The media and the environmentally conscious were disturbed during the most recent quarter as President Donald Trump made the decision to formally withdraw the United States from the Paris Agreement. Adopted in 2015, and put into effect on November 4, 2016, the agreement called for nations to take steps to mitigate greenhouse gas emissions. As part of the Paris Agreement, each nation would be responsible for determining its own contribution and ambitious targets, albeit non-binding and unenforceable, to help achieve this collective global goal.
The Paris Agreement calls for the world’s richest economies, also some of the largest greenhouse gas polluters, to commit to pay billions to help the world’s poorest adapt to the effects of climate change. The United States, under the former President Barack Obama administration, spent $2.5 billion from 2010 through 2016 to help poor countries adapt to climate change and develop clean sources of energy. Further, the United States committed an additional $3 billion to the Green Climate Fund, also for such purposes, while committing the United States to reduce emissions to 27% below 2005 levels by 2025.
Trump and other climate change skeptics point to the difficulty of measuring with any precision the degree of human activity’s impact on global warming, highlighting long historical cycles of the Earth’s warming and cooling trends. Critics state the Paris Agreement is really three things: an anti-industrial, environmental political cause; an effort by the Chinese to undercut the U.S. economy by layering on costly, job-killing regulations which would disadvantage U.S. energy and manufacturing businesses; and a waste of taxpayer money. They also highlight China and India as having no obligations under the Paris Agreement until 2030, and argue an active volcano under Antarctica as the primary reason for the acceleration of polar ice melt, a representative symbol for the climate change movement.
We are not climatologists nor environmental scientists, but we can use the climate change debate as this quarter’s analogy to the changing economic landscape, with central bank actions being deliberated for their impact on economic and market cycles over short and long periods of time. On a short-term basis, although with a lag, central bank activity is meant to be a dampener of economic volatility, providing liquidity in times of stress while removing liquidity when economic conditions are overheating. While over the long run the economy may ultimately get to the same destination, avoiding economic extremes (especially deep economic recessions) is a worthwhile practice by improving predictability and confidence in decision forecasts. Business leaders and institutional investors are also instrumental in providing capital when future returns are attractive, while limiting capital when expected returns are inadequate.
As written ad nauseam, by slashing the Fed funds rate, and embarking on an aggressive Treasury and Agency bond purchase program (aka Quantitative Easing or QE), the Federal Reserve and Treasury stepped in to stabilize the economy and financial markets. Central bankers were credited with saving the financial system, as their efforts engendered stability during a very challenging economic environment. As market interest rates declined due to these government bond purchases, corporate CFOs embarked on their own ambitious financial engineering strategies, including the issuance of low interest rate debt, stock repurchase programs, and dividend increases. Given the uncertain economic future, these strategies were substitutes for capital expenditures and reinvestment back into the business to support long-term growth. While the Fed’s actions provided a floor to the economy and markets, the normal capitalistic process of allowing undercapitalized, flawed business strategies to fail was disrupted, thus allowing weak businesses to survive. This bloated, less efficient outcome could be considered one reason for the less than robust expansion witnessed over the ensuing years.
At the time, fundamental analysts and portfolio managers questioned the validity of the equity market’s advance. It was led by higher risk companies who benefitted most from financial restructuring, as well as from defensive, high dividend yield, bond surrogate companies/sectors, even where their future growth expectations were uninspiring. In an environment where traditional, fundamental business analysis metrics (examples: sales growth, margins, return on equity, free cash flow, etc.) mattered little, active managers trailed the blind buying behavior of passive index as well as higher risk strategies.
We fast forward to the current environment, with the economy now growing consistently in the low 2% range, the unemployment rate below 4.5%, and general confidence and business conditions recovering. Indeed, the Federal Reserve has made some progress towards their goal of “normalizing” the Fed funds rate, now at 1.25%. Additionally, they have recently announced plans to gradually reduce their $4.5 trillion of accumulated QE debt holdings, although expected to take multiple years to unwind so as not to disrupt the market. The U.S. central bank is not alone in their tapering effort, with the European Central Bank (ECB) also discussing the ending of their own QE program, as the Eurozone appears to have turned the economic corner and making progress towards stability and growth.
This change in business climate, while not as robust as past cycles, has certainly been recognized by investors. Domestic equity valuation is on the higher end of their historical range, but consistent with low inflation environments, and not at levels considered extreme. The improvement in economic conditions, both domestically and now internationally, has generated a recovery in current earnings, as well as favorable projections for future periods. More importantly, while central banks are moving towards becoming less accommodative, they are not close to being labeled as restrictive, or at a point of choking off the recovery. Bond yields on the other hand, remain depressed, as yields are below expected inflation and spreads on high-yield bonds have narrowed meaningfully.
With improving global conditions, investors have been showing greater confidence towards expanding their exposures to areas outside the United States. Monies have generally been withdrawn from U.S.-based investment opportunities, with foreign developed and emerging markets seeing the greatest inflows. With the Fed potentially on hold for the remainder of the year, the dollar has declined relative to foreign currencies, down 4.7% during the quarter, causing year-to-date foreign equity returns to have far outpaced domestic equity returns on a dollar basis.
Long cycles occur in many areas of the market and we continue to believe international markets, after years of underperformance, in both their economic recovery and investor flows, are in their early innings. Should the dollar continue to depreciate, domestic export oriented businesses would become more competitive, large multi-national businesses would see improved earnings on repatriated overseas profits, and domestic inflation pressures would build.
A rising economic tide would float all boats, improving corporate earnings, but could also cause erosion of corporate excess liquidity and runs the risk of a more aggressive tightening of monetary policy. Additionally, as investors have embraced passive investing, reaching emotional and social acceptance (reaching 40% of flows), and as correlations across stocks have declined, we believe fundamental, active investing is positioned to regain an edge over passive indexing.
Finally, whether due to climate change or capitalistic interests, companies who want to stay relevant will embrace and adapt to the demand for products and services appealing to their customers. The declining cost of renewable energy should eventually make this capital investment decision appealing to both environmentalists and industrialists, likely making the world a better place for everyone.