Going to Glasgow?

To start with the bad news: the leader of the world’s largest carbon emitter is not going to the Glasgow climate summit this week. China’s Xi Jinping is staying home, as he has since Covid-19 began. Vladimir Putin of Russia and Jair Bolsonaro of Brazil are also shunning the conference. And leaders attending the weekend gathering in Rome of the G-20 countries — which account for 80 percent of global emissions — were unable to make new progress on climate commitments ahead of Glasgow. This is disappointing. The Conference of Parties (COP) 26 climate summit is the most important such gathering since global leaders met in Paris in 2015. That breakthrough meeting also came just after a G20 leaders summit which had ironed out differences among major countries. In Paris, 192 leaders from around the world agreed on a global approach to reducing emissions over time, rooted in countries’ own “nationally determined contributions” (NDCs) and dependent on transparency and mutual global stock-taking of progress. This year’s COP), delayed from 2020 because of Covid-19, was supposed to take the next big step after Paris.
There is, however, important good news as well, especially from the private sector. That matters for investors. Inflation, interest rates and economic growth naturally dominate investor concerns day to day. This week’s meetings of the Federal Reserve and Bank of England may crowd out news from Glasgow. Fed Chairman Jerome Powell and colleagues are expected to begin the long-awaited tapering of asset purchases, and BoE governor Andrew Bailey and colleagues may even decide to move interest rates off the floor. Fears of rising interest rates and inflation infected markets last week more than fears of rising sea levels. But understanding and getting ahead of climate risks — and opportunities — is increasingly important for investors. Insurers, lenders, builders, real estate companies, health care facilities, and farmers are just a few of the private sector players made aware by extreme weather events that climate change is a today issue, not a future problem.

Going into Glasgow, it is clear that attitudes have changed more broadly since Paris. Private sector companies and financial institutions, as well as climate specialists and politicians, are pledging to take action to curb and even reverse emissions. Driven in part by shareholder and investor concerns, even the fossil fuel giants are shifting, as they admitted to past sins to the US Congress last week and pledged to do better. Debate over whether Shell should separate renewables from their fossil fuel business — pressed by an activist shareholder and resisted by company executives and some other investors — has centered on what is the best way to move to greener energy, while keeping returns for investors high.

Technology has also advanced at an unexpected pace. The goal of cutting solar costs to 6 cents per kilowatt-hour (kWh) to enable it to compete with cheaper fossil fuels was met in 2017 — 3 years ahead of schedule. Halving the cost by 2030 is the new goal. Two key technologies that would shift the paradigm, according to John Podesta, architect of the Obama-era China-US joint statement that opened the way for agreement at Paris, are green hydrogen and battery storage. Some dreamers might add nuclear fusion.

On the policy front, the USA — the world’s second-largest emitter today — is now poised to spend more than half a trillion dollars to spur investment and consumption in green energy, with large new tax credits the tentpole measure. Many see the climate measures that seem to have survived the legislative sausage-making as game-changing, including Senator Ed Markey of Massachusetts, who commented that he now believes tax credits would “supercharge the renewable revolution” and work in tandem with the administration’s newly adopted regulations. They do not include carbon pricing, which economic purists believe is the simplest way to set incentives and speed action economy-wide — as RockCreek Founder & CEO Afsaneh Beschloss and RockCreek Senior Advisor Dame DeAnne Julius argued most recently in a piece for Chatham House. Steps to penalize fossil fuels were also dropped, under political pressure from West Virginia Senator Joe Manchin. But the remaining tax credits, buttressed by regulatory changes, are a big step forward. Optimists on policy hope that the next phase will be to spread incentives globally, through adoption by major countries — read the EU and the US — of trade measures that will impute a price for carbon on imports from countries that are not recognizing the costs of emissions in their production and impose tariffs to create a level playing field with home-produced goods. Such a Carbon Border Adjustment Mechanism (CBAM) would be challenging to compute and agree. It would also create problems with big emitters in the developing world who see advanced countries as morally and practically responsible for helping their adjustment to carbon neutrality with aid and finance, not tariffs. But getting the price right globally is probably the most efficient way forward.
Observations and takeaways for investors:
Inflation staying — for a while — and central banks on the move

