Green Alpha Advisors’ Market Commentary – Q3 2018

But uncertainties in the political world—led by the specter of trade wars—loom large along with interest rate rises and the winding down of QE. In September, Fed Chairman Powell went out of his way to remind everyone that, while the economy is growing sufficiently to merit a 0.25% raise to the Fed Funds rate, the Fed is not responsible for trade policy. He stated that “many of our country’s economic challenges are beyond the scope of the Fed, but we are doing all we can to keep the economy strong and moving forward.” Separately, and specifically on trade, Powell recently said, “The truth is this: Since War II we’ve had this trading system develop, and consistently tariffs have come down and trade has grown. And I think that’s served the global economy, and particularly the United States economy, very well… Part of the independence that we have is to stick to our lane, stick to our knitting, so really wouldn’t want to comment on fiscal policy really, or trade policy.”

Ford Motor Company, by contrast, did recently comment on current trade policy: “The metals tariffs took about a billion dollars of profit from us,” said CEO Jim Hackett at a Bloomberg event in September. Q3 also saw ongoing efforts to renegotiate several trade deals, most importantly NAFTA, China, and Japan. As of the end of the quarter, nothing has been signed, and China is threatening to cancel the next meeting with US delegates. The scene right now can be summed up as: growth with uncertainty. (Note: as of 10/1, a provisional tri-lateral update to NAFTA—now the USMCA—has been agreed to by the U.S., Canada, and Mexico. Uncertainty is diminished a little—in this hemisphere, at least.)

On the interest rate hike, Chairman Powell noted that the Fed doesn’t see in their data any reason to fear a recession in the next year or two and therefore multiple raises may be in order for 2019. More raises in the short-term rate could have the effect of inverting the yield curve, but the Fed doesn’t necessarily see that as a harbinger of recession (although history does show a correlation there).

Yet a correction is certainly plausible. In general, the very low interest rate environment we’ve been in for years now has encouraged even conservative investors to leave bonds and money markets for investments that have higher yield or return potential but are farther out on the risk curve. Often, this means stocks. The often-discussed scenario—a stock market correction resulting from some combination of rising rates (which attract risk averse money back out of stocks and into cash and debt instruments), QE winding down, and trade uncertainty—seems plausible at some point in the next few years. So, how do we proceed?

Start by focusing on what’s emerging, growing and gaining market share from incumbent economy predecessors and counterparts. Even in bear markets, there will always be parts of the economy that are developing faster than others.

Then, focus on intrinsic value—the ‘true value’ based on a company’s tangible and intangible assets. If you can buy a company because you can get it for close to what it’s worth—as opposed to buying it regardless of its intrinsic value because it’s in an index—you have a better chance of avoiding overpriced stocks. Therefore, you are more likely to withstand a downturn and better positioned to recover early and with some velocity. Stocks do tend to return to their intrinsic value more quickly than they will return to being overvalued. On that point, it’s worth revisiting the portfolio characteristics as of the end of Q3, 2018 on page 2 of our portfolio review documents (see below for links under “Portfolio Commentary”).

Owning growth in the form of innovative, sustainability-driving companies without paying too much (at the aggregate portfolio level) above intrinsic value is what we strive to do.

Markets are always going to be changing on us. There will always be new events and innovations, including things far outside our control. What we can do is be adaptable. We can consider the most likely scenarios and prepare for them. At Green Alpha, we look to scientific consensus, since science aims to show us what’s real; it is the closest we can come to truly knowing what those future scenarios hold and how to address them.

While some progress is slowly being made, the financial industry has by and large failed to integrate such scientifically-based risk calculus into its methods. Many investors continue to buy fossil fuel-based stocks as though there is no risk to the underlying assets and there are no financially viable alternatives. This tells us they are not being skeptical. This won’t last. What will cause the fossil fuels bubble to burst is the accelerating development of renewable energies (e.g., China’s clean energy push) and energy efficiency technologies, followed by plunging prices.

The overall picture at the end of Q3 2018 is one of growth with uncertainties, both geopolitical and economic, with a plausible case for market correction or even recession over the next few years, along with areas of rapid growth and productivity improvements occurring within that context.

