Adam Bernstein, ESG/Impact Analyst
At the start of 2023, investors and economists anticipated a challenging year for markets, and according to Bloomberg, 70% of economists polled expected a U.S. recession. Contrary to these predictions, it was an excellent year for the stock market and the economy. Q4 and the full year (2023) Gross Domestic Product (GDP) growth came in above analyst expectations, showing a robust increase at an annual rate of 3.3% for the quarter and 3.1% for the year.1 Inflation has also gracefully descended towards the Fed’s 2% target. These developments have bolstered confidence in the Federal Reserve’s ability to engineer a soft landing, a cyclical slowdown in economic growth that avoids recession. The positive surprise in GDP was fueled by a quarterly uptick in inventories and an enhanced trade balance. Notably, personal spending growth continued to be the key driver, accelerating throughout the quarter, and culminating in a significant surge during the holiday season. While many economists have tempered their recession forecasts for 2024, doubts linger, and both a recession and soft-landing scenario remain a close call amongst forecasting communities.
So why was Wall Street so wrong about its recession call in 2023?2
I’ll start with a short explainer of some capital dynamics leading into 2023. Quantitative Easing (Q.E.) and zero-interest rate (ZIRP) policies, which were remnants of the 2008 financial crisis, artificially propped up unprofitable businesses and fueled unproductive investments. As measured by the Consumer Price Index (CPI), consumer price inflation averaged just 1.6% from January 2009 to December 2019, but inflation was not absent from the economy. It shifted to assets owned mainly by the wealthy, a group with the lowest marginal propensity to spend additional wealth. Due to a weak labor market and low wage growth, there was an absence of significant fiscal stimulus among lower/middle-income households, who traditionally have a high propensity to spend. As a result, consumer demand did not put substantial upward pressure on the prices of goods and services in the pre-pandemic era. In the pandemic, massive fiscal stimulus was directed into households and at consumers who had a high propensity to spend at historically significant volumes, and over a short time frame. This turbocharged any existing excesses and put pressure on prices. The S&P 500 gained 94% from its April 2020 low through the peak in December 2021, and home prices rose 45% from early 2020 through June 2022. This dynamic, coupled with pandemic supply chain disruptions caused demand to outpace supply, leading to further price hikes and the onset of our current inflation problems.
In 2023, inflation proved easier to tame than expected, thanks to the unwinding of pandemic-related supply shocks and the Fed’s successful anchoring of inflation expectations. We’ve seen a notable reduction in Headline CPI inflation rates, which came down from their peak of 9.1% to 3.3%.1 This occurred without causing a severe economic downturn or materially increased unemployment rates, giving markets cause to celebrate.
- Pandemic-induced supply chain disruptions and labor shortages gradually eased, naturally decreasing inflationary pressures, and avoiding harsh economic contractions.
- The Federal Reserve’s commitment to a 2% inflation target and quick action prevented a wage-price spiral.
Reducing supply bottlenecks has been the primary driver of disinflation success in 2023, but future gains will have to come from the hard-to-battle services inflation. A robust CPI print for December underscored the challenges to achieving a sustained return to 2% inflation. While a decline in shelter costs (the most significant component of services inflation) is anticipated, planned price increases in other core service sectors (healthcare and utilities) are poised to support inflation.
Taking all of this into consideration, when we look at inflation, we expect it to continue coming down unless there’s some shock. Right now, both JPMorgan and Bloomberg’s macro strategists forecast core CPIs getting near 2% by December. Threats to this view include a successful effort by producers to reduce inventory levels, which will mitigate the deflationary pressures observed in core goods over the past six months. Other risks include heightened geopolitical tensions and extreme weather patterns that can disrupt significant trade routes. For instance, closures of the Panama Canal and Suez Canal due to droughts triggered by El Niño could wreak havoc on global supply chains. Similarly, an escalation of conflict in the Middle East could disrupt trade flows through the Strait of Hormuz.
