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Category: Insight

Wild Turkey Inflation Run

Written by John Heneghan

Equity and bond market investors have a very busy week ahead of them after giving thanks with friends and family this past week.  The Federal Reserve also has its work cut out for them on the inflation front.  Unfortunately, a lackadaisical Fed Reserve has let inflation go on a wild turkey run. The latest Consumer Price Index (CPI) reading for October 2022 came in at a roasting annual increase of 7.7%.  As usual whenever inflation is an issue, it’s typically driven largely by the necessities of human existence.  Energy prices increased most of the CPI measurements at 17.6% followed by food increases of 10.9%.

According to the University of Illinois, 46 million turkeys are eaten each Thanksgiving.  The American Farm Bureau Federation estimated that the average cost of this year’s Thanksgiving holiday meal for ten people increased 20% to $64.05 from the 2021 average of $53.31. America’s collective Thanksgiving spending increased more than $225 million for just the turkey and not counting side dishes (46 million times $4.97 AFB price increase for turkey). U.S. Secretary of Agriculture Tom Vilsack had previously warned all Americans of a large turkey shortage. Free-market Austrian economists chortled that Secretary Vilsack had neglected to count the docile turkeys at the Federal Reserve and in leadership in the executive and legislative branches of the Federal government.

All kidding continued, let’s talk turkey about inflation. The greatest economic uncertainty and focus for investors seems to be whether the Federal Reserve gaggle is succeeding in reining in inflation or not. Stock market bulls are feeling a little more confident that the Federal Reserve is moving closer to ending its tightening program after “minutes” from the November policy meeting showed “most” of the Fed herd favored slowing the pace of interest rate hikes “soon.” According to the Fed minutes, some turkeys even warned that continued rapid monetary policy tightening increased the risk of instability or dislocations in the financial system.

Most Wall Street experts predict the central bank clucks will raise the benchmark rate by 50-basis points at its upcoming December 13-14 meeting following four consecutive 75-basis point hikes. The most important inflation updates this coming week will be the PCI Prices Index on Thursday and the November Employment Situation on Friday. Investors are also anxious to hear Top Cockster Jerome Powell discuss the US economic outlook during an appearance at the Brookings Institute on Wednesday afternoon. Powell recently crowed that the Fed could shift to smaller rate hikes next month, but, like all two-handed economists, also squawked that rates may need to go higher than policymakers thought would be needed by next year. Stock market bears maintain that the more important issue is how high rates will ultimately need to go and how long the Fed will hold them there.  All of which is of course dependent on how fast inflation comes down. This is the key question being debated among economists, business leaders, investment advisors, and investors.

For their part, the Fed members generally see inflation coming home to roost rather quickly.  The range of Fed member projections from their last dot plot exercise in September, 2022 are as follows – 2022 (5.0% to 6.2%), 2023 (2.4% to 4.1%), and 2024 (2.0% to 3.0%).  This Federal Reserve has lost an incredible amount of market credibility by being stubbornly beholden to its “inflation is transitory” mantra in 2021. It’s prudent for all economic actors, particularly low- and middle-income consumers and workers who arguably suffer the greatest hardships during inflationary periods, to at least consider that the turkeys at the Fed are once again being too optimistic on inflationary trends.  If the moral sense of the global working-class population is that inflation is a secular trend, it may likely become a secular trend. Look for striking workers and protesting citizenry in the U.S. and globally.

I believe it was Founding Father Patrick Henry of “Give me liberty or give me death!” fame that also counseled, “I have but one lamp by which my feet are guided, and that is the lamp of experience.  I know no way of judging the future but by the past.”  Thankfully, the investment professionals at Research Affiliates (RA) have examined inflationary eras of the past in their recent article, “History Lessons: How “Transitory” Is Inflation?” RA examined a meta-analysis of 67 published studies on global inflation and monetary policies.  Their key conclusions from their study were as follows:

  • The US Federal Reserve Bank’s expectation for the speed of reverting to 2% inflation levels remains dangerously optimistic.
  • An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.
  • Reverting to 3% inflation, which we view as the upper bound for benign inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with the median of over 10 years.
  • Those who expect inflation to fall rapidly in the coming year may well be correct. But history suggests that’s a “best quintile” outcome. Few acknowledge the “worst quintile” possibility in which inflation remains elevated for a decade. Our work suggests that both tails are equally likely, at about 20% odds for each.

As Fed Chair Jerome Powell remembers well because he lived it, the last secular inflationary episode in the United States was in the 1970s and 1980s.  If Shakespeare is right that “What’s past is prologue,” here is a summary of the return performance of various major asset classes in the 20-year inflationary period from 1970 (CPI breached 6% in 1969) to 1986 (CPI declines to 1%) to illuminate the darkness of an unknown investment future.

Source: Data complementary of the TIAA Center for Farmland Research

The best risk-adjusted return profiles from this secular inflationary period were high quality fixed income instruments of varying maturities and farmland. Note that farmland and bonds were negatively correlated over this period so may complement each other rather nicely in a portfolio positioned for secular inflation.  REITs and gold provided similar annual returns but at much higher levels of volatility/standard deviation.

In bowling, three strikes in a row is called a turkey. In economic parlance, that’s the triptophanic effect of the sleepy leadership at the Federal Reserve and in the executive and legislative branches of the Federal government.