As always, we remain true to thesis, never engage in style drift, are fossil fuels free, and focused on what’s next.

In Q3 2018, our portfolios saw generally favorable results, but with some dispersion between strategies. Returns are summarized on pages 5 and 6 of the Portfolio Reviews (see links below). As a supplement, here is a look into Q3’s performance attribution by strategy.

Next Economy Index

Click here for Q3 Portfolio Review

• The Green Alpha Next Economy portfolio returned 6.07% for Q3 2018, aided primarily by the Consumer Non-cyclical, Technology and Industrial sectors, which contributed 1.85%, 1.84% and 1.80%, respectively, to portfolio return.
• Consumer Non-cyclicals were boosted mainly by Commercial Services, which added 1.22% to the sector’s return for the quarter. The return leader of the sector was the leader in e-commerce, which offers distributed, more democratized access to merchant services, which in turn enables entrepreneurship and lowers barriers to entry for retail startups.
• In Technology, digital security was the main driver, responsible for 1.01% of Tech’s 1.84% quarter. Given the rise in cybercrime and hacking attempts, perhaps it should come as no surprise that four of the seven top contributors from the Tech sector in Q3 are either entirely or partially engaged in providing security for digital/internet transactions and data movement.
• Within Industrials, returns were diversified, with Electronics, Electrical Components & Equipment, Building Materials, and Machinery combining to contribute the 1.80% for Q3. IoT-enabled smart meters and personal wearables were standouts in Q3.
• Two sectors had negative contributions in Q3; Energy detracted 0.12%, and Basic Materials detracted 0.09%.
• Within Energy, detractors were primarily in Renewables—specifically solar—which netted -0.11% from the Next Economy Index in Q3. Solar has been damaged by the perceived effects of tariffs in the US and by Chinese policy that modified how support for new solar projects will be administered.
• In Basic Materials, the specialty sub-industry of recycled steel was responsible for the Sector’s entire 0.09% loss. Steel is always a volatile commodity. Although sourcing it from 100% reused sources is important to the realization of a sustainable economy, recycled steel is no exception. The portfolio’s exposure to recycled steel is U.S.-based, so it is conceivable that recently enacted steel tariffs for imported product may prove advantageous for the position.

Next Economy Social Index

Click here for Q3 Portfolio Review

• The Green Alpha Next Economy Social Index portfolio was up 7.04% for Q3 2018. Technology was the top contributing sector, adding 2.62% during the quarter.
• Within Technology, a wide array of industries and sub-industries contributed to the quarter’s performance. Digital security (0.96%), computers and devices (0.72%), and design and engineering software (0.55%) led the sector.
• Consumer Non-cyclical added 2.31% to the Social Index during the quarter.
• Consumer Non-cyclicals were boosted mainly by Commercial Services, which added 1.32% to the sector’s return for the quarter. The return leader of the sector was the leader in e-commerce, which offers distributed, more democratized access to merchant services, which in turn enables entrepreneurship and lowers barriers to entry for retail startups.
• Of the nine sectors held in the Social Index, only two sectors were negative during Q3. Energy was the primary detractor at -0.13%.
• Within Energy, detractors were in Renewables, and specifically solar, which overall netted -0.13% from the Social Index in Q3, despite some positive contributions from wind energy. Solar has been damaged by the perceived effects of tariffs in the U.S. and by Chinese policy that modified how support for new solar projects will be administered.
• In Basic Materials, the specialty sub-industry of recycled steel was responsible for the Sector’s entire 0.09% loss.
• Steel is always a volatile commodity. Although sourcing it from 100% reused sources is important to the realization of a sustainable economy, recycled steel is no exception. The portfolio’s exposure to recycled steel is U.S.-based, so it is conceivable that recently enacted steel tariffs for imported product may prove advantageous for the position.