Last week confirmed that inflation is here to stay for longer than most central banks and analysts planned for. Instead of the lower for longer interest rates that have buoyed markets since the pandemic, we are looking at higher for longer inflation. Friday’s report showed the Fed’s preferred measure of core inflation, based on personal consumption expenditures, still high at 4.4 percent on an annual basis, although the month-on-month rise moderated slightly to 0.3 percent.
Market reaction to this new reality has been muted so far. In part, that reflects continued uncertainty about where the economy is headed. A case can be made that inflation will subside towards the Fed’s 2 percent “average” target as pandemic-related disruptions to supply, described in last week’s note, are gradually overcome. Most believe that it may take time to resolve the many bottlenecks and shortages that have sprung up over recent months. But as the problems have spread, there is growing focus on finding solutions, maybe even with the help of AI, argues a new paper from MIT Technology Review. As supply constraints ease, optimists say, a gentle tap on the monetary brakes may be enough to ward off a spiral of rising costs and prices.

But it is also possible to tell a story of a surprise abrupt tightening, that could destabilize markets, if wages and other costs take off. Nominal wages have indeed been rising. Last week’s employment cost index (ECI) which adjusts for changes in the labor force to give a truer measure showed wages and salaries were up 4.2 percent over the past year. This is less than inflation, so real wages were dented over the twelve months. However, this shifted in Q3, when real wages rose slightly. The pattern of the pandemic recession and recovery is so unusual that it is hard to find convincing analogues in history, whether the post-Korean War benign period or the worrisome 1970s. One thing is clear: spending, corporate earnings and output have all picked up much more rapidly than after the 2008/09 recession. This is good news. The downside is that inflation is up as well.

As a result, US central bankers at the Federal Reserve meeting this week are expected to begin tapering asset purchases. Fed Chair Jerome Powell is in an awkward spot with his renomination still undecided. But he was clear last week that if inflation is worrying, the Fed will act to choke it off, stating, “If we were to see a serious risk of inflation moving persistently to higher levels, we would certainly use our tools to preserve price stability…” Across the Atlantic, European Central Bank (ECB) President Christine Lagarde gave a different message. Despite Euro-area inflation in October that exceeded expectations, topping 4 percent compared to a year earlier and matching the record since the currency was launched, Lagarde repeated her view that it would be a long while until the time was right to raise — currently negative — policy rates. Quite a change for this low inflation zone. But policymakers have been trying in vain to lift inflation up to target for two decades. And with the ECB’s main hawk — German Bundesbank President Jens Weidman — announcing his retirement Lagarde’s ECB has a decidedly more dovish tone.

In contrast, last week Canada and Brazil moved sharply to tighten. In Canada, the central bank signaled an earlier than expected rate rise next year and announced it would end asset purchases. Brazil raised rates 150 bps, another example of the more limited policy space that developing countries have.

Who wants a job?

The FOMC has to decide on tapering and tightening before seeing the next labor market report, due Friday. The detailed data for jobs and unemployment in October is expected to validate the Fed’s tentative view that we are seeing substantial progress in the labor market. Indeed, many indicators suggest that the jobs market is tight, just as employers have been telling us. New unemployment claims fell again last week, and are now close to pre-pandemic norms. Job openings exceed 10.4 million. Quit rates reached a high of 4.3 million at the end of the summer.

The enduring puzzle is that millions of Americans who were employed pre-pandemic are now out of work, whether by choice or because it takes a while to find new jobs after businesses have closed or relocated. For some, the continued cloud of Covid-19 and concerns about child care are a factor. For some lucky workers, the option to stay remote is appealing and worth waiting for. And perhaps low-paid and tough jobs will just be harder to fill, post-pandemic, unless employers improve wages and working conditions. Recent data from the job site, Indeed, shows that interest in jobs from home health to food services to warehouse loading and stacking has plummeted, while searches for IT specialists, media and other communications positions are surging. Who can blame them? Some politicians and unions have pressed in vain for a reduction in inequality and better working conditions to help the working poor. Maybe Covid-19 will lead to change? So far, the pandemic has tended to worsen inequality. But the longer-term story is one to watch.

