Snowstorms and Cold Economic Data

2.19.19 photo.jpg

Two stories gripped Seattle last week. The first was the snowiest February in 100 years, and the second was some equally cold economic data. Though the events are certainly not related, as correlation does not imply causation, there is a common moral to these stories.

First, the snow. Seattle does many things well including technology, aerospace, ecological awareness and the perhaps the best public ferry system in the world. But it appears Seattle is less than efficient in plowing its roads when it snows. Everything was snarled for days and grocery shelves were stripped bare. Luckily the snow melted fast and all is now back to normal.

The second story is the cold economic data. Last Thursday the U.S. Census Bureau finally released its December retail sales data, which showed the sharpest drop in a decade. Headline retail sales dropped 1.2% month-over-month, far worse than the 0.2% increase economists anticipated. Retail numbers were weak across the board. Even the “control” category of sales, which strips out items including cars, gas, building materials and food services, reported the poorest reading since 2001. Also on Thursday, Germany’s 4th quarter GDP came out at 0.0%, just above the negative reading in the 3rd quarter. The economic engine of Europe is at stall speed. Finally, on Friday January’s industrial production numbers came in far weaker than expectations. All in all, it was a chilly end to the economic week, leaving the markets to worry about economic prospects in 2019.

So, what is the common thread between these stories? Snow melts fast in Seattle’s temperate climate, and weak economic news should soon dissipate as the U.S. is still growing above trend, unemployment is at generational lows and the Fed is patient. As for your portfolios, we know despite the vagaries of weekly economic data that the overall trend for economic growth is weakening, so we will maintain our conservative risk positioning.

Sources: Bloomberg, The Financial Times, The U.S. Census Bureau

Equity Market Impact on Public Pension Funding

As we discussed on our 2019 Market Outlook Call in January, we are expecting more variability in the performance of various municipal sectors this year after what was a benign environment in 2018. The reemergence of pension funding issues is one of the reasons why.

Public pension systems have benefited from positive investment performance during the current long-running economic expansion. Investment performance has been driven by strong equity returns. For example, the total return of the benchmark S&P 500 index has exceeded 300% over the last 10 years. Equity returns do not always follow a straight line upward, however, as evidenced by the 13.5% decline of the S&P 500 in Q4 of 2018. While the Q4 equity sell-off has unfavorably impacted pension returns, most pension contributions and funding ratios are based on fund balances at the end of the fiscal year, which (fortunately for most municipalities) occurs on June 30. This will potentially enable the pension systems to offset some mid-year losses during the subsequent two quarters of the fiscal year.

The impact of the sell-off on pensions will be driven by each plan’s exposure to equities and the potential for a rebound in equity prices in Q1 and Q2. According to Bloomberg, through Wednesday February 6, “The median government employee pension, whose assets are heavily weighted toward U.S. stocks, lost 7.5 percent in the fourth quarter, according to data released…by the Wilshire Trust Universe Comparison Service. Public pensions have lost 4.9 percent since the beginning of the fiscal year on July 1.” While these returns are certainly unfavorable, equity returns since January 1 have benefited plans that are invested in equities. Through the first five weeks of the new calendar year, the total return of the S&P 500 has been approximately 9%. With the rebound this quarter, the return of the S&P 500 since July is now back in positive territory at about 1.5%.

As there is a high level of volatility in equity prices, the prospects for improved funding levels over the next few months to the close of the fiscal year are uncertain. Despite market volatility, the strong gains in equity prices have driven investment returns and improved funding levels for a vast majority of pension systems. We are more concerned for those pension plans that have continued to flounder in a period of economic expansion and solid investment returns. We expect that the systems most negatively impacted will be those sponsored by state and local governments who make annual pension contributions at levels below actuarially determined contributions. Potential market downturns will exacerbate their low funding levels, and further pressure those systems. Examples of such pension systems include the states of New Jersey and Illinois, as well as the City of Chicago.

Source: Bloomberg

The Fed Is a Two-Handed Economist

2.4.19 photo.jpg

“Give me a one-handed economist. All my economists say, 'On the one hand...' then, 'But on the other...” – Harry Truman

On the one hand, the Federal Reserve announced last week that further rate hikes are on pause and shrinking the Fed balance sheet may end sooner than anticipated. The U.S. economy is solid and inflation is well controlled, said the Fed, but since the rest of the world was a bit wobblier, it would be prudent to wait for more data. Patience is the world of the day. There is nothing like a dovish announcement from the Fed to plump the price of financial assets. The financial markets now believe more strongly that economic growth should continue for a while longer as monetary and fiscal policy stay accommodating. The Fed has our back.