Commodities Refresh

Written by John Heneghan

Investors are shaking out the dustbin of their investment strategies to take a fresh look at commodities that haven’t seen a strong portfolio allocation since the 1970s/80s. With inflation rampant and the U.S. consumer price index hitting a 40-year high in September of 8.2% annual rate, it may be time to reconsider commodities as an investment option.  With this inflationary backdrop, it’s the first time in a generation that investors are losing sleep over inflation eating away at their purchasing power and devaluing their hard-earned life savings.

Conventional wisdom holds that commodity investments can provide beneficial portfolio diversification and hedging benefits against inflation. The commodity asset class is generally considered a tactical insurance policy rather than a strategic asset allocation.  The returns from commodities are more episodic driven primarily by inflationary surprises leading to commodities’ primary use as a tactical or trading instrument. Historically, commodities have not been a stable source of returns. On a forward-looking basis, investment firm Research Affiliates projects measly expected annual returns of 0.2% over the next ten years with an expected volatility of 15.5% for commodities (Asset Allocation Interactive research platform).  That said, commodities’ asymmetric return profile can provide valuable inflation protection similar to recoveries under an insurance policy from catastrophes.

Accordingly, we think of the commodity asset class as a tactical/trading tool to deploy before a wave of unexpected inflation or a long period of sustained inflation.   In hindsight, an opportune time to allocate to commodities was earlier in 2021 while the Federal Reserve’s mantra was “inflation is transitory” and well before the Fed’s December 15, 2021 inflation capitulation.  For instance, an allocation to the iShares S&P Goldman Sachs Commodity Index (GSCI) Commodity-Indexed Trust (GSG) returned 39.0% for calendar 2021 and has gained a further 26.0% through October 26, 2022.  Although we were appropriately concerned about inflation trends and adjusted Servant Financial client portfolios accordingly, we did not add any direct exposure to commodities to client portfolios. We opted instead to tilt model portfolios, subject to client risk tolerances, to real assets and inflation hedges with more stable risk-adjusted return profiles – gold/precious metals (CEF, GDX, SLV), bitcoin (GBTC, HUT), farmland (FPI), and Horizon Kinetics Inflation Beneficiaries ETF (INFL).

With spectacular commodity price responses to the unexpected spike in inflation now largely behind us, we are hard-pressed to add commodity exposure to client portfolios at this juncture unless we were highly confident that a long period of sustained inflation or what is called a Commodity Super Cycle (Super Cycle) has begun.  Super Cycles are extended periods of time of around a decade where commodities as a whole trade at prices that are greater than their long-term moving averages.  A Super Cycle will usually occur when there is a large industrial and commercial change in demand within a country or globally that requires more resources or supplies of commodities with large demand-supply imbalances.

There have been four super cycles over the last 120 years. The first started in late 1890 and was accelerated with widespread industrialization of the United States and industrial build-up associated with World War I. This cycle peaked in 1917. A new Super Cycle started in the late 1930s with the advent of World War II and peaked in 1951 after Europe and Asia’s heavy rebuilding from the war was complete.

The next Super Cycle started in the 1970s at the beginning of a long phase of global industrialization.  World economies industrialized and populations moved to urban centers, requiring more raw materials and energy to sustain this more intensive growth. The Vietnam War and Nixon’s closing of the gold window (halting foreign nations’ convertibility of U.S. dollars to gold and the dollar plunged by 1/3rd in the 1970s) were also significant factors in this cycle.

Note that the Vietnam War was one of the first Cold War-era proxy wars with eerily similar characteristics to the current Ukraine-Russian conflict. The Vietnam war took place in Vietnam, Laos, and Cambodia from November 1955 to the fall of Saigon in April 1975.  It was “officially” fought between North Vietnam and South Vietnam. However, North Vietnam was supported by the Soviet Union, China, and other communist allies.  While South Vietnam was supported by the United States and its democratic allies. Ominously, the Vietnam war lasted almost 20 years.  The 1970 Super Cycle came to an end as the Vietnam War ended and foreign investments fled as extractive industries became nationalized.

The most recent Super Cycle began in 2000 as China and its population of 1.3 billion, or 20% of the world’s population, joined the World Trade Organization.  With 1.3 billion Chinese jumping on the globalization and industrialization bandwagon, demand for energy and raw materials needed to build new megacities surged. The Great Recession hit in 2009 and ended this last Super Cycle.

The current spike in inflation and commodity prices could well mark the beginning of a fifth Super Cycle.  The Ukraine-Russia conflict, destruction and/or destabilization of global supply chains from the COVID-19 pandemic, breakdown in global trading partnerships, dangerously loose global central bank monetary policies, and a shortage of new investment in energy and raw materials exploration and development point to the makings of a fifth Super Cycle potentiality.

Ole Hansen Head of Commodity Strategy at Saxo Bank believes this lack of investments in materials and energy sectors, as depicted below, together with the forces of decarbonization, electrification and urbanization will keep supply tight and inflation high.

At a minimum, investors should consider the possibility of a new Commodity Super Cycle.  The key matter of debate is whether investors believe the Federal Reserve will ultimately be successful in taming the inflation beast.  The Fed is playing catchup after letting the beast run wild for some time before taking credible action.  For a more in-depth discussion on the Fed’s chances of policy success, readers are encouraged to watch investment research firm Real Vision’s video where perspectives on both sides of the economic debate – deflation/disinflation/recession and inflation/stagflation – are discussed.

