The Impact of Rising Rates on Long Duration Stocks
The unprecedented rise in interest rates beginning in 2022 and lasting through mid-2023 has been a challenge for our SRI models. Central banks, particularly the Federal Reserve, implemented aggressive interest rate hiking policies to combat inflation that sprung up after the global economy rebounded post Covid-19. As you can see below, inflation (as represented by the US Consumer Price Index) surged above 9 percent, forcing the Federal Reserve to raise the Federal Funds rate from near zero to above 5 percent in less than 18 months.
This created a challenging environment for long duration (interest rate sensitive) stock strategies. Our SRI portfolios intentionally lean toward positive impact strategies through exposure to themes such as renewable energy, sustainable infrastructure, and biotechnology. These themes have been particularly affected by the higher rate environment.
For example, many of the companies focused on renewable energy and sustainable infrastructure are utility companies, and the utilities sector is known for its relatively attractive yield compared to other sectors of the stock market. However, due to elevated short-term rates, investors can currently get 5 percent or higher yields on low-risk assets like money markets, certificates of deposit, and short-dated US Treasury bonds.1 As a result, utility stocks in general look less attractive when investors can get similar or better yields without taking additional risk simply by investing in US Treasury bonds.
Higher interest rates also increase the discount rates applied to future earnings, disproportionately impacting companies with large research budgets and longer-term growth prospects (i.e. the opportunity cost for waiting is higher). As a result, stocks in sectors such as biotechnology have also struggled to keep pace with the overall market in this environment.
Underweight Exposure to “The Magnificent Seven”
Another factor contributing to the challenging environment for SRI portfolios has been our relative underweight position in “The Magnificent Seven”, a group of mega-cap technology and communications stocks that has been driving the market higher. Companies such as Nvidia, Microsoft, and Meta have experienced extraordinary growth recently, driven by investor interest in artificial intelligence and cloud computing. As a result, those names are now among the largest companies in the world and are top holdings of many market-cap weighted indexes (for example, see the Top 10 Constituents of the MSCI ACWI index, below).2
Our SRI strategies intentionally lean toward responsible investments and positive impact themes, and as a result, have less exposure to these mega-cap names. That posture has not been rewarded recently, as these tech behemoths have outpaced the broader market and some themes embraced by our SRI portfolios (see Impact Themes Out of Favor slide below). However, we believe that this positioning may prove advantageous going forward, as we’ll discuss in the next section.
Embracing Opportunities by Remaining Patient
Despite these challenges, we are encouraged by recent developments and remain optimistic about the potential for the SRI portfolios. While interest rates remain elevated, the aggressive interest rate hikes are beginning to show their intended effects by reducing inflation worldwide (see falling global inflation forecasts below). We believe that this shift is already fostering a more favorable environment for utilities focused on renewable energy and biotechnology firms, and we believe the shift will be amplified if interest rates begin to fall.
Moreover, the narrative around artificial intelligence is expanding beyond the confines of the technology sector. AI's transformative potential is being recognized across various industries, including healthcare, utilities, and manufacturing, creating new investment opportunities that align with our positive impact themes. We believe that companies committed to leveraging AI for sustainable and positive impact purposes can emerge as industry leaders across multiple sectors.
Lastly, we believe that the Inflation Reduction Act (IRA) represents a significant tailwind for renewable energy and sustainable infrastructure.3 This legislation provides substantial incentives and funding for clean energy projects, energy efficiency improvements, and sustainable infrastructure development. The IRA's support for renewable energy not only accelerates the transition to a greener economy but we believe it also helps position our portfolios to benefit from the anticipated surge in clean energy investments and innovations.
In conclusion, while the past two years have presented challenges for our SRI models, we remain steadfast in our commitment to sustainable, responsible, and impact investing. We believe that the evolving economic landscape and the broadening application of AI, along with supportive policy measures like the Inflation Reduction Act, provide a fertile ground for our strategy to rebound and thrive. By staying true to our principles and adapting to new opportunities, we are confident in our ability to deliver long-term value for our clients while promoting a sustainable and responsible future.
As always, we appreciate the trust you place in our firm as we navigate the complexities of today’s investment landscape. We remain committed to making prudent, impactful decisions on your behalf, and we look forward to continuing our partnership in the years to come.
1 Source: YCharts
Past performance may not be representative of future results and all investments are subject to loss. Forecasts regarding the market or economy are subject to a wide range of possible outcomes. These views are as of the date listed on the material and are subject to change based on changes in fundamental economic or market-related data. These materials are not intended as any form of substitute for individualized investment advice. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.
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