Environmental Strategy Review | Q4 2021

January 23, 2022

The calendar year 2021 was another strong one for U.S. stocks. However, the overall results mask an increasing level of volatility under the surface. In some ways, there have been two distinct market environments since the start of last year.

The one in the first half of 2021 was supportive of risk assets. At the outset of the year, there was good news with regard to the pending deployment of new vaccines. Further, fiscal and monetary stimulus measures remained in place and had largely offset what could have been a very negative economic story globally. As 2021 unfolded, the employment picture continued to improve, ultimately getting back to pre-pandemic levels as measured by the unemployment rate. Nominal GDP finally exceeded pre pandemic levels early in 2021 as well.

The landscape became much more volatile and uncertain in the second half of the year, and that volatility has accelerated in early 2022. There are several drivers of the change in tone. Some of the above-mentioned improvement in the unemployment rate was due to people dropping out of the workforce. About 4 million fewer people were working in the U.S. at the end of 2021 relative to pre pandemic levels. Although pundits debate the causes for this decline, the effects have been quite noticeable. Service, hospitality, and transportation industries have had a very difficult time staffing to meet demand, in some cases resulting in reduced profits or even closure. Transportation bottlenecks have disrupted supply chains still further, resulting in a scarcity of products reaching the end consumer.

The labor shortages have led to higher wages. This, combined with the supply chain issues and a loose monetary and fiscal policy environment, has resulted in elevated consumer prices. The Federal Reserve initially believed these inflationary pressures would be transitory. However, they now appear more systemic, and the Fed is reflecting that belief by starting to remove the extreme monetary accommodation that has been in place since the start of the pandemic.

As January 2022 has unfolded, many market participants have become convinced that the Federal Reserve will need to become more aggressive than originally planned in the removal of that stimulus. This has led to higher interest rates (and lower prices) in the bond market and a significant repricing in the stock market, particularly in higher growth areas like the technology, communications, and consumer discretionary sectors.

As a result, in the 6+ months between July 1st and the date of this letter, the total return on both U.S. stocks (as measured by the Russell 3000 index) and U.S. bonds (Bloomberg Barclays Aggregate Index) has been negative. The return on international stocks has also been negative during that time.

For investors focused on climate change, the variation in sector-specific performance in recent months has presented a further headwind. By far the best-performing market sector since the middle of 2021 (as measured by the return on Vanguard’s sector ETFs) has been traditional energy, with utilities second. In January alone, energy is up by more than 11% so far on the back of higher oil prices, while every other market sector is down between 2% and 13%. Perhaps the most effective way to illustrate the dichotomy is by comparing two familiar names. Since New Year’s Eve, the return on ExxonMobil stock has been almost 18%, while the return on Microsoft stock has been about -12%, a 30% return gap in a matter of three weeks.

While traditional energy companies have performed well, clean energy companies (solar, wind, etc.) have not. Because many of these are less mature companies with lower current profits and higher price to earnings multiples, they have been particularly vulnerable in an environment where technology and growth companies in general have underperformed. The S&P Global Clean Energy index is down more than 20% since the middle of 2021.

It is important to cover what has happened in the market and why. It is more important to discuss what may happen going forward, the implications for investors, and portfolio positioning around that.

First, we should emphasize that the type of adjustment we are experiencing is endemic to markets and investing. If anything, investors have probably become too accustomed to consistent returns and lower volatility. It’s worth repeating something that we stated in our last quarterly letter: “…investors should moderate their expectations for market returns over the next decade relative to what we have experienced in the last ten years….With interest rates still near all-time lows and stock valuations elevated, the potential paths available to achieve double-digit forward returns seem limited.” To this we add that the degree of volatility accompanying those returns is likely to be higher as well.

That said, investors with a long-term mindset should be able to navigate that type of environment more successfully than those who attempt to move in and out of the market based on short-term volatility. In the short-term, there are innumerable factors that drive what happens in markets, most of which are inherently unpredictable. Over longer horizons, returns are generally driven by economic growth and the profits and cash flows created by the underlying businesses. That is why 100% of the down markets in the history of the U.S. stock market have eventually been followed by a new all-time high. It is also why we believe, regardless of how well fossil fuel businesses may perform in the near term, technology businesses, including those involved in clean energy, are more likely to outperform long-term.

It is difficult to know whether this current downdraft will evolve into a larger correction or even a bear market (defined as a peak to trough decline of 20% or more). Our view has been that some of the inflation we are experiencing is likely to moderate as 2022 evolves through a gradual abatement of some of the supply chain issues. However, inflation to this point has proven more stubborn than we originally expected, so we acknowledge the possibility of a less sanguine outcome.

Regardless, it seems likely that the pressure on growth stocks may continue for a while until the market has a more concrete idea of how this plays out. For that reason, we are exploring ways to add some additional value-focused exposure to the portfolio without materially changing our carbon profile. Healthcare, for example, is one low carbon sector that we think is relatively inexpensive.

Small cap stocks have underperformed their large cap counterparts in the last year. At this point, we think small cap is underpriced relative to large cap and we will continue to maintain our allocation there, with a larger tilt toward value companies where possible.

While international stocks look fairly inexpensive relative to the U.S., we are reticent to add in that area, primarily due to concerns around China.

There are two facets in particular we think are important. One is the increasing tension with its neighbors and with the U.S. We hope and believe the chances of armed conflict with China are remote. That said, the possibility has received increasing attention in the press and from our peers, and we believe it should not be ruled out as a possible “black swan” event in the year(s) ahead. This comes at a time when President Biden is also addressing tension along the Ukrainian border, threatening Russia with sanctions if they should overstep there. Hopefully, all of this ends up as no more than saber rattling, but we do believe geopolitical risk is sufficiently high to warrant its inclusion in our investment decision making process.

Another concern is the over leveraged Chinese real estate market (roughly 30% of the country’s GDP), the potential for pervasive default/contagion, and the as-yet-unknown “solutions” to be employed by Beijing. The Chinese economy has always been somewhat opaque, with information standards lacking relative to its Western counterparts.

On the fixed income front, while bonds have produced a negative return since the start of 2021, we think they still play a critical role in balanced portfolios. If stocks do continue to struggle and/or economic growth disappoints, market focus may eventually shift from the risk of high inflation to the risk of a recession. In that environment, bonds should provide a valuable buffer. We continue to adhere to investment-grade only on the bond side, with favoritism shown to U.S. Treasuries as the only positive carry asset class that has historically exhibited a negative correlation with equities.

Environmental Characteristics

As a reminder, for an individual company, carbon intensity is defined as tons of CO2 equivalent emissions per million dollars of sales. For an investment fund, the carbon intensity metric represents a weighted average of all of the companies owned by the fund. The weighted average carbon intensity of our environmental model stock portfolio remains approximately 50% lower than the level of major U.S. stock indexes as of the end of 2021. The portfolio’s exposure to companies that own any fossil fuel reserves remained at roughly 0.8% as of December 31st, which represents a reduction of about 80% relative to the overall U.S. stock market¹.

Frank, Josh and Keith

1. U.S. stock market is proxied using the iShares Russell 3000 ETF (IWV) and the Vanguard S&P 500 ETF (VOO). Carbon intensity and fossil fuel data for the environmental model holdings and for IWV utilizes the most recent available data as of the end of the quarter. Data is sourced from MSCI, Inc. via ETF Database.com.

Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. Investment in securities involves the risk of loss. Investment process, strategies, philosophies, allocations and other parameters are current as of the date indicated and are subject to change without prior notice.