We’ll be watching for signs that the Federal Reserve’s interest rate hikes and quantitative tightening cycle are having the desired economic impact – the destruction of demand for goods and labor.  One factor we’re highly focused on is the labor market and whether unemployment levels will trend higher and if inflationary wage pressures lessen.  Secondly, we’re watching for signs of a possible Federal Reserve policy mistake, like a premature policy pivot before the back of inflation is broken.

Our preferred investment vehicle for a tactical allocation to commodities is the Invesco Optimum Yield Commodity Strategy No K-1 ETF (PDBC).   PDBC is an actively managed exchange-traded fund (ETF) that seeks broad-based commodity exposure through financial instruments (commodity futures and swaps and U.S. Treasury Bills) that are economically linked to the world’s most heavily traded commodities.  The Fund’s commodity allocation is production weighted and therefore structurally overweights the energy complex relative to other commodity indexes.  The following summarizes commodity allocations (current % and strategic rebalance target %):

 

Sector

Current % Allocation

Strategic Rebalance Target %

Commodity Allocation
Energy 63% 55% WTI Crude, Brent Crude, Natural Gas, Gasoline
Precious Metals 8% 10% Gold & Silver
Industrial Metals 9% 13% Aluminum, Copper, & Zinc
Agriculture 20% 23% Corn, Soybeans, Sugar, Wheat

 

PDBC outperformed GSG in 2021 returning 41.9%, but the Fund is lagging that GSG year-to-date at 20.7% in gains through October 26, 2022.  Importantly, the Fund does not generate a K-1 tax reporting obligation.

Clear signs of an impending Fed policy mistake would lead us to aggressively consider a tactical allocation to commodities through PDBC.  One low-probability scenario would be a significant dislocation or lack of market liquidity in the U.S. Treasury market that forces the Fed to purchase treasuries.   The Fed would effectively be adopting yield curve controls, much like the recent Bank of England’s actions in the gilts market to stem an uncontrolled blow-out of gilt yields.  One expected casualty in this outlier fact set would be foreigners’ loss of faith in the U.S. Dollar with an ensuing currency devaluation like in the 1970s when Nixon ended dollar convertibility to gold.

Almighty Dollar

Written by Ailie Carlene Elmore

Current Status of US Dollar

What do George Washington, Abraham Lincoln, and Benjamin Franklin have in common? These three American icons found on the $1, $5, and $100 bills have been getting much stronger the past several months. The U.S. dollar is undergoing one of the longest periods of almost steady appreciation in several decades impacting domestic and foreign economies alike. The ICE U.S. Dollar Index, the most widely adopted currency index, measures the international value of the US dollar against other major fiat currencies with a weighting of Euro (58%), Japanese Yen (14%), British Pound (12%), Canadian Dollar (9%), Swedish Krona (4%), and Swiss Franc (4%). The buck’s value is currently up 22% since the start of 2022 with little end in sight.

Source: Wall Street Journal

The rise in the dollar’s value is unsurprising as record inflation in the United States has prompted the Federal Reserve to aggressively raise interest rates over the past several months. Just last week, the U.S. central bank decided on another .75 percentage point increase, the third consecutive rate hike. This pushed the implied Fed funds curve higher, with terminal Fed funds now expected to peak at 4.6% and remain above 4.0% through the end of next year. The yield curve inverted further with the 2-year versus 10-year treasury spread at 50 basis points (0.5%).  These changes in the risk-free U.S. treasury rates are driving the cost of capital higher for all risk assets and significantly impacting equity and currency markets. While the stock market has experienced significant losses, the dollar has been benefiting from increased capital flows due to rising treasury yields. The U.S. 10-year treasury note is at a multi-year high, yielding over 3.5%. Rising U.S. interest rates have foreign investors flocking to higher-yielding U.S. treasuries and pulling capital out of lower yielding, perhaps riskier currencies, bond and equity investments in other countries. This trend is particularly visible in energy dependent jurisdictions like the European Union, China and Japan.

Impact of the US Dollar on the Global Economy

Efforts to combat inflation through interest rate hikes have been counteracted by the strengthening dollar, fueling cheaper imports for the American people. However, the rest of the world has felt the brunt of this change. The economies being hit hardest by the punch of the U.S. dollar, are some of the U.S. largest trading partners: China, Japan, and Europe.

On September 26th, the British pound hit its lowest value ever against the U.S. dollar, sending U.K. bond yields soaring. Emerging economies have also declined in value relative to the dollar with currencies in Egypt, Hungary, and South Africa falling by 18%, 20%, and 9% respectively.

Not only are rising U.S. interest rates impacting these economies, but geopolitical concerns between Ukraine and Russia have Europe in an economic war of its own with Russia. Combined with surging inflation and the aftershocks of the COVID-19 pandemic, the war between Russia and Ukraine has Europe in an energy crisis, only furthering their currencies’ devaluation. Energy prices have skyrocketed while supply dwindles as Europe, particularly Germany, was very heavily dependent on natural gas imports from Russia for its global manufacturing base and winter heating. As European countries are forced to look to the U.S. and other markets for alternative oil and gas imports, the devalued Euro currency is only deepening the economic damage as most imports are traded in U.S. dollars.

