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The subject of DE&I – diversity, equity, and inclusion – is having its moment in discussions about companies and workforces. Numerous studies have been conducted attempting to quantify the degree to which all manner of performance metrics improve when access and representation look more like the population at large. We are entirely supportive of a focus on DEI, but not necessarily the focus as it currently stands in the investment world. There is a strong impulse to count and score things to reduce the uncertainty of qualitative observations to quantitative data points, which is not unique to DEI or ESG. DEI happens to lend itself well to that approach because people can be counted. How many women? How many indigenous peoples? How many veterans? What we find is that counting or checking boxes can illuminate deficiencies, but does little to uncover how or why, and fails to understand the interdependencies between different categorizations, such as veterans and health and disability, or race/ethnicity and economic status and education. For instance, a company hiring STEM workers may come up short in its hiring of women or people of color, which could be a failure of policy and practice, or it could be that the supply of qualified candidates is insufficient because universities are not producing a diverse pool of graduates from which to draw. For us, it is a systems-level question. We start with the reasoned assumption that diverse, equitable and inclusive workplaces are more productive and more profitable as well as being more fundamentally just, but our focus is on the systems that perpetuate unproductive biases. That could be and often is rooted in discriminatory practices and systemic biases, but those biases do not exclusively live with the hiring manager or company nor are they fixable in the immediate term no matter how radical a policy shift is implemented. It takes time to establish systems of good governance, cultivate and develop talent, and equalize compensation and promotion opportunities, and those systems extend well beyond the four walls of a given company into our communities and our education, nutrition, health care and other civic services. High performance through an ESG lens where DEI is concerned is establishing and fostering systems and processes that naturally produce a more representative workforce by developing and improving the capability and capacity of candidate workers and opening access to opportunities. [charts courtesy US Bureau of Labor Statistics, Current Population Survey]
Let’s talk about something that proves that short-sighted or wrong-headed decisionmaking in ESG is bipartisan. One of the incredibly unfortunate halo effects of the Ukraine conflict is the global food shortage caused by Europe’s breadbasket being at war and the sanctions limiting access to Russian natural gas (key source for fertilizer). In addition to placing at risk a large percentage of the world population that are already nutritionally insecure, it has the effect of driving up commodity and food prices in the developed West. As we have discussed in prior blogs and newsletters, the conflict has also destabilized the petroleum market because of Russia’s role as a petrostate. The US is effectively energy independent, or nearly so if we look at all of North America together, but no question energy prices are higher. So what’s an American to do in the face of a global food and energy crisis? The US administration has an answer – put food in your gas tank. The decision to move to E15, 15% anhydrous denatured alcohol in the fuel mix, for the Summer arguably makes the whole situation worse. Referring to the US Energy Information Administration, the ASTM D4806 specification for ethanol compatible with spark-ignition engines is produced by “fermenting the sugar in the starches of grains such as corn, sorghum, and barley, and the sugar in sugar cane and sugar beets”. The first chart is from the USDA Foreign Agricultural Service and shows just how material Ukraine is to the global food supply. The second from the USDA statistics service shows already how much US corn production goes to fuel. There is a whole additional discussion to be had about the sense or senselessness of grain and cane crops being turned into fuel, from the energy intensity of the chemical conversion to the natural gas used to make fertilizer to the diesel burned for farm equipment to the climate costs of unsustainable monocrop farming practices that strongly suggests shortening the path from drill bit to burner tip is more efficient. But right now, we are focusing on the fact the US could (profitably) ameliorate rising food scarcity and prices with the same agricultural products it is planning to ferment and burn to save 10 cents on a $5 gallon of gas at the pump.
With the release of “Climate Change 2022: Mitigation of climate change”, which is the third segment of this year’s sixth assessment report (AR6) from the IPCC, most of the attention will be focused again on the doomsday charts. One of the notable ones in the press packet is entitled “We are not on track to limit warming to 1.5 (deg) C.” But, the report is surprisingly optimistic in one very critical sense – it declares the problem addressable if global action is taken promptly and capital is called in off the sidelines to drive a transition in energy, land use, industry, urban zones, buildings and transportation that could halve GhG emissions by 2030. At this point the debate then usually swings to the nature of capitalist systems and that capital will flow to where it can be used most efficiently and to greatest effect (e.g. risk-adjusted return), and there it stops. Advocates for changing policy on climate will trot out the “if we don’t act we’ll all die and your money won’t mean anything” argument, having failed to learn that existential threats don’t tend to deter markets until they become existential realities, supporting a party-like-it’s-1999 mentality. However, one slide in the press packet which probably won’t get much attention actually holds the key to activating capital entitled “(In some cases) costs for renewables have fallen below those of fossil fuels.” This is profound in that it doesn’t require the rest of the science or policy or existential concerns to affect the flow of capital. It is simply becoming cheaper to convert today’s sunshine and wind into electricity and shove it into batteries than to dig up fossilized sunshine from more than 65 million years ago and burn it. Even with investment and innovation in efficiency, modern society will continue to be increasingly energy intensive, and as more of the world’s population joins the middle class, utilization will become even more widespread. Intelligent allocators of capital will pursue the cheaper inputs that will meet that demand.
