainable Investing Policy Trends
What a change a few months can make! At the beginning of the year, the US had an administration that was openly hostile not just to efforts to combat climate change but that took measures to impede shareholder activism and sustainable investing in general. The new Biden administration has made its commitment to combatting climate change crystal clear. President Biden started by immediately rejoining the Paris Accord and naming top officials across his administration with both expertise and commitment to climate change issues. A series of executive orders – including cancelling the less than successful sale of oil drilling leases in the Arctic National Wildlife Refuge – have further underlined the new administration’s change of course. Biden’s proposed infrastructure plan is heavily focused on clean energy, public transportation and other measures to reduce the US’s carbon footprint. There is an expectation that Biden will announce an ambitious national emissions reduction target in the framework of the Paris Accord. The rules changes that made it harder for shareholders to propose resolutions at annual meetings and for retirement plans to offer sustainable investment options are also in the process of being reversed. It is much too soon – of course - for any of these changes to have had any concrete results but it makes a big difference that the US government is now aligned with the sustainable investing community instead of at loggerheads with it.
Beware of “Greenwashing”
Sustainable investing is all the rage these days. Companies are competing to show their shareholders how seriously they take sustainability issues in their businesses. Increasingly they are disclosing information about their carbon footprint and what they plan to do to reduce it and announcing plans to address racial disparities. On the investing side of things, longstanding sustainability focused investment firms have now found themselves competing with the new sustainable offerings of the big mainstream fund managers. The variety of investment products that are labeled “sustainable” or “ESG” has grown dramatically in just the last few years.
This rush to declare oneself sustainable creates risks for investors, however. Not all companies and investment funds are as sustainable and transparent as they claim to be and there are many examples of “greenwashing” in both the corporate and investment spheres. Among companies, for example, Saudi Aramco declared an artificially low carbon footprint by excluding assets that it owned with partners (Bloomberg), Google declared that its motto was “Don’t be Evil” while going public with a share structure that privileged its founders and other key investors over the vast majority of shareholders and has allegedly tolerated a work atmosphere that was hostile to women and minorities, BP cleared carbon off its balance sheet by selling its Alaskan assets to a small competitor with a worse environmental record (Bloomberg, again).
The SEC released a Risk Alert on April 9th revealing that that some fund managers are promoting their funds as ESG investment products when they are not, highlighting that some firms lack formal procedures to ensure that investments billed as “ESG” are in fact meeting these standards. The SEC signaled that some firms mischaracterizing their investment products in this way could be violating securities laws.
Here at White Pine Advisory, we uncovered what appeared to be an example of greenwashing when investigating a potential investment for an endowment that seeks to keep its portfolio fossil fuel free. We were considering buying an ESG Aware Emerging Markets ETF but noticed that it had a higher-than-expected carbon intensity. On further investigation we discovered that the fund held both Saudi Aramco and Russia’s Gazprom. Not only are both of these among the biggest fossil fuel companies in the world, but they are also majority government owned, which poses risks for other shareholders. Saudi Aramco has disclosure issues, as noted above. Gazprom is well known for aligning itself with the Russian government - sometimes at the expense of other investors - and for its problematic track record on safety and the environment. We reached out to the fund manager for an explanation. They were very responsive and helpful and explained that the ETF excludes coal and oil sands but not fossil fuels in general. Additionally, they do not actually take corporate governance issues into account and so do not exclude companies that mistreat minority shareholders. It seems that “ESG Aware” in this case means “some limitations on energy investments, some sectors (such as guns) not allowed on social grounds and no awareness of governance issues.” Unfortunately, this made the ETF uninvestable for the endowment in question.
As always, “Caveat Emptor”. Investors should always be sure to do the proper due diligence before putting their money to work.
What’s Next?
The big question on the mind of investors is inflation. The pandemic driven global shutdown was a major deflationary shock whose effects are now wearing off as the economy re-opens. It stands to reason that rebounding demand will lead to rising prices and in fact that has already been seen at the gas pump. And – of course – the Federal Reserve vastly increased the liquidity available to the markets at the time that shut-downs began while the US government has pumped close to $4 trillion into the economy to keep it afloat. Foreign central banks and governments have followed suit. The combination of strong demand and high levels of liquidity has proven to be inflationary in the past and many economists - including former Treasury Secretary Larry Summers - have warned that the groundwork has been laid for this to happen again in the relatively short term.
March consumer inflation (CPI) numbers seemed at first glance to bear out these fears, with the annual rate rising to a multi-year high of 2.6%. But this was largely driven by higher oil prices, with core inflation remaining safely below 2%. With high levels of idle capacity remaining, the service sector still only partly re-opened and the labor market still scarred by the pandemic businesses continue to see limited ability to increase prices. Bond investors appear comfortable with the risk of inflation: an auction of long-term US Treasuries that came soon after the announcement of March CPI went better than expected and US ten-year interest rates have moved back below 1.7%. The Biden administration told the NY Times that it is paying close attention to inflation (https://www.nytimes.com/2021/04/13/business/economy/biden-inflation-stimulus.html?smid=url-share) while Fed Chair Jerome Powell has publicly stated more than once that he is not concerned about inflation at this point. As is the case with the stock market vigilant optimism seems to be the appropriate stance for investors to take.
With the US expected to reopen fully over coming months the outlook for the economy is strong. The Biden administration’s proposed infrastructure plan – assuming it gets through Congress in some form- would provide further impetus, even with the proposed higher taxes on corporation and the wealthiest individuals. In addition to the boost to growth from increased public investment, the planned infrastructure improvements should lead to a much-needed gain in American productivity. Tools such as the proposed permanently increased child tax credit and other measures aimed at reducing inequality and strengthening the safety net should also support the economy, since the less wealthy are more likely to spend their increased income than the wealthy who benefited from the 2017 tax cut. Market observers ranging from JP Morgan Chase CEO Jamie Dimon to Senate Minority Leader Mitch McConnell have predicted that the US economy will see strong growth well into 2023.
Wall Street has already been raising its forecasts for GDP growth and for corporate earnings for this year and next. A strong US economy would not be a surprise for investors. The strong economic outlook remains, nonetheless, positive for the stock market as long as inflation expectations stay well-anchored. If the Biden infrastructure plan gets through Congress that should provide a further boost to growth expectations over a longer period of time. The bull market seems likely to continue as long as neither growth nor inflation disappoint.
Urban Larson
Principal
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