Domestic companies with international operations are also being squeezed by the strong dollar. McDonald’s reported global revenue fell 3% this past summer while Microsoft stated that the changes in foreign currency values cut their revenues by close to 1% in the last quarter. According to a report by CBS news , companies comprising the S&P 500 receive 40% of their revenues from foreign countries. This has only added fuel to the downward spiral of the stock market as earnings expectations are lowered due to foreign currency translation losses and inevitable demand destruction. Domestic and foreign companies alike are pointing at the U.S. monetary policy as the root cause of the dramatic economic slowdown globally.

Investment Opportunities

In every market scenario there are winners and losers, and the current strength of the U.S. dollar is no different. While the U.S. stock market has entered a bear market with 20% declines across most major stock indices, treasuries and corporate bond yields have been on the rise in recent months as outstanding bond prices have declined in response to Fed interest rate hikes. Moody’s reports Aaa corporate bonds are currently yielding 4.65% which is up from 2.60% just a year ago while Baa bonds are currently yielding 5.78% on average, up from 3.26% a year ago.

Source: Bloomberg

The looming energy crisis in Europe has some adventuresome investors looking to clean energy options to capitalize on potential long-term secular growth. Even though the energy crisis is worse in Europe, the U.S. has still experienced stubbornly high oil, gas, and electricity prices over the past few years, contributing to the high inflation rate. Last month, we told you about the iShares Global Clean Energy ETF (ticker: ICLN) and the First Trust NASDAQ Clean Edge Green Energy Index Fund (ticker: QCLN) with assets under management of $5.5 billion and $2.4 billion, respectively. Each ETF has demonstrated strong 10 year returns and the government has deepened its commitment to clean energy through the Inflation Reduction Act, meaning this strong performance is likely to persist in the future.

One way to make a contrarian play on the strength of the U.S. dollar waning, or mean reverting over time, would be to invest in a basket of emerging market currencies which for the most part are energy and resource rich.  We explored these alternatives on Research Affiliates Asset Allocation Interactive website seeking a fixed income alternative that is expected to pay a real yield (nominal yield less expected U.S. inflation of 4.0%) and an attractive Sharpe ratio (return per unit of risk).  Perhaps the best alternative was Emerging Market Cash asset class.  As of August 31, 2022, Research Affiliates expects EM Cash to generate a real return of 2.4% (real return in excess of U.S. dollar cash of 4.6%, ie. real loss of (2.2%) holding U.S. dollar) with volatility of 7.2%. This compares to a real return of (0.4%) with volatility of 3.8% for U.S. Treasury intermediate bonds.  Of note, Research Affiliates’ risk and return metrics for the EM Cash asset class were derived using a variety of information, including using the J.P. Morgan ELMI+ index as a representative example.  Servant Financial portfolio models generally include an allocation to the J.P. Morgan EM Local Currency Bond ETF (EMLC).  EMLC yields over 7% and is comprised of mostly investment grade (72%) sovereign debt obligations in local currencies.  The top 4 currencies represent 38% of its holdings – Indonesian Rupiah (10%), Chinese Renminbi (10%), Brazilian Real (9%), and Mexican Peso (9%).

As you might expect, the price of EMLC has been declining in line with the U.S. dollar strength this year.  We rebalanced the model portfolio last week and at much earlier juncture in 2022 where EMLC was among the list of buys both times.  Rebalancing is a prudent investment practice whereby investors buy more of their losing positions and sell winners to get back to overall targeted asset class allocations. Research Affiliates recommends modest allocations to EM Cash of 2% to 4% in conservative to aggressive risk models.

Conclusion

2022 is turning out to be one for the financial record books as inflation, geopolitical pressures, and the bear market has George Washington, Abraham Lincoln, and Benjamin Franklin being stretched in every direction in our wallets. Global recession concerns are rising as the Federal Reserve’s high conviction battle with inflation is affecting consumers and markets all over the world. As participants in a global economy, we need to remember the words of the man found on the $5 bill. “The money power preys on the nation in times of peace and conspires against it in times of adversity. It is more despotic than monarchy, more insolent than autocracy, more selfish than bureaucracy. It denounces, as public enemies, all who question its methods or throw light upon its crimes.” -Abraham Lincoln.

The ubiquitous strength of the almighty dollar and resultant market mayhem suggest the Jerome Powell led Federal Reserve is currently playing the role of Lincoln’s “money power.”  The Fed is wielding economist Adam Smith’s “invisible hand” with brass knuckles as it tries to break the back of inflation.  The potential collateral damage of the Fed’s heavy-handed approach include the domestic and global economies, the credibility of the Fed, and the almighty dollar’s dominance as the sole global reserve currency.

Don’t Judge A Book By Its Cover

Written by Will Slattery

Goals of the Inflation Reduction Act

The Inflation Reduction Act of 2022 was officially signed into law by President Biden this month. While the name gives the impression that the bill is narrowly focused on inflation, in reality the bill is a complicated 730 page document of objectives and regulations covering a variety of issues. Most notably, the bill includes historic investments in energy and climate reform spanning a  ten year period. While the bill itself is long and complicated, the overall goals and methods are easily identifiable.