While many other things dominated the headlines from the Russian/Ukrainian conflict to inflation and policy response to COVID-19 Omicron part deux, something that was considered mostly unthinkable by scientists happened in Antarctica. According to the US National Ice Center (https://usicecenter.gov/PressRelease/IcebergC38): “(USNIC) has confirmed that iceberg C-38… has calved from the Conger Ice Shelf in the Wilkes Land Region of Antarctica. As of March 17, C-38 was centered at 65° 40′ South and 102° 46′ East and measured 16 nautical miles on its longest axis and 10 nautical miles on its widest axis. C-38 comprised virtually all that remained of the Conger ice shelf, which was adjacent to the Glenzer Ice Shelf which calved last week as iceberg C-37.” Eyes had been on another part of Antarctica over concerns about the potential collapse of the so-called “Doomsday glacier” — Thwaite’s glacier. But, Conger beat Thwaite to the punch with a break-away described as nearly the size of Los Angeles. Our attached chart from NOAA NCEI chronicles the decline in global sea ice just since 1979. When split into hemispheres, Northern loss is faster at -2.68% vs. “only” -0.33% for Southern (decadal trend). The fact Conger collapsed and Thwaite’s is trying is deeply concerning because it illustrates just how fragile the system is. Failure to adjust climate-changing activities and to start building resiliency and adaptation into industries and communities poses real threats to economic stability and prosperity and the performance of investments over a shorter-term horizon than many expect.
This week we get to take a break from talking about inflation to talk about… inflation. Although, in this case, what effects Russia’s moves on Ukraine might have. Russia’s economy is the 11th largest in the world as measured by nominal GDP, which seems significant until we realize it is smaller than Canada’s and 1/10 the size of China’s. Ukraine is 55th. Where Russia is most consequential in terms of their economy on the world stage is energy – petroleum and natural gas. Europe is a net importer of natural gas, a significant portion but not all of which comes from Russia. They have been increasing LNG imports from the US and Qatar, but that is mostly offset by a steady decline in domestic production. Natural gas is not the only major piece of the European energy portfolio, but it is material. Prices have already been high, and the decision to delay certifying Nord Stream 2 in response to Russian aggression means little relief is on the way. Globally, “OPEC+” has been falling short of targets to increase production post-COVID wind-down and the Ukraine conflict will not help climbing prices for oil either. The West is putting the framework for a new sanctions regime in place but that will mostly be about deciding who takes what share of the economic pain to box out Russia. Rising oil prices have similar effects on the economy as rising interest rates, so we are interested to see how the Fed digests the changing macroeconomic environment and the need to be aggressive on policy rates later in the year. Looking longer term, assuming the priority does not become preventing total war as Putin tries to reassert the borders of the former Soviet Union, we see this moment as a tipping point for Europe to accelerate their transition to a low-carbon future because it is an undeniable security imperative for the EU member states. [Sources: US Energy Information Administration https://www.eia.gov/todayinenergy/detail.php?id=51258 and McWilliams, B., G. Sgaravatti, G. Zachmann (2021) ‘European natural gas imports’, Bruegel Datasets, first published 29 October, available at https://www.bruegel.org/publications/datasets/european-natural-gas-imports/]
The February 10th inflation report for January was higher than expected. Key stock market gauges declined and were particularly weak toward the day’s close. Notably, all major inflation segments continue to rise — Services, Goods, and Food — with the exception of Energy, but oil and gas prices are up so far in February.
The benchmark 10Y UST yield rose above 2.0%, which has been an adverse trigger level for stocks in the recent past. The real yield on US Treasuries is more than -5%, a historic anomaly. Meanwhile, the US Federal Reserve will begin reducing its balance sheet in March. It currently stands at $8.9T, increasing over $5T since the pre-pandemic low of $3.75T, about a 134% increase since the Fall of 2019. Furthermore, the Fed is set to increase policy rates several times this year, perhaps as many as six times.
It is difficult to envision the Fed backing away from its intent to restrain monetary liquidity, especially considering that inflation trends appear to be gaining momentum. Consumer prices initially began to accelerate in March of last year, rising from 2% to about 4.5%, and had another upswing last Fall through the latest report. Headline inflation, now stands at 7.5%, a 40-year high level that very few, if any, at the Fed have had to deal with in a professional capacity.