On the other hand, what was so wobbly about the rest of the world to make the Fed rethink both its path of interest rate normalization and the size of its still bloated balance sheet? Chairman Powell laid out the case quite eloquently in the first of the Fed’s expanded news conferences. “Growth has slowed in some major foreign economies,” he said, “Particularly China and Europe. There is elevated uncertainty around several unresolved government policy issues, including Brexit, ongoing trade negotiations, and the effects from the partial government shutdown in the United States. Financial conditions tightened considerably late in 2018, and remain less supportive of growth than they were earlier in 2018.” We applaud the Fed’s new policy of increased transparency, including more frequent press conferences.

Furthermore, we are glad economists only have two hands—more would be too confusing! We see the Fed’s actions as consistent with promoting economic growth and full employment, all within the bounds of its 2.0% inflation target. But we also see economic growth slowing around the world as we approach the later stages of the current economic and credit cycles.

Sources: Bloomberg, the Financial Times, The Federal Reserve

All Eyes on the FOMC

The Federal Open Market Committee is set to meet this week to discuss the current state of affairs in the economy and to set monetary policy. In the past, this meeting would have been relatively uneventful as Fed Chair Powell only gave post-meeting press conferences after every other meeting. Market participants took this to mean that any significant changes were unlikely at a non-press conference meeting. This is no longer the case as there will be a press conference after every meeting moving forward. The Fed made this change to promote transparency, which has been a long-standing goal of the past few Fed Chairs. While transparency will certainly increase with the move, so will the focus by the market.

This week the focus will be on the word “patient,” which has been used extensively by FOMC members in recent public communication regarding their approach to any future rate increases. It wasn’t long ago that their decision to raise the Fed Funds Rate in December, and pencil-in another two rate hikes this year, caused quite a stir across financial markets. Since then, FOMC members have been doing their best to calm markets by indicating their willingness to wait some time before another rate hike. This “patience” campaign has been well received as financial markets have performed quite well thus far in 2019.

We expect the tone of this week’s meeting to continue with the “patience” theme and expect to hear an update on the wind-down of the Fed’s balance sheet, which has become a hot topic in financial circles of late. Ultimately, Fed decisions will be a focus across financial markets this year, for both bond and stock investors alike, particularly as we are approaching the later stages of the current economic and credit cycles.

How Doing Good Can Sometimes Be Bad

A quick note: The SNW Impact Strategy is entering its third year this month. To highlight the Strategy, over the course of 2019 we will be periodically sharing thoughts and observations from the team responsible for the research and ratings. These pieces are intended to share the context of how the ratings are derived, the philosophy behind ESG and impact ratings, and how the industry is currently positioned. They may feature entities that we do not currently invest in.

The Law of Unintended Consequences

Every action results in both intended and unintended consequences. No action—good, bad, neutral or mixed—is exempt. As human beings, we lose sight of this when we feel we are doing what is right, but even a good action can result in negative consequences. And these consequences can outweigh the benefits of that good action. This is true for nonprofits, governments, individuals and private corporations.

Negative consequences, especially those that outweigh the positive benefits of an action, are something we certainly want to avoid as ESG product managers and investors.

TOMS Shoes: A One-for-One Giving Model

TOMS Shoes offers perhaps one of the most familiar examples of a good action creating unwanted and unintended consequences. At one point, for every pair of TOMS shoes bought, the company donated a pair of shoes to a child in a developing or undeveloped country. Many agreed that this was not just good for humanity, but also good for business. Using this system, TOMS gave away more than 35 million pairs of shoes between 2006 and 2015.

Unfortunately, TOMS’ one-for-one giving model was harmful in ways the company had not anticipated. In recipient communities, local producers were put out of business or struggled to make a living, thus disrupting the local economy.