Another area Wall Street misjudged was the resiliency of the consumer. Consumer spending defied expectations, remaining robust thanks to a strong labor market and positive wage adjustments. The labor market was much sturdier than anticipated, with unemployment reaching a 50-year low despite concerns about job losses due to quantitative tightening. Personal consumption expenditures in Q4 accounted for nearly 68% of GDP, the most significant component of its growth. Recent data also indicates an encouraging improvement in consumer sentiment, with a 13% increase in January 2024, compared to the previous month, and a 21.4% rise in the prior year. 1 The significant role of consumer spending in shaping economic direction underscores the importance of understanding consumer trends. Our view of consumers is that they don’t stop spending just because it’s prudent to stop spending; they stop when they are forced to, making consumer debt monitoring important in understanding spending. Total household debt in the U.S. reached a record high of $17.29 trillion in the third quarter of 2023, representing a 4.8% increase over the previous year. Credit card debt alone surged by 16.7% for the one-year period ending September 30, 2023, surpassing $1 trillion for the first time ever. Despite these concerning figures, household debt service payments for 2023 only represented, on average, less than 10% of disposable personal income. For reference, 2008 debt service payments were ~13% of disposable income. With wage growth and personal savings at 4.1% and 3.7% in December, the 4.8% growth in household debt seems manageable.3 During 2023, the net worth of all U.S. households rose by $11.8 trillion or 8.1%, a sizable increase in wealth that will help households continue to spend and feel better about borrowing money.4 Consumer strength seems to have more runway, but an uptick in corporate layoffs could shift this picture quickly.
In the latest labor reports for December, the robustness of the labor market persisted, with hiring picking up pace even after seasonal adjustments. The ratio of job openings to unemployed workers remained stable at 1.4, indicating a healthy demand for labor. Despite this, the quits rate is expected to stay relatively low at 2.2% below pre-pandemic levels, which could help alleviate wage and inflation concerns by reducing labor-market churn. The steady quits rate suggests that despite the high number of job openings, there may be less urgency for businesses to fill positions left vacant by departing employees, especially with recent productivity gains. As measured by the Employment Cost Index (ECI), wage inflation came slightly below expectations in the fourth quarter, consistent with inflation that’s primarily been receding faster than anticipated. These labor stats are still above the typical pace seen in the years before the pandemic, but as they cool, the Fed can feel more comfortable considering rate cuts. Despite economic worries, business spending held up well, driven by government subsidies for strategic industries like semiconductors and clean energy. Overall, 2023 presented a picture of surprising economic resilience and adaptability, defying many of Wall Street’s pessimistic forecasts.
There has been a notable increase in concern regarding the sustainability of U.S. fiscal policy. This heightened unease is partially attributed to the extraordinary fiscal measures implemented during the pandemic, which led to a federal debt-to-GDP ratio of 98%, nearing levels observed after World War II. According to a June report by the Congressional Budget Office, projections indicate a continuous upward trajectory of the debt ratio in the forthcoming decades. With interest-rate expectations having shifted higher since then, the fiscal outlook looks even more troubling now, begging the question, can the U.S. afford higher rates for longer?
What does all this mean for our outlooks and portfolio positioning?
The Fed and the market are betting on an economic slowdown in 2024, but to differing degrees. The market has already priced in most potential gains from the Fed’s dovish stance, leaving little room for upside should anything but the prescribed rate cuts materialize. Moreover, the inverted yield curve and historically poor central bank track record in achieving soft landings suggest potential dangers. Therefore, investors should remain cautious while the Fed’s pivot toward dovishness has temporarily calmed markets and brought major indexes back to all-time highs. Maintaining agile portfolio positioning that can weather both dovish and hawkish scenarios is crucial, given the uncertainties surrounding the future trajectory of inflation and the Fed’s response.