Broadly, the key focuses of the Inflation Reduction Act are increasing taxation and enforcement of taxation for wealthy corporations and individuals, climate and energy reform, and improving health-care programs to increase coverage and lower prices of certain drugs. The last focus is where the bill receives its namesake, to fight historical inflationary levels. However, inflation reduction measures only receive a small fraction of the allocated spending. Of the areas of spending, climate and clean energy receive the largest investment with a historic $379 billion investment. All of these key areas of focus could warrant further examination given the complexity and depth of each of the issues. However, for the sake of viewing this subject through an investment lens, we will briefly highlight the biggest areas of legislative change. We will then examine climate and clean energy reform specifically as this area receives the most funding and creates the most investment opportunities.

What does the IRA do?

The major source of funding for spending and investment in the Inflation Reduction Act comes from the tax reform aspects in the bill. The most significant of these being a minimum 15% corporate tax for enterprises with adjusted income exceeding $1 billion. According to summary documents on the tax effects of the Inflation Reduction Act, “up to 125 corporations that average nearly $9 billion in profit paid effective tax rates of 1%”. This provision alone will generate an estimated $313 billion over the life of the bill. In addition to this, the bill implements a 1% stock buyback fee or tax. In addition, the bill includes improved funding for the IRS to improve collection and increase the number of audits for individuals with annual income exceeding $400,000. These and other smaller changes are expected to generate a total of $468 billion in revenue for the bill.

The next area of focus for the Inflation Reduction Act is health care reform. The health care provisions include large investments but also generate substantial funds. Some of the key changes made include a) empowering Medicare to negotiate prices of certain medications, b) capping Medicare patients out of pocket payments to $2,000 a year, c) extending Affordable Care Act subsidies for three years, and d) establishing better controls over pharmaceutical companies’ medication price increases. These and other lesser changes made in the health care sections will save an estimated $322 billion of revenues and only require $98 billion of spending.

While the name of the Inflation Reduction Act would likely lead you to believe reducing inflation would be the main focus of the bill, many economists are skeptical that inflation will be reduced at all. According to a study from the Penn Wharton Budget Model, “the impact on inflation is statistically indistinguishable from zero” over the life of the bill. The bill is essentially designed to raise necessary funding through tax reform and healthcare savings and invest those funds into the Administration’s spending priorities in healthcare and climate reform. Any remaining funds are put towards reducing the U.S. budget deficit. While the Biden administration has claimed the Inflation Reduction Act will counter inflation through deficit reduction and fiscal policy with the 15% minimum tax rate, economists believe these methods are unlikely to have much, if any, effect. The estimated $300+ billion that will be put towards deficit reduction wouldn’t even cover the $400 billion deficit we have accumulated this year alone, not to mention the additional government deficits that will accumulate by the end of the bill’s life. Additionally, some economists disagree with the idea that deficit reduction has any effect on reducing inflation at all. Under our current system, the only real way to control inflation is through the Federal Reserve raising interest rates to control the quantity of money in the money supply. Unfortunately this is not something that can be accomplished overnight. For average Americans, most, if any, inflation reduction will be seen through slightly reduced energy prices from policy reforms and investments made in energy and climate change.

Climate and Clean Energy Reform

The largest focus of the Inflation Reduction Act is the reform and investment in our climate and energy sectors. As mentioned above, the bill allocates $387 billion of the total $485 billion of total funding for a variety of energy and climate-related improvements. This section of the Inflation Reduction Act has four core goals: 1) Lowering consumer energy costs by providing $9 billion in home energy rebate programs, ten years of consumer tax credits to make homes more energy efficient, additional tax credits for the purchase of electric vehicles, and other smaller things to lower consumer energy costs. 2) Improving American energy security and increasing domestic manufacturing by administering $30 billion in production tax credits for manufacturers creating clean energy tech. Grants and loans will also be administered to convert existing auto-manufacturers to electric vehicle production or building of new facilities as well as any other smaller incentives to increase U.S. production of clean energy technologies. 3) Decarbonize our economy by providing incentives in the form of grants, loans, and tax credits to improve our clean energy production and consumption, as well as other programs to reduce industrial emissions. 4) Investing in conservation, infrastructure, and rural development through investments in climate-smart agriculture, infrastructure projects to support rising demand for electricity and reduction in carbon emissions by roughly 40% by 2030, and other miscellaneous programs to improve conservation efforts. This historic investment in climate and clean energy improvements will likely create great investment opportunities in the next decade.

Opportunity to Invest?

Like many technological advancements in the past two decades, many renewable energy sources have gone from fringe and somewhat inefficient technologies to being extremely desirable and widely adopted. Since 2000, U.S. renewable energy sources have increased by 90%. This market has appeared to be a sound investment for many years now. With all of the incentives for advancement and increased adoption of these technologies from the Inflation Reduction Act, there has never been a more attractive time to invest in renewable and clean energy markets. For our purposes, we have our eyes on two exchange-traded funds(ETFs) in the clean energy and renewables space.

