Early January will probably see the sign-off on the much discussed Build Back Better Plan – one of the most important pieces of legislation that could position the US as the environmental innovation powerhouse of the world.
Proposed by US President Joe Biden ahead of his inauguration, the plan focuses on social services and allocating funds towards reducing the effects of climate change. In our view, it could be a major catalyst for a re-rating of stocks in the environmental space.
Since we advocated for adding to environmental solutions markets in May after the macroeconomic fallout from rising inflation, we have seen a 24% increase in the iShares Clean Energy Index versus a 36% increase in the BNP Paribas energy transition strategy through the end of October. This compares with a 7% gain for the MSCI ACWI (EUR) over the same period.
Since early November, however, there has been a significant drawdown similar in magnitude and speed of -16% in iShares Clean Energy and -15% in the energy transition strategy (se Exhibit 1). This was triggered by factors including Omicron, worries over inflation, uncertainty ahead of economic data releases and the next US monetary policy meeting.
Swings in Sino-US rhetoric between hot and cold did not help. In addition, there has been climate policy uncertainty with protracted negotiations in Washington.
This sets the stage for a potential significant opportunity as the gap between iShares Clean Energy (-21% year-to-date through November) and MSCI ACWI (EUR) (+15% year-to-date through November) is as wide as it was in May, meanwhile, the BNP Paribas energy transition has outperformed the theme by 19%, being just -2% year-to-date.
We believe this setup gives the environmental solutions space an interesting risk/reward.
While the recent COP26 climate conference in itself was impactful, we see a significant number of catalysts on the horizon such as:
Combined with attractive valuations across the environmental space, we believe there is a significant probability of a ‘Santa rally’ into year-end and beyond with the environmental theme outperforming markets significantly.
At the time of writing (7 December 2021), media reports are suggesting that the much-awaited US Build Back Better plan could be voted through ahead of Christmas.
On 3 December, Politico reported that Senate Majority Leader Chuck Schumer reiterated his intentions to put the USD1.7 trillion childcare, climate, education and healthcare bill on the floor and pass it before Christmas. According to another report, Senator Sherrod Brown is confident the nearly USD 2 trillion Build Back Better bill will be passed soon, according to The Vindicator.
On the climate portion of the bill, it today includes the following:
Clearly, the tax incentives would significantly boost the growth and market penetration in hydrogen, solar and wind.
This is the process of strategically selling investments at a loss to reduce the taxes owed on investments you sold at a gain and repurchasing similar assets.
This all has to happen before 31 December and our market checks indicate that this has put major pressure on the environmental space, which has seen a significant sell-off resulting in losses that can be used to offset tax liabilities.
Net metering is a mechanism that credits solar energy system owners for the power they add to the grid. If a PV system generates more electricity than the home uses, the electricity meter will run backwards to provide a credit. Customers are only billed for their ‘net’ energy use. On average, only 20-40% of a solar energy system’s output ever goes into the grid, and this exported solar electricity serves nearby customers.
We note that in certain US states there is legislation that would ultimately reduce this compensation to households and jeopardize the government’s decarbonisation plans. There are signs that this is extremely unlikely to be as harsh as feared. If that is the case, we could see a substantial rally in the solar space. Even if there are meaningful changes, it would likely just speed up the adoption of battery usage to avoid selling power back to the grid – another theme we are invested in.
There are more signs of policy easing in China, with policymakers signalling that they will loosen real estate market curbs, while pledging to maintain both a ‘proactive’ fiscal policy and ‘flexible’ monetary policy in the coming year.
After the recent cut in the reserve requirement ratio for most banks , hopes of more easing measures have helped to fuel a sharp rally in Hong Kong stocks , with the Hang Seng posting the largest daily increase since early October and the Hang Seng Tech index jumping by more than four percent.
Portfolios have seen significant de-grossing and Commodity Trading Advisors have created havoc across asset classes with outsized moves in oil prices in particular, but also by taking down major equity exposure.
This leaves much less overhang with the distinct possibility of seeing new highs in equity markets before year-end.
De-grossing occurs when investors take risk off the table, and for CTAs, it can also be triggered by an increase in volatility, as we have seen over the last few weeks.
The Federal Open Market Committee meeting on 14-15 December will be held after the latest inflation data and with expectations already on the hawkish side, we see potential for a surprise resulting in what we have seen so many times in December: a Santa rally.
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