Our base case remains that the Fed will ultimately be unable to keep rates higher for longer because something will break, causing the excesses in the system to unwind. The labor market and consumers have so far remained surprisingly resilient, partially due to structural changes in the labor force resulting from the pandemic, and economic growth has remained strong so far despite the Fed’s tightening attempts. Some market catalysts we are watching include the $684 billion in unrealized losses on bank balance sheets, China’s property market instability, commercial real estate challenges, housing market struggles with high mortgage rates, rising geopolitical risks, deglobalization trends, and U.S. political dysfunction. Until such a breakdown occurs (or a soft landing is assured), we expect upward pressure on rates to continue as higher for longer rates get priced in, particularly at the long end of the curve. Credit spreads have only recently begun to widen, and we expect widening to continue to reflect the increased credit risk present in a higher-rate world. A risk-off shift may halt the upward pressure on rates and ultimately spread to equities, which look particularly vulnerable given the elevated valuations of a narrow bull market and the opportunity to earn 5% risk-free on cash and short-term bonds.
To better understand the market rally in 2023 and how to position portfolios best this year, we looked at other times in history when the Fed paused hiking rates and then plateaued before eventually cutting. Before 1990, the Fed was all over the place, and there were no periods we could easily identify as being the typical Hike Rates -> Plateau -> Cut Rates pattern we are used to seeing today. But after 1990, apart from the early-mid 90s when the economy was robust, and the Fed was able to keep rates at a normal level for a few years, the pattern has been for risk-on markets during the plateau, followed by risk-off/recession around the time the Fed begins cutting rates. The average S&P 5005 return based on the last five rate plateau periods was 18.54%,6 lasting an average of 10 months. The S&P, since the start of the plateau for this cycle, has only returned 8.69%5 as of 1/30/24 over almost six months, meaning we might be able to expect another ~10% melt-up in markets over the next four months, if history is a guide, before the cycle turns. But we want to take only some of our direction from history, so when we combine this historical analysis with forward-looking expectations, we find that the S&P500 is priced for perfection and hard to buy at the current valuation levels. Still, utilities and infrastructure assets are trading at significantly discounted valuations and are set to benefit from policy shifts like the Inflation Reduction Act (IRA)bill, the Chips and Science Act, the Infrastructure Investment Act, and the global trajectory towards a low-carbon economy. These trends have yet to fully bear fruit for investors, as 2023 was a slow year for renewable energy and infrastructure businesses, primarily attributable to elevated interest rates. As the economy, inflation, and rates normalize, these types of investments are set up to have long runways to perform.
Climate and ESG Update
This quarter, we will focus on unpacking the investment case of what we believe to be one of the most significant opportunities available to investors today: energy-system investments in the era of climate change. The basket of public and private investment opportunities that underlie this market segment represents a compelling opportunity due to several long-term trends converging on a concentrated basket of stocks with clear short-term catalysts. These trends include:
1. Issues with existing infrastructure/ energy sources
We were experiencing rising global energy demand and declining supply, which manifested in surging prices, grid failures, and rolling blackouts around the world, even before the COVID-19 pandemic and the Russia-Ukraine war. In most places where we produce oil (Organization of the Petroleum Exporting Countries, OPEC, Russia, U.S., Brazil), the amount we produce is dropping. We have already depleted the best oil fields, and well-depleting math only accelerates as we go to lesser fields. Oil demand will likely peak in the short term, but global energy demand is still accelerating and has grown by about 2% yearly since 1973. Currently, non-OPEC+ countries dominate medium-term capacity expansion plans, led by the United States, Brazil, and Guyana. The relatively substantial supply increases from non-OPEC+ producers, and the projected slowdown in oil demand increase the spare capacity for oil, keeping energy prices in check.
Due to this dynamic, many investors need to pay more attention to a sustained rise in commodity prices. Capital limitations and the depletion of resources are poised to propel prices upward in the years ahead, contrary to the past decade’s trends. We think the “end of oil” will result from price-related demand destruction, not technology-driven obsolescence. Before we get there, we will likely see marginal producers bought by lower-cost providers with scale until it is harder and more expensive to transport traditional energy around the grid than renewable sources. We are witnessing a system in transition that needs trillions of dollars of investment to serve our evolving needs. Valuations for the companies involved in this process are still very reasonable, and pose an opportunity to investors who are watching these trends unfold. On the flip side, investors who are not paying attention to these major shifts will have to content with stranded assets and asset abandonment risks for firms who will not be able to sell down inventories or operate their businesses in a warmer climate.