The first opportunity is iShares Global Clean Energy ETF (ticker: ICLN), one of the leading clean energy ETFs holding a portfolio of the industry’s top performing companies. Currently, ICLN holds over $5.5 billion in assets under management and is one of the most popular clean energy ETFs with an average trading volume of around 3.8 million. The second ETF we are watching is the First Trust NASDAQ Clean Edge Green Energy Index Fund (ticker: QCLN). QCLN, another of the more popular clean energy ETFs, holds over $2.35 billion in assets under management with a similar portfolio of top-performing stocks in the clean energy market but with a lower average trading volume of 309,670. Both of these opportunities have historically performed well over the long term. QCLN has been riskier, returning 22.7% per year over the last 10 years through July 31, 2022 and (8.3%) year-to-date compared to 15.9% annualized ten year return and 6.0% year-to-date for ICLN. QCLN’s 8% allocation to Tesla, Inc. (TSLA) might have something to do with its higher volatility. Given the significant investments that will be made in the clean energy and renewables market through the Inflation Reduction Act, this strong performance will likely continue.

In conclusion, the Inflation Reduction Act makes historic improvements to many different areas unrelated to current inflationary trends. Most significantly, the bill will incentivize the transition to a “greener” future as well as improve healthcare for millions of Americans by raising taxes and closing “loopholes” for certain profitable, yet low-tax corporations. The jury is still out on whether this act will successfully achieve its cover story of combatting inflation. However, fiscal policy reforms and deficit reduction efforts will at least ease the load on the Federal Reserve monetary policy somewhat.

Riding the Bitcoin Rocket

Written by Will Slattery

What is Bitcoin?

Over the past few years it is more than likely you have either directly encountered Bitcoin or heard of it, and this is for good reason. As cryptocurrencies are still so new and foreign to most people, reluctance and skepticism are a natural hurdle. Just as many people thought the internet was a waste of time during its inception, Bitcoin is bound to face similar issues. However, popular financial figures such as Elon Musk and Anthony Scaramucci have sung cryptocurrencies’ praises for its innovative blockchain technology. Bitcoin has the potential to significantly disrupt current financial systems such as our current fiat money system while revolutionizing data collection and financial transaction systems.

In 2008, a person using the name Satoshi Nakamoto published a white paper on a public online mailing list. The paper, titled Bitcoin: A Peer-to-Peer Electronic Cash System stated the objectives of the currency as well as the actual code for how to make it possible. As the name suggests, the main objective of Bitcoin is to create a decentralized digital currency that is fully peer-to-peer, not requiring any regulators, banks to be a mediator, or middlemen for transactions. Additionally, Bitcoin avoids rapid fiat currency inflationary episodes like we are seeing currently because the number of bitcoin to be mined has been fixed at 21 million. All of these are made possible through the computer code for blockchain which Satoshi provides in the same paper.

Blockchain Technology

Blockchain is the technology that makes Bitcoin and all cryptocurrencies possible. While it is an extremely complicated system altogether, it can be summarized in a fairly digestible way. Blockchain is essentially a linear public ledger of all transactions, using encryption and decryption as a means of verifying transactions. As Bitcoin transactions are made, they are publicly broadcasted to all computers in the blockchain network and grouped into blocks. These blocks must then be decrypted by the network of computers in the system. Once one of these computers solves the block, the ledger is permanently updated with that block being the newest block on the end of the chain. This process continues indefinitely, constantly adding verified blocks full of transactions. This process eliminates the risk of double spending while remaining decentralized. Double-spending occurs when a single digital token can be spent more than once through duplication or falsification of the blockchain record. The information for all of these blocks as well as the individual transactions within them are all public and can be viewed at any time. While the crypto wallet public key is displayed for transactions, no information is linked to the key that could compromise anonymity.

Mining and Supply

There is only a single way new Bitcoins are created. That is through the process of mining. Calling it mining is slightly misleading as in reality mining is an essential process that maintains the blockchain network. Miners are the computers connected to the blockchain network which complete the decryption process to verify and post blocks. Whichever computer eventually solves the encryption by providing the correct 64-digit hexadecimal value is rewarded a set number of new Bitcoins. This is the only way new Bitcoins are added to the system.

About every four years or 210,000 blocks verified, the Bitcoin reward for solving a block is halved. This rate was established at inception to limit the supply growth and cap the total number of Bitcoins that will ever exist at 21 million. In addition to this, the blockchain system adjusts the difficulty of its encryptions to the amount of mining power in the network to maintain this rate. This is how Bitcoin handles inflation. These countermeasures to inflating the supply are hard-coded into the blockchain. Unlike the U.S. fiat dollar system where money can be arbitrarily created whenever needed by the government, Bitcoin has a fixed total supply and rate of adding to the supply that is not controlled by an irresponsible third party. Today, the reward for solving a single block is 6.25 BTC which currently, would be valued at around $144,000.

While a $144,000 payout for running a computer sounds attractive, the odds of actually being the one to solve the encryption is estimated to be about 1 in 22 trillion. Mining technology is becoming more productive every year with inventions like ASICs (Application-Specific-Integrated-Circuit) which are computers designed for the sole purpose of mining Bitcoin. However, even with one of these top-of-the-line computers, odds of solving the encryption are terrible as there are many other individuals and companies running mining operations at a scale that no individual can afford. This issue has led to the creation of mining pools. These are pools of individuals all agreeing to share in the profits of their combined computing power. With thousands of times the computing power, the chances of being the one to solve and be rewarded Bitcoin go up significantly. These profits are then divided up amongst individuals in the pool by how much computing power they offered to the pool.