Green Alpha Next Economy Select

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• The Green Alpha Next Economy Select portfolio was up 0.94% for Q3 2018. Industrials was the top sector, contributing 1.36%.
• Within Industrials, the sustainable building materials specialty subsector added 0.47%. Demand for recycled product viewed as higher-quality-for-price versus primary resource materials continues to grow in the U.S.
• Communications followed as the second highest contributor, adding 0.80% to portfolio return.
• In Communications, Internet of Things connectivity modules contributed 0.51%. The beginnings of 5G networks, together with greater global data flow, are the key catalysts here. We expect this to continue.
• The largest negative contribution came from Technology at -0.89%.
• In Technology, the detractors were all from the semiconductor space. Within the Select portfolio, eight of nine semiconductor holdings were negative for the quarter, causing the group to detract 1.84% from the portfolio overall. Semiconductor firms had a difficult quarter in Q3 as near-term analysis at many large banks’ research desks saw reasons to expect weaker sales in Q4. Given that data and computational demand continue to expand along with continued device proliferation, we view this signaling as short-term ephemera. Growth in this space should continue for many years to come. Semiconductor shipments will continue to grow year-on-year for the foreseeable future.
• Consumer Cyclical detracted 0.73% during the quarter.
• The Consumer Cyclicals holdings in Next Economy Select are all electric vehicle related. Within that group, half were up and half down, but the down outweighed the up by a portfolio-level detraction of 1.05%. This was largely due to regulatory overhang, which negatively impacted share price despite output growth.

Growth & Income Portfolio

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• The Green Alpha Growth and Income Portfolio was up 5.50% for Q3 2018. Financials were responsible for the lion’s share of this return, adding 2.41% during the quarter.
• In Financials, venture debt investing added 0.98% to GAGIP in Q3, and financing services for renewable energy and energy efficiency projects contributed 0.78%, as funding providers for both new innovation and infrastructure upgrades continue to see strong demand.
• Consumer Cyclicals added 1.12% to portfolio performance during the quarter.
• In Consumer Cyclicals, the office furnishings industry was responsible for the sector’s entire 1.12% contribution. Higher-end, sustainably-made office furnishings continue to see robust demand as corporate capex remains steady.
• Basic Materials was one of the two detracting sectors within the portfolio this quarter, taking away 0.38%.
• In Basic Materials, the specialty sub-industry of recycled steel was responsible for the Sector’s entire 0.38% loss. Steel is always a volatile commodity. Although sourcing it from 100% reused sources is important to the realization of a sustainable economy, recycled steel is no exception. The portfolio’s exposure to recycled steel is U.S.-based, so it is conceivable that recently enacted steel tariffs for imported product may prove advantageous for the position.
• Negative contributions secondarily came from Consumer Non-cyclicals, detracting 0.04%.
• In Consumer Non-cyclicals, Biotechnology was the detractor at -0.25%. Biotechs can be speculative, and although they hold tremendous long-term potential, they can be and are volatile over short-to-medium-term timeframes.

Sierra Club Green Alpha

Click here for Q3 Portfolio Review

• The Sierra Club Green Alpha portfolio was up 3.07% for Q3 2018, boosted primarily by Industrials, which added 1.52%.
• In Industrials, renewable building materials was the main contributor adding 0.62%, with Electrical Components and Equipment not far behind at 0.49. Demand for recycled product viewed as higher-quality-for-price versus primary resource materials continues to grow in the U.S.
• Communications added 0.75% to portfolio return during the quarter.
• In Communications, Internet of Things connectivity modules contributed 0.46%. The beginnings of 5G networks, together with greater global data flow, are the key catalysts here. We expect this to continue.
• The portfolio was diminished by only two sectors. Consumer Cyclicals reduced returns by 0.30%.
  • Auto Manufacturers detracted 0.89%, more than offsetting gains from sustainable office furnishings. This was largely due to regulatory overhang, which negatively impacted share price despite output growth.
• The sector detracting the second most from the Sierra Club Green Alpha portfolio in Q2 was Industrials, taking 0.45% away from the quarter’s total return.
• Energy was the second detractor at -0.20%.
• Within Energy, detractors were in Renewables, and specifically solar, which overall netted -0.20% from the portfolio in Q3, despite some positive contributions from wind energy and renewables-based utilities. Solar has been damaged by the perceived effects of tariffs in the U.S. and by Chinese policy that modified how support for new solar projects will be administered.