Policy conditions are visibly changing, yet the equity market over the past couple of weeks attempted a rally from late January’s bottoms. The recent bid on US stocks could be value seekers, although the market is still fully valued if not overvalued considering a higher rate environment. It could be a response to more and more US states announcing a wind-down of COVID-era policies, or simply that capital needs a place to land and US stocks are more attractive than international equity markets or global bonds.
Absent a meaningful catalyst (we are still looking) we do not anticipate a sustained rally and expect the general trend of US equity prices to be range bound to downward. Investors must come to grips with a tighter monetary policy environment, higher interest rates and inflation. We note that other major central banks, notably the BOE, have increased policy rates, and the ECB is publicly debating the need to address inflationary trends on the European continent. And, many emerging market CBs have already embarked on a tightening cycle. [chart data from US BLS © 2022]
The market, in our view, is trying to come to grips with a less accommodative yet still supportive monetary and fiscal policy environment. Federal Reserve policy is dominant at this moment, since it appears fiscal policy progress has stalled until the mid-term elections and perhaps beyond. The Fed is unlikely to turn away from its recent pivot towards being less “dovish”, which in light of recent inflationary trends is still is a far cry from an aggressively “hawkish” stance.
It seems probable the market will re-test the lows of January 24th over the coming days or weeks, and from there we will ultimately see from which way the equity market breaks. The recent intra-day volatility was reminiscent of some of the price action during the financial crisis, particularly around the 2008 election. When it appeared that President Obama would easily win, the S&P 500 rallied over 18% from October 27th to election day November 4th. With deep uncertainty about who would fill the new President’s cabinet and what steps they would take to address the worsening crisis, the S&P 500 subsequently fell nearly 33%. The market ultimately bottomed when Timothy Geithner, Obama’s most important new cabinet appointee at that moment (Sec. Treas.), announced the deployment of the TARP funds. There are certainly differences between 2008-2009 and now, most notably the health of the financial sector. However, the market fears uncertainty and that is a common thread between now and then. Another more tenuous thread, but one worth watching, is the speculative bubble in digital assets that has already partially ruptured, and the run-up in residential real estate in part fueled by loose lending practices. Today’s uncertainty is primarily around what the future holds in a less accommodative monetary and fiscal environment. Economic activity, while still growing, appears to be slowing and high inflation persists, prompting concerns about the potential for stagflation. [chart: Wilde Capital Management © 2022, data from Standard & Poor’s 500 Index]
Evidence of consumer price pressure abound ranging from rising food to energy to consumer staples. Overall, US consumer prices rose over 7%, a growth rate the US has not faced since the 1980s. There are several well-documented reasons why prices have risen so rapidly, including the pandemic-forced economic shutdowns and supply chain disruptions of the past two years. How long will inflationary conditions persist, and will it become structural? Prior to the pandemic, the US was in a benign inflationary environment. Then, disinflation resulting from government-mandated shutdowns across the country suppressed prices. The annual change in US CPI averaged 1.4% from April 2020 to April 2021. The current CPI reading on December 31, 2021 is based off pandemic nadir levels, and the base effect may lead to higher “headline” inflation in the months ahead. However, if annual gains in consumer prices fail to keep pace with the high inflation trends of 2021 [which include 2020’s low base effect], forward looking inflation could moderate. Capital markets will likely remain on edge, and the US Federal Reserve will be challenged balancing appropriate monetary policy against inflationary trends that may prove temporary, but also may not. (chart © 2022 Wilde Capital Management, data from Bureau of Labor Statistics)
Since March 2020 the US federal government has injected an enormous amount of stimulus into the economy. There have been seven stimulus and reliefpackages ranging from the original Coronavirus Preparedness and Response Supplemental Appropriations Act to The Families First Act to the CARES Act to The Consolidated Appropriations Act and the most recent American Rescue Plan. Even without Build Back Better, this fiscal expenditure legislation amounts to nearly $15 trillion over the life of the legislation with more on the way with the new infrastructure plan. The Federal Reserve has also injected a tremendous amount of liquidity in the system by expanding its balance sheet by $4.5 trillion since March 2020 while maintaining a benign interest rate and regulatory environment. The combined government stimulus over the past twenty months amounts to over 83% of current US GDP (as of end Q3 2021). Compared to the recessionary bottom in 2020, the same stimulus is nearly 100%. By contrast, the 2009 TARP expenditure amounted to about 5% of US GDP at the time. We do not have to look far to see from where upward pressure on asset prices and inflation comes.