Bitcoin Today

Fourteen years later, it is hard to imagine Satoshi had any idea that his creation would become such a big deal with some countries even using Bitcoin as legal tender. While the coin came from extremely humble beginnings, with a value as low as $0.09 per Bitcoin in 2010, it has hit astonishing highs of nearly $69,000 per Bitcoin just last year. Bitcoin’s price has fallen considerably from this point, today being worth just under $23,000 per coin. This decline is largely from a recent crypto panic caused by the crashing of multiple extremely over-leveraged crypto companies. Despite this recent dip, Bitcoin still shows immense promise for all of the reasons listed above. Even for those skeptical about Bitcoin, the blockchain technology surrounding it has taken off in every sector from food and supply chain to insurance and banking. American Express, Facebook, Walt Disney, and Berkshire Hathaway have all invested in the technology. As the fiat money system becomes more and more problematic and the importance of data collection grows, individuals and countries will be looking to Bitcoin and blockchain technologies for guidance.

Investing in Bitcoin

If you are considering putting money in Bitcoin there is a lot to consider. Crypto wallets can be intimidating and are only for direct investment in crypto assets. Instead, we will be focusing on investment opportunities that are tradeable like typical stocks but still provide exposure to the crypto markets. These come in a wide variety and may have different approaches to how they offer crypto exposure. For our purposes, we will cover three of these opportunities.

The first fund has been in the news for the past couple of months. Grayscale Bitcoin Trust (ticker: GBTC) is a closed-end fund holding purely bitcoin assets.  Unlike actual bitcoin, GBTC can be held in a tradional investment brokerage account or an IRA (individual retirement account).  Grayscale currently has assets under management of around $15 billion, making it the largest Bitcoin fund in the world. The fund provides the opportunity for people to gain exposure to the direct price changes in Bitcoin. Grayscale has plans to convert to an exchanged-traded-fund (ETF) which would allow them to use the creation and redemption technique of an ETF to stabilize the value to the net asset value (NAV). Currently, Grayscale’s inability to use this stabilizing technique has led to GBTC trading at nearly a 30% discount from the NAV of the underlying Bitcoin. In June, the SEC denied Grayscale’s application to convert to an ETF, citing concerns of potential manipulation. Grayscale is now suing the SEC over the decision following previous inconsistent approvals from the SEC for a Bitcoin futures ETF. If Grayscale ends up receiving approval for conversion, the current 30% discount will become a 30% profit for investors as the price will return close to NAV.

The next few investment opportunities take on more of a “pick and shovel” approach to investing in Bitcoin and crypto. This means investing in the tools that make this sector possible, such as computer chips and ASICs and the mining companies, rather than the crypto assets themselves as they can admittedly be volatile. The first of these is Fidelity Crypto Industry and Digital Payment ETF (Ticker: FDIG). This ETF holds assets across Fidelity’s entire Crypto Industry and Digital Payment Index, closely tracking the performance of the crypto sector rather than the potentially volatile prices of the cryptos themselves. Currently, FDIG holds assets under management of about $13 million with a NAV of $16.71. The second company we have an eye on takes a similar pick and shovel approach to invest in crypto. Bitwise Crypto Industry Innovators ETF (Ticker: BITQ) is another ETF holding shares of companies innovating in and supporting the crypto industry. Specifically, only companies that generate at least half of their revenues from crypto business activities. BITQ currently has assets under management of $72 million and a NAV of $8.10. These could be good options for those who are interested or have faith in crypto but want to take a more diversified approach on the sector.

   

 

 

 

 

 

An investment in GBTC, FDIG or BITQ can be as volatile as owning bitcoin or any other crypto.  We recommend only modest allocations to the crypto space of 1% to 5% within an investment portfolio because of the higher risk and speculative aspects of this nascent industry/technology. Servant Financial client portfolio models include GBTC and were recently rebalanced to purchase more given the market correction in the crypto sector along with traditional stock and bond markets.  More risk tolerant client models also hold Hut 8 Mining (NASDAQ: HUT) and these models were also rebalanced.  We typically do not invest in ETFs that do not have more than $100 million in assets under management so we will continue to monitor FDIG and BITQ.

Looking Forward

Crypto is still only in its beginning phase. With the application and acceptance of Bitcoin and other cryptos increasing each year, demand is expected to increase significantly. Broader acceptance and application of the technology is expected to lead to improved regulation of these currencies which will serve to increase adoption and overall understanding of cryptos as well as the benefits they have to offer. Bitcoin and crypto will continue to establish themselves as major disruptive forces to the current financial system. Bitcoin and crypto can potentially disintermediate traditional financial institutions much like what the internet and e-commerce did to traditional retailers, like book stores. As innovators such as Steve Jobs, Nikola Tesla, and Jeff Bezos will tell you, being on the right side of change can reap financial benefits and societal advancements.

Environmental, Social, and Governance Investing

Written by Ailie Carlene Elmore

What is ESG Investing? 