Spend, spend, spend

Meantime, corporate earnings may stay strong if consumers keep on spending. Data released last week showed disappointing Q3 growth, as RockCreek has anticipated for some time in the summer. Advance data showed GDP up by just 2 percent at an annual rate over the summer. But spending was picking back up by the end of the quarter, albeit at a slower rate than in the booming Q2. Importantly, as Covid-19 fears retreat it seems that traditional spending habits are returning. A revival in demand for services — travel, eating out, having fun — would also ease pressure on supply chains that have been strained by extraordinary demand for goods. In real, inflation-adjusted terms, Americans spent 15 percent more in September on goods than they had in February 2020. Even with the recent increase, spending on services is still 1.7 percent lower in real terms than it was pre-pandemic. In Europe, the growth pattern has been reversed from that of the US. The second quarter was marred by Covid-19 concerns and restrictions. But in Q3, Euro area GDP grew at an astonishing 9 percent annual rate (2.2 percent quarter on quarter, as usually reported in Europe).

Last week ended with a mixed bag of earnings, but despite this, US equity markets continued to rally for the fourth consecutive week. Overall corporate earnings results were better than expected and drove equity prices back to record highs for the month after a dismal September. The best performing sectors were consumer discretionary and communications for the week with financials and energy being the laggards.

Although earnings in the US have been strong — with Alphabet and Microsoft reporting earlier this month and their stocks up over 4 percent after reporting — downsides are emerging. Almost every company reporting has noted the severity of margin and supply chain pressures bringing on higher prices and foreshadowing for higher prices. Cost inflation drove future quarter revisions lower and it was across sectors like restaurants, staples, apparel, footwear and household durables. At the end of last week, Apple and Amazon reported and highlighted supply chain problems and tight labor markets again as weighing on profits — Apple said that supply chain disruptions were hindering the manufacturing of iPhones and Amazon posted lower than expected sales plus signaled that these two factors would weigh on fourth-quarter earnings — the two companies together erased $180 billion in value last Friday morning based on where their stocks were trading after the news.

Emerging Markets

There were few bright spots to report in emerging markets last week. Chinese equities gave up much of the previous week’s gains as corporate earnings underwhelmed and Chinese GDP growth looks to slow further. The selloff was broad-based, including the largest companies in the tech, insurance, EV, and commodity sectors. The country’s power crisis that began in September showed up in the data last week with Chinese manufacturing activity showing a sharp decline. Some of the most acute effects of China’s power rationing have been felt in the country’s power-hungry metals industry. For instance, aluminum production has suffered a 2.3 million ton drop since September, triggering a rally in the price per ton to a 13 year high of $3,000. Magnesium and steel have also seen significant price increases. The current trend is set to continue until the country brings additional sources of green energy online. Until then, global transport, packaging, and construction sectors will continue to face supply constraints, and the world’s central banks will have to grapple with China’s exported inflation. Indeed, emerging markets central banks continued to address inflationary concerns, with Russia hiking rates for the sixth time this year and Brazil hiking rates by a whopping 150 bps on Wednesday alone.
Brazil’s latest rate hike comes as the market grapples with the consequences of the Bolsonaro administration’s decision to repeal the country’s constitutionally mandated fiscal spending cap. The combination of higher rates and prospect of profligate fiscal spending has spooked domestic investors, leading equity markets to flirt with March 2020 lows. With an upcoming Presidential election and former President Lula rising in the polls, investors are in for a wild ride. We are more convinced than ever that opportunity and stability lies elsewhere in emerging markets. We see some of the best opportunities in India and the ASEAN economies, areas that have traditionally been eclipsed by the dominance of China in the recent past.

In India, we are focusing on a growing list of tech companies with plans to go public as well as companies that stand to benefit from supply chain bifurcation. While ever mindful of the potential for new Covid-19 outbreaks and the risks tied to rising oil prices, the fact is that activity levels in India are now above pre-pandemic figures. There are signs of an incipient CAPEX cycle and market reforms that could potentially lead to a sustained economic up-cycle in India. In the ASEAN area, we expect to see countries that have lagged in Covid-19 recovery to begin to inflect as vaccines and treatments become readily available. With cyclical recovery on the horizon, and with valuations at historic lows, any shift in institutional sentiment will drive ASEAN markets higher. We saw that in high relief in August and again in October. Low valuation and foreign ownership levels only bolster our view.
RockCreek Update
Join us for a series of discussions from the COP26 Summit in Glasgow with leading climate scientists, investors and entrepreneurs.

On Wednesday, Nov. 3rd at 9am EST, Divya Seshamani, Managing Partner of Greensphere Capital LLP, will join RockCreek for a discussion on the latest from COP 26. Register here.

Team RockCreek

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