In this quarter’s commentary, we’ll consider valuation risk in the wake of equity markets reaching near record highs in 2016 and take a closer look at what a Trump presidency may or may not mean for investors in cleaner energy and low-carbon technologies. First though, it’s constructive to take a brief look back at how we got here, with a recap of 2016 investment highlights.
U.S. stock markets, in general, posted solid gains in 2016 as evidenced by the following chart and table. Small caps were the big winner and value handily beat growth. Developed equity markets as represented by MSCI EAFE Index did not fare as well, mainly due to a strong dollar negatively impacting returns. Bonds were generally lackluster, with the exception of the high yield market, which delivered very strong returns on the back of an improved economic backdrop.
In many ways, 2016 was an extraordinary year. The markets sold off significantly for the first six weeks of the year, registering negative double digit returns. Equity markets rallied substantially off their February lows, delivering returns on the remainder of the year ranging from outstanding to spectacular depending on the market segment. These returns were boosted by the post-election rally fueled by speculation about the impact of pro-growth policy expectations of a Trump presidency.
What happened is fact. What will happen ranges from speculation to informed judgement, but no matter how well-informed a forecast is, it can still be wrong. Late last year, the New York Times ran a story whose theme was summed up at the beginning with this: “Every December as the holidays approach, Wall Street gurus examine the stock market, and nearly all declare that stocks will rise in the forthcoming calendar year.” But since 2000, according to the source1 the Times story cites, those forecasts have been stubbornly rosy, and far rosier than their outcomes. Average December forecast: 9.5% rise. Average performance: 3.9% rise.
Assessing the equity market in 2017 is particularly challenging given the nature of the extraordinary run equities enjoyed, the speculation driving the post election rally and the extremely rich valuation of equities at year end. The performance since February market lows was largely beta2 driven, with higher risk stocks leading the way with little regard to underlying fundamentals. While the markets took a respite in October, the election of Trump reignited the beta-driven rally as expectations of increased economic stimulus in the form of lower tax rates and increased spending on infrastructure and defense would be good for the economy and the equity market.
This run has left domestic equity markets significantly overvalued in our opinion. The forward price-to-earnings (P/E) ratio3 on the S&P 500 Index and Russell 2000 Index are at levels not seen since 2008. Further, for small cap companies in the Russell 2000 Index that are actually generating earnings, the median P/E is at the highest level in more than 30 years.4 The market run-up after the election reflects a very strong expectation that President Trump will be able to quickly deliver on his promises. If there are disappointments on the delivery or timing of these developments, the market might be vulnerable. We believe current equity levels fully reflect positive information on current policy, economic and corporate earnings expectations.
For investors interested in sustainability, however, expectations are more like “cloudy with a chance of catastrophe.” That does not mean that sustainable investing returns are expected to lag broader markets; it means that the policy infrastructure that can accelerate or impede the progress of investments in more sustainable areas is expected to be much more difficult in the
Trump administration than in the Obama administration. That policy underpinning might affect investment returns, and it might not. Drawing straight lines between any policy and investment returns is anything but simple, and often anything but correct.
There’s very little doubt that the incoming administration will be less friendly to policies designed to curb climate change and stimulate a low-carbon transition than the outgoing administration. But it is premature to assume that potential policy changes means woe for investors in cleaner energy and low-carbon technologies.
Why? Because the transition, which is already underway, is driven far more by economics and technology than by policy. The International Energy Agency’s most recent medium-term forecast notes that growth in renewable capacity continues to set records and that for the first time in 2015, renewables accounted for more than half of net additions to power capacity and overtook coal in terms of installed capacity, worldwide. Lazard’s annual Levelized Cost of Energy Analysis notes that some renewables technologies “continue to be cost-competitive with conventional generation.” Bloomberg New Energy Finance’s 2016 outlook notes that “Cheaper coal and cheaper gas will not derail the transformation and decarbonisation of the world’s power systems. By 2040, zero-emission energy sources will make up 60% of installed capacity.”
Moreover, renewables still have considerable ability to capitalize on rapid technological improvements, and the well-known ability of technology to drive down costs. That is simply not true in the business of creating electricity from fossil fuels. The last time that business was considered a high-tech driver of innovation was about a century ago.
The momentum in renewables has benefited from some public policy, to be sure, including subsidies (many past, some present) for renewables. But that’s even more true of fossil fuels than it is of renewables: the International Energy Agency estimated in 2013 that consumer subsidies for fossil fuels at $548 billion was more than four and a half times greater than subsidies for renewables at $121 billion. Clearly, subsidies don’t explain all performance, especially recently. The economic currents driving the deployment of renewables are increasingly swift, making it ever more difficult for fossil fuel technologies to navigate up this river. It’s hard to imagine any leader of a single nation being able to reverse this current, or dam it, especially when others are working to amplify it. China, for instance, is plowing $361 billion into renewable power generation in the next three years.
Moreover, when we consider the new administration’s likely moves on energy and climate policy in light of another Donald Trump promise—to preserve jobs and create new ones—it’s useful to remember that renewables employ more people than oil, gas and coal combined.
All the forces that contribute to impelling renewables forward apply in reverse to the dirtiest of the fossil fuels, coal. It would take a Herculean effort to bring coal back. The retirement of coal plants is a trend that’s been underway for decades—U.S. Department of Energy’s Energy
Information Administration shows that clearly for the U.S., and that trend is also continuing in Australia, Germany, France, the UK, Finland, Holland, and many more countries. Even China, which is still quite dependent on coal, is committed to phasing out coal, and its coal use has fallen for at least two years in a row. Even if it reneges on its intentions to phase out coal, how likely would that result in a increase in coal production in the U.S.? Not very.
Michael Bloomberg summed things up in a way that makes sense to us: Obama didn’t kill coal. The market did.
We are mindful that some of what the new Administration will bring can affect markets, and we’re continually evaluating our own investments for exposure to potential risks and
opportunities. That involves diligently evaluating developments from both a sustainability and financial standpoint and assessing their implication for the market, sectors and individual stocks.
We are also mindful that there may be an uptick in market volatility at these valuation levels as we obtain clarity on policy proposals. These events shouldn’t be viewed as solely negative.
Disciplined active managers can use those periods to put cash to work and buy stocks on sale. In an environment where positive earnings surprises may be one of the few market drivers, astute stock selection and nimbleness will be key.
1 Bespoke Investment Group
2 Beta reflects the sensitivity of a fund’s return to fluctuations in its benchmark; a beta for a benchmark is 1.00, a beta greater than 1.00 indicates above average volatility and risk.
3 Forward Price-Earnings Ratio or P/E FY1 ratio is a ratio for valuing a company that measures its current share price relative to its per-share earnings over the next 12 months.
4 Furey Research
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net”, which includes dividend reinvestments after deduction of foreign withholding tax.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
The Russell Midcap Index measures performance of the mid-capitalization sector of the US equity market. The index is a float-adjusted, capitalization-weighted index of the 800 smallest issuers in the Russell 1000 Index. The index is a subset of the Russell 1000 Index and serves as the underlying index for the Russell Midcap Growth and Value Index series. The Index is reconstituted annually.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Bloomberg Barclays US Aggregate Bond Index is a broad base index, maintained by Bloomberg L.P. often used to represent investment grade bonds being traded in United States. The BofA Merrill Lynch High Yield Index tracks the performance of below-investment grade, US-dollar-denominated corporate bonds publicly issued in the US domestic market.
One cannot invest directly in an index.