2. The transition to a low-carbon economy
COP28 took place in 2023, marking 31 years since the United Nations Framework Convention on Climate Change (UNFCCC) was adopted, and eight years since the Paris Agreement was signed at COP21. The “Conference of the Parties” (or “COP”) brings together all the governments that have signed the UNFCCC, the Kyoto Protocol, or the Paris Agreement to address climate change and its impacts jointly. The negotiated agreements and outcomes of this conference give investors and consumers insights into the direction of travel for most of the world’s developed and developing economies.
COP represents one of the largest global organizational bodies that focuses on critical climate issues and its ability to mobilize diverse stakeholders to create specific industry action, making it one of the great investor roadmaps. Some of the significant outcomes of this year’s conference include a tripling of global renewables capacity by 2030 and double energy efficiency improvements. This suggests a substantial increase in global capital investment in the energy system, and projections are for an average of $4 trillion annually through 2050 to meet the goals. This marks a notable rise from the current level of investment at just over $2 trillion annually. By 2050, it’s envisioned that low-carbon sources will constitute approximately 70% of the world’s energy output, up from ~20% today. Advancements in energy storage, electrified transport, and alternative fuels for aviation and shipping are expected to persist, driven by ongoing technological innovation to reduce costs and enhance efficiency. While the transition towards a low-carbon economy offers investment prospects, it also serves as a critical lens to evaluate investment strategies and associated risks. Given the magnitude of this transition, capitalizing on it necessitates investors to develop insights into cost trajectories, technological trajectories, and the evolving dynamics within value-chain segments. Although the transition’s impact is most keenly felt in the power, infrastructure, technology, and utility sectors today, it is imperative to adopt a comprehensive portfolio perspective when navigating these shifts.
3. Electrification of the grid
Governments have tried to curtail energy demand, mainly through passing CAFÉ standards (efficiency standards) on vehicles, ride-sharing incentives, fuel taxes, investment in public transportation systems, and demand control of high energy usage appliances. Generally speaking, the global population grows by 0.9%, and thetotal energy demand grows by 1.4% annually. The energy mix has started to shift when you look at data from 1973 until 2019, noting increases in nuclear and natural gas, and renewables, while the total energy produced has also risen by about 2% per annum. One of the most significant changes to our energy system has been increased electricity generation (often powered by natural gas).
To meet this growing demand, we need more production. There has been a revolution in renewable energy capacity added to the grid to solve this problem. Electrification emerged as a pivotal strategy to increase energy output, curtail emissions, and transition towards decarbonized energy supply chains, playing a crucial role in achieving net zero objectives. As various grid systems undergo electrification, the proportion of electricity in total final energy consumption is anticipated to surge, projecting a rise from 20% in 2022 to over 27% by 2030 in the Net Zero Emissions by 2050 (NZE) Scenario. While there has been a consistent upward trajectory in this proportion recently, aligning with the NZE Scenario demands a notable acceleration, necessitating a doubling pace to meet the 2030 milestone. The administration estimates that planned investment in clean energy and related sectors has exceeded $110 billion since the IRA passed. Bloomberg Intelligence compiled a group of the 36 top companies focused on boosting power efficiency for the grid and found that the group bested the S&P 500 index by 31% in 2023 and by 53% over the last four years.