TOMS and its founder came under fire for what was widely seen as a short-sighted and overly simplistic approach to corporate social responsibility (CSR). Although this is an older example, we use it to illustrate how a company can take a more nuanced approach to corporate social responsibility. After receiving intense criticism, TOMS retooled its CSR strategy. TOMS still operates on a one-for-one model, but now the one-for-one system is leveraged to build thoughtful partnerships and improve access to safe drinking water, reduce birth-related fatalities through training, provide medical care for vision-related issues, and address bullying through training and prevention programs.

USDA and Crop Dumping

The United States Department of Agriculture (USDA) often sells surplus crops abroad below market prices, or gives them away for free as a form of foreign aid, ostensibly to countries and communities in need of these crops. It seems like the perfect solution: surplus crops do not go to waste, and poverty- or disaster-stricken communities receive much-needed food.

But there is another side to this coin. Critics of the system often refer to it as “crop dumping.” In 2016, the USDA sent 500 metric tons of peanuts to Haiti despite a coalition of approximately 60 aid groups in the country arguing against it. This sudden infusion of peanut crops into the Haitian economy undermined the country’s peanut industry and the local economy, thus perpetuating and deepening existing economic issues. This type of foreign aid also has the potential to increase dependence on the aid, making it more difficult for communities and countries to prosper independently.

Affordable Housing in Low-Income Neighborhoods & Transit-Induced Gentrification

It makes sense to build more affordable housing units in low-income neighborhoods, but is there a point of diminishing returns? While low-income communities certainly need affordable housing, an increased number of available affordable housing units can actually lead to gentrification. In low-income and working-class neighborhoods, the addition of affordable housing can invite low-income creative and entrepreneurial populations who are looking not only for affordable places to live, but places where they can make a mark.

Both populations tend to engage in placemaking and spur revitalization efforts, which makes low-income neighborhoods attractive to middle- and high-income populations. And this, of course, can lead to displacement of the original low-income residents. Transit-oriented development can also lead to gentrification and displacement by appealing to young professionals and upwardly mobile populations who are increasingly wary of car ownership and attracted to areas with good public transportation.

Gentrification is a sticky subject, a complex phenomenon that engenders strong opinions. But any public planning, private development or community investment project targeting low-income neighborhoods or populations must consider both the short-term and long-term implications of that project, including whether it will lead to gentrification and displacement.

Why CSR and Public Programs Such as These Don’t Work Every Time

There are a few reasons why many corporate responsibility programs, public projects and nonprofit initiatives sometimes get it wrong when trying to do right:

  1. Many problems are multi-faceted and complicated. Giving a pair of shoes to a child, though commendable, does not fix the systemic issues causing that child to be shoeless in the first place. Just as governments cannot print money to fix an economy, giving donations, whether clothing items or food items, does not address the cause of the problems they are meant to fix.

  2. Citizens and governments of developed countries do not necessarily know what is good for a developing or undeveloped country. And companies such as TOMS, though well-meaning, come from a position of western privilege and rarely have a true understanding of the social, political and geopolitical issues causing or affecting critical situations in these countries and communities.

  3. Communities ravaged by environmental disasters or poverty know what they need, but their input is rarely part of the equation when it must be. A lack of input from community members and stakeholders is a blind spot that even the best-intentioned are susceptible to.

Doing Good in an Informed and Deliberate Way

We all want to feel like we are doing good in the world, whether that means serving food at a soup kitchen or investing in a company with a strong corporate social responsibility program. These are by all accounts good things. But doing good is about more than making a gesture; it is about taking the time to understand the true costs and benefits of an action, and either doing what is in the best interest of the community you are trying to help or best serving long-term environmental goals.

We must be especially careful about not investing in bandages when we should be investing in cures. For us, this means evaluating investments with an understanding that surface good may not be good enough, and that to make positive social and environmental impacts we as a society must cultivate a deeper understanding of cause-and-effect. We must be informed and deliberate in our actions.

With this in mind, our approach to evaluating investment opportunities for the SNW Impact Strategy is a holistic approach based on realistic and pragmatic inputs. We go beyond just the use of proceeds in the immediate term to evaluate what the medium- and long-term positive social or environmental impact may be. With many of the credits we invest in, the projects have been completed and we are able to look at the outcomes with real certainty. With projects and issuers that are new to the market, our evaluation is predicated on known data and conservative projections. Our aim is to identify those investments with the clearest net positive social or environmental impact, to ensure that we avoid good intentions leading to bad outcomes.