As investors review their portfolios at mid-year, they have plenty to smile about.
Equity markets reached the halfway mark of 2019 posting excellent results. The S&P 500 Index delivered a very robust 18.5% return, approximately 8.5% higher than its long-term average historical return for an entire year.
Small cap companies modestly lagged large cap companies, but the Russell 2000 Index still delivered a solid 17.0% return. Large cap growth stocks were the biggest winners, as the Russell 1000 Growth Index returned 21.5% and bested the Russell 1000 Value Index by 5.25%, continuing the trend of the growth style domination over recent years. Non-U.S. Developed Market stocks, as measured by the MSCI EAFE Index, returned 14.0%, but once again lagged U.S. stocks.
Bonds also delivered solid returns as interest rates declined precipitously over the course of 2019, driving a 6.1% return for the Bloomberg Barclays US Aggregate Index.
While these results are gratifying, there are reasons for caution as we look to the second half of the year. The solid 4.3% second quarter return for the S&P 500 Index masks volatility along the way. After the sharp rally to begin the year, the S&P 500 Index sold off -6.4% in May before recovering 7.1% in June. This mirrors the pattern we saw in the fourth quarter of 2018 and early 2019, where investors sold off on earnings risks only to recover on indications that Federal Reserve policy was increasingly dovish.
In our view, risks to earnings continue to be substantive. Most of the gains to equities in 2019 were due to multiple expansion as prices continued to rise while earnings growth slowed. Continued economic weakness remains a threat to earnings. Global economic growth expectations have been reduced. The Global Purchasing Managers Index (PMI), a widely followed indication of economic sentiment, has declined over the last year, and more than two-thirds of countries’ manufacturing PMIs are indicating an economic contraction. The U.S. PMI, while still in positive territory, has also been declining.
Big questions remain. Will central bank intervention provide enough of a stimulus to reduce the threat to global economic growth and earnings? Is Federal Reserve policy easing already priced into stocks? What are the impacts of an unfavorable resolution, or no resolution, to the current trade dispute with China?
These are challenging times for investors with high equity valuations and bonds offering meager yields at current interest rate levels. Investors should ensure that their current asset allocations are truly reflective of their risk tolerance and reduce exposures that are unwarranted.
As investors, we’re particularly attuned to indicators of long-run resilience, and first among those indicators is competitiveness.
For many decades, both on financial markets and in public policy discourse, efforts to cope with environmental problems, social issues and treatment of workers were regarded as de facto penalties on economic and financial performance.
That narrative is still alive, but it’s got some serious opposition from a more expansive, less myopic point of view. The latter view encompasses not only the costs to business from regulatory interventions such as environmental standards or worker safety statutes, but the benefits to society as a whole from creating a more sustainable economy and keeping the infrastructure of a civil society in good repair.
How does that work in the real world? Let’s consider two current-events examples: automobile fuel efficiency and capping greenhouse gas emissions in electricity production.
Following the Great Recession, the American auto industry agreed to meet more stringent fuel efficiency standards as part of a larger $50 billion government bailout to avert fallout from possible bankruptcies. And then time passed, and the economy recovered slowly, and a new Administration was elected, and then, two years ago, the Alliance of Automobile Manufacturers petitioned the Environmental Protection Agency (EPA) to throw out the more stringent standards.
The industry got what it ostensibly wanted, when the Administration announced a major rollback in tailpipe pollution standards. However, alarmed by the “expanding scope” of the Administration’s rollback, the auto industry recently wrote a letter urging the Administration to return to negotiations with the states, some of which rejected the Administration’s proposed freeze on fuel efficiency and proposed to continuing to enforce their own stricter standards. The splintered standards, said the automakers, would engender instability and lower profits, and they urged the Administration to split the difference between a freeze on fuel efficiency and the original target they signed up to meet during the bailout.
Would a single standard be nice? Sure. But the story that’s buried in all the drama is one of competitiveness: The rest of the world is moving forward with fuel efficiency, and some of it is working diligently to electrify vehicle fleets. Globally, there are already multiple standards, and there have been for years. If the auto industry is “forced” to live with a U.S. market that has more than one standard, it will be crucial for the industry to recognize that the states with tougher standards are the ones whose standards would best position the industry to compete globally. Freezing our fuel economy standards at a level that lagged the rest of the developed world five years ago, would mean that the U.S. automakers are essentially stuck with a stagnant market at home and would be increasingly uncompetitive in overseas markets that are more interested in decarbonization (see Figures 1 and 2, below).
Figure 1: With multiple standards, the world is moving forward with fuel efficiency
Source: The International Council on Clean Transportation
CAFE stands for Corporate Average Fuel Economy (CAFE) standards
Figure 2: Stagnant U.S. auto market
Source: Tradingeconomics.com, AUTODATA Corporation. https://tradingeconomics.com/united-states/total-vehicle-sales
There’s a similar story playing out in electricity, where the Administration recently introduced its Affordable Clean Energy Rule, Trump’s ostensible replacement for Obama’s Clean Power Plan. Despite its name, this new plan would do almost nothing to promote cleaner, lower-carbon electricity production, and would actually prohibit states from requiring electric plant conversion from coal to gas.
This is still a competitiveness story, but it’s entirely domestic: The pressures on the electric power industry are not from overseas regulations or competitors but from the fact that the old, coal-fired power plants simply aren’t cost-competitive anymore, with cleaner power production from gas, and especially from wind and solar electricity.
There are essentially no new coal-fired power plants planned in the U.S., and it would simply be foolish for any company, no matter how attached to coal, to build one now. Coal plants last awhile: The average coal-fired power plant in the U.S. is more than 40 years old, and the oldest ones could be collecting Social Security, having been born in the 1940s and 1950s.
In an age when it is clear that we must decarbonize to stave off catastrophe, it is silly to expect any company to throw a billion dollars at a new coal power plant that could last for 50 years, whose viability depends on the policies of an Administration whose future extends to five years at most.
Renewables, meanwhile, have become increasingly competitive with coal and, to a lesser extent, gas. Technology continues to improve the efficiency and cost profiles of renewables, and is expected to “fundamentally reshape” electricity in coming decades. That is not a result of regulation; it’s the market. Rolling regulation back to a time when coal was cost-competitive based on technology and operating costs alone will not save or revive it.
What binds these two stories together is an emerging and powerful logic that has shaped our investment approach since the beginning: Sustainability is not a job killer, and it’s not a ball and chain on competitiveness. It’s very much the opposite. The more concerned the world is with impending catastrophes such as climate change, resource scarcity and biodiversity loss, as well as with the threat of eternal conflict if we don’t address sustainability challenges such as racial, ethnic and gender inequality and income disparity, the more sustainability will be a competitive advantage to firms, nations and investors that recognize its value.
That is why we participated in several of the dialogues held by the Climate Action 100+ groups with automakers, urging them to cease pushing for fuel economy rollbacks and disavow the dubious research in their original petition to EPA for those rollbacks. It is why we’ve engaged with utilities and materials companies — both sectors are far more carbon intensive than fossil fuel companies — urging them to decrease emissions, adopt science-based targets for reduction, and report on climate risks through the TCFD (Task Force on Climate-Related Financial Disclosure) Framework, which we have done. We believe these kinds of engagements will help to make companies more competitive — and better investments.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
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 1000 Growth Index is a market capitalization weighted index that measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth rates.
The Russell 1000 Value Index is a market capitalization weighted index that measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth rates.
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.
One cannot invest directly in an index.