4. Energy consumption trends
Consumer trends are substantially accelerating energy demand, reinforcing our need for more energy sources. Artificial intelligence (A.I.) operates at a high energy intensity, demanding considerably higher power consumption than typical cloud-computing operations. As a result, energy consumption by companies such as Meta, Amazon, Microsoft, and Google has tripled since 2018. Projections suggest that by 2030, the energy requirements of data centers alone could triple, accounting for 3% of global demand; however, this figure could escalate to 5% without substantial efficiency enhancements, as highlighted by an analysis conducted by Huawei. The shift towards electrification across various sectors is crucial to mitigating climate change. Bloomberg New Energy Finance (BNEF) estimates that by 2030, E.V.s will witness a power consumption growth comparable to data centers, which are anticipated to drive the bulk of the 60% surge in demand for communication technologies. A.I. holds promise in delivering significant climate benefits, such as predictive maintenance and real-time energy-consumption analysis. These gains will likely entail increased utilization of clean energy and companies that can lead the way in power optimization and electrification.
5. Market buy-in opportunity
The opportunity set investors have for investing in the energy system is split into a handful of industries: technology hardware, semiconductors, communications equipment, electrical components, utilities, data centers, and power producers accounts for a bulk of the opportunity. Of these industries, renewable energy generation companies are reeling from a painful run in which this sector has badly lagged the broader market due to high-rate sensitivity and resurgent oil and gas thanks to heightened geopolitical risk. Battered valuations in the clean energy sector make this a promising moment to buy into one of economic history’s biggest structural growth stories. The utility sector is a significant component of the renewable energy themes that have underperformed this year. Negative yield spreads for utilities vs. U.S. 10-year treasury bonds have been a significant headwind for the utility sector. Look at the S&P water index (~40% utilities) or the renewable energy producers index (~94% utility). You can see why renewable energy investors performed poorly this year, with the utility sector down (-14 %)5 in 2023. Regulated utilities make money by providing essential services to customers, like electricity or water. The key to their profitability is the rate base, which is the total value of their assets minus depreciation. They are allowed to earn a reasonable rate of return on this rate base. Regulators, such as public utility commissions, oversee and regulate these utilities, deciding how much profit they are allowed to make each year. Authorized utility returns generally move directionally with long-bond yields, but with several quarters of lags. If the market is correct on the path of interest rates, and energy prices remain in check, utilities may be poised for a breakout year.
The other industries are more technology centric and growth oriented. These companies invest in critical components of a modern, sustainable energy system but are driven by different market factors than the utility and power portion for the energy grid opportunity set. While investors in wind and solar, exemplified by the S&P Global Clean Energy Index, saw declines of over 20% last year, electric grid technology and optimization companies, exemplified by the Nasdaq Clean Edge Smart Grid Infrastructure Index, saw gains of over 20% over the same period. These components can come together in a portfolio that is strategically aligned with the changing energy landscape, set to benefit from policy shifts like the IRA bill, CHIPS Act, and Infrastructure Investment Act, along with the global trajectory towards a low-carbon economy.
Transforming our energy system is not just an environmental aspiration; it’s a race against time. Climate change sounds warnings through intensifying weather extremes, and scientists warn of looming tipping points, irreversible thresholds beyond which the Earth’s systems shift radically, potentially with catastrophic consequences.
In 2023, the global climate witnessed unprecedented warming, with surface temperatures reaching record highs and numerous regions experiencing extreme weather events, including devastating wildfires in Canada and deadly heatwaves in various parts of the world. This heightened climate urgency underscored the discussions at the COP28 climate summit in Dubai. Despite the Earth’s discomforting temperature anomalies throughout the year, exacerbated by human-induced climate change and natural factors like a robust El Niño event, some scientists suggest that 2023 may be a precursor to even more pronounced warming trends in the coming years. The events of 2023 highlight the pressing need for comprehensive climate action and underscore the risks associated with continued greenhouse gas emissions.
- Bloomberg, accessed on 2/2/2024 ↩ ↩2
- https://gittermanasset.com/q3-2023-market-commentary-what-do-monetary-policy-and-forest-management-have-in-common/ ↩
- U.S. Bureau of Economic Analysis. Access on 2/2/2024 ↩
- JPM Asset Management webinar “Policy Easing Prospects in a Political Year.” Access 1/31/2024 ↩
- S&P500 TR USD Index. The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. ↩ ↩2 ↩3
- Morningstar Direct. Accessed on 2/2/2024 ↩