Earlier this year we introduced ESG investing to you as one of our 2022 investing themes to watch. Since then, it has continued to grow in interest not only for institutional investors but consumers as well. But what exactly is this phrase “ESG” and what does it mean as an investor? ESG stands for Environmental, Social, and Governance with the investment goal to put money to work to make the world a better place. An investment strategy geared towards ESG investing means investing in companies or funds that score well within the ESG standards set by independent research companies or groups. Investments are evaluated based on what kind of impact they have on the environment – positive or negative, how the company is improving society through its social impact, and in what ways the company’s leadership is paving the way for positive transformation organizationally through transparent and affirmative business practices. Overall, ESG investing aims to create an impact that is positive not only for the surrounding community and environment but for investor returns as well.

Rise and Growth of ESG Investing

ESG investing has grown in popularity within the last 5-10 years as more investors and shareholders are demanding companies be held accountable for their business activities and impacts on the surrounding community. Society as a whole is becoming increasingly concerned with social change and environmental impact which has trickled down to the investing world. While investment in positive change has been occurring long before the term ESG was coined, the 2015 Paris Agreement that pledged to limit global temperature increases caused societal and investor interest in the investment strategy to grow in popularity and as a method of capital allocation. The concept of ESG investing is now a mainstream theme and Morgan Stanley found that 79% of individual investors are interested in sustainable investing with millennials and younger investors showing the most interest. Growth in the sector has exploded in the past 5 years. Currently, it is estimated that there is $2.74 trillion invested in the ESG thematic globally and $357 billion invested in the U.S. This burst in interest was driven by increasing environmental concerns, the COVID-19 pandemic, and other societal issues.

Source: SustainFi

Regulation and Reporting for ESG Investing

ESG investing relies on independent research firms to provide scoring models and rating standards to evaluate companies on their ESG initiatives. Each research firm has different reporting standards but the pillars of Environmental, Social, and Governance remain. Some of the most popular reporting agencies are Bloomberg, S&P Dow Jones Indices, and MSCI, and typically their scoring follows a 100-point scale with the higher the score meaning the higher the rating. Companies in the U.S. are not presently required to report their ESG metrics. However, pressure from shareholders and other stakeholders has prompted many companies to start reporting their sustainability data.

A variety of reporting frameworks exist such as the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI) but there is no standardized reporting regulation globally. This discontinuity has caused speculation about reporting standards and an MIT study found that there is only a 60% correlation in ratings among different ESG reporting regimes. A conflict also exists on how much weight is placed on the individual factors within the diverse ESG standards. For example, Tesla and Exxon Mobil both received an “average” rating by MSCI even though some may argue that Tesla’s business model is much more sustainable while Exxon is an oil and gas company whose carbon based products are a major contributor to climate change. Exxon has much higher ratings for worker treatment and safety than Tesla does which raises its ESG ratings. As an individual investor, you have to decide which letter in the ESG acronym is the most important to you.

Investing in ESG

As in any investment strategy, you need to ask yourself what your investment goals and purposes are and consider your risk and return profile. The same goes for choosing an ESG investing strategy. Think about which issues within the ESG framework you are the most concerned with. For many investors, current economic concerns may drive their portfolio allocation decisions. Rising energy costs and fossil fuel concerns have many people looking to alternative energy sources to invest in. Solar, wind, and geothermal energy have all caught the attention of investors and consumers as oil and natural gas prices have been on the rise throughout much of 2022, making the switch to alternative energy more competitive across various applications. An alternative energy ETF that has been gaining investor attention is the iShares Global Clean Energy ETF (TICKER: ICLN). With $4.8 billion assets under management, it is one of the largest alternative energy ETFs with holdings in multiple solar, wind, and energy technology companies. It has a AAA rating in ESG standards from MSCI which is the highest rating given. Another ESG ETF we have been watching is ALPS Advisors’ Clean Energy ETF (TICKER: ACES) that has $658 of assets under management. ACES has a more diverse allocation of companies involved in solar, wind, energy management and storage, bioenergy, hydrogen/geothermal, electric vehicles, and fuel cell technology. Another fund with a diverse ESG themed allocation is Northern Trust Corporation’s ESG index fund (TICKER: ESG). It has diverse holdings in major large-cap stocks investing in technology, health care, energy, and industrials. Microsoft is its largest single company holding which has a AAA rating by MSCI for ESG standards.

Source: Getty Images

Future of ESG

Investors and markets of today are much more varied and dynamic than they were 50 years ago. Investors today are generally more passionate about making a positive impact on their communities and allocating capital with purpose to ensure its being put to work for the greater good of society, the planet, and future generations. Broadridge Financial Solutions predicts that investments in ESG will reach $30 trillion by 2030. Not only are investors demanding more sustainable investment options, but they also want better corporate transparency and the application of uniformed standards to hold companies accountable. It is expected that the U.S. Securities and Exchange Commission will issue more rigorous ESG reporting guidance and regulations for corporate disclosures on carbon emissions and environmental sustainability. While investors are interested in driving change, they also want to maintain strong portfolio returns. This doesn’t appear to have been an issue for ESG Themed Funds historically. Morningstar research found that ESG funds produce a good return on equity with lower volatility when compared to traditional funds. Environmental, Social, and Governance investing is here to stay and with the help of technology, data management, and uniform reporting, today’s investors will be more empowered to invest with purpose and include ESG holdings in their portfolios that are aligned with their investment preferences. For more information of ESG themed investments, please visit us at https://servantfinancial.com.

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