Soaring Markets and Valuations
A strong fourth quarter capped off exceptional 2019 performance across virtually all asset classes.
The S&P 500 Index rose 9.1% in the fourth quarter to deliver a total return of 31.5% for 2019, its best year since 2013. Small cap equities lagged large caps for the year, but were still up nearly 10% for the quarter and the Russell 2000 Index delivered a robust annual return of 25.5%. As has been the case over recent years, Non-U.S. developed market stocks lagged U.S. stocks in 2019, but again, the MSCI EAFE Index still returned 22%. It was also a very strong year for fixed income, as the Bloomberg Barclays US Aggregate Bond Index returned 8.7% and the high yield market returned 14.4% as represented by the ICE BofAML US Cash Pay High Yield Index.
While anticipated impacts of tariffs on economic growth waxed and waned over the course of 2019, the main constant driving asset prices higher was falling interest rates. Declining interest rates drive bond prices higher, but they also encourage more risk-taking across asset classes and were a primary contributor to higher equity prices. This is evident in breaking down the S&P 500 Index’s 31.5% return for 2019. In an environment of flat earnings growth, approximately 90% of that return was derived from price-to-earnings (P/E) expansion.
As we enter 2020, investors are wrestling with where they should commit capital in the coming year. With elevated P/Es on stocks, interest rates near historic lows and tight credit spreads, it is clearly a challenging environment in which to identify value.
While we grapple with these valuation challenges in our asset allocation decisions, within each portfolio, we are guided by the risks and opportunities of the transition to a more sustainable economy. We examine those risks and opportunities across all regions, sectors and securities, and we integrate fundamental ESG (Environmental, Social, and Governance) research into all of our investment portfolios.
As we begin the new year, let’s take a closer look at how we are strengthening our portfolios by addressing climate risk and targeting three opportunities that we believe can drive alpha.
Climate Risk and Fossil Fuels
Climate change is an investment driver on many levels, including increasing investor awareness of the limited future of fossil fuels. Expected government intervention to regulate greenhouse gases, changes in consumption patterns, potential litigation and other liabilities pose material risks to fossil fuel companies. We believe these climate change transition risks are not sufficiently priced into securities for fossil fuel companies.
We employ a proprietary sustainability lens as well as fundamental ESG research and analysis to identify companies and areas of the market where sustainability opportunities outweigh risks. As a result, our equity funds and investment-grade bond fund have exited the energy sector to become fossil fuel free, as we believe numerous risks could negatively impact energy sector performance. Nine Pax World Funds are now fossil fuel free.
As part of our management of climate risk in our beta strategies, we have introduced SmartCarbon™ into the investment process. SmartCarbon is a risk-based investment approach for managing exposure to companies with fossil fuel reserves on their balance sheet. The three funds now using this approach are completely fossil fuel free, replacing energy company holdings with a diversified basket of energy efficiency stocks.
We believe that re-allocating exposure from fossil fuel energy to energy efficiency provides a more optimal risk-return profile. Not only does the approach reduce climate change-related risks but it positions portfolios to benefit from the more efficient use of energy as we transition to a more sustainable economy.
Energy Efficiency and Decarbonization
Capturing opportunities associated with the growing demand for energy efficiency solutions is also an area of focus for our active equity portfolios, where we are focused on identifying stocks that we believe will generate long-term returns across areas of energy efficiency, including transportation, industrial efficiency and building efficiency.
Energy efficiency companies can impact many industries, and transportation is a particularly notable example. Of the major contributors to U.S. greenhouse gas emissions, transportation now accounts for a larger share than electricity production. Opportunities to reduce transportation emissions are growing rapidly, and no example illustrates this trend better than vehicle electrification. Electric vehicles emit less than half the tailpipe emissions of gasoline powered vehicles, and less than hybrids as well. In addition, fast-rising interest in autonomous driving can also contribute to reduced vehicle emissions, in the neighborhood of 2-4% reduction in oil consumption and combustion engine-related emissions every year.
We own shares of companies that are leading the push toward electrification of vehicles worldwide. This megatrend should persist for the next 30+ years as technology advances toward fully autonomous vehicles, which will require advanced electrical architecture, connectors and navigation systems. Two companies in the space that are broadly held across a number of our portfolios are Aptiv and TE Connectivity. Aptiv manufactures safe, green and connected mobility devices and systems such as collision avoidance and emergency braking systems, and TE Connectivity manufactures connector systems and terminals for transportation applications.
Energy efficiency is also a durable investment driver in industrial processes and in-home and commercial heating, ventilation and cooling. These products and services, while facilitating the more efficient use of energy, reduce carbon emissions and energy costs. We own shares in companies that produce products that save energy and money, so upgrading equipment is a win-win proposition for customers, manufacturers and the environment.
Examples of such companies include Ingersoll-Rand, which produces energy efficient HVAC equipment for corporate and retail uses, and Eaton Corp, which manufactures engineered products for numerous end-market applications.
Assuring the availability of clean water is also a significant investment opportunity. In part this is due to climate change, which will make both droughts and floods more numerous and severe; we are now seeing firsthand evidence of the former with Australia’s terrible fire season. But population growth and rising gross domestic product also put pressure on the Earth’s precious, and relatively scarce, supplies of clean water. While Earth is rich in water, only 2.5% of that is fresh water, and only about 1% of the fresh water is accessible; most of the fresh water on the planet’s surface consists of glaciers and snowfields.
Like every challenge, this one also presents investment opportunities to use the water we have more efficiently and treat effectively the water we do use. We own shares of companies that facilitate the critical infrastructure that provides clean water to the world’s population. Examples include Xylem, which manufactures water pumps, sensors and leak detection equipment, and American Water Works, which operates clean water and wastewater systems in 15 states for 12 million customers, comprising 621 water treatment plants, 130 wastewater facilities and 51,000 miles of pipeline.
Efficiency is an opportunity beyond environmental considerations. One of the most powerful megatrends to invest in today is the rapid transformation of data storage and analysis from on-premises solutions to the cloud. These cloud-enabling companies are helping corporations manage and exploit the explosion of data that has been captured in recent years.
Examples are Microsoft, whose Azure cloud computing service is growing at a very rapid rate, and Equinix, which owns and operates data centers globally. Compared to the days when we all bought software in the form of discs, along with paper and plastic packaging, cloud computing offers not only better access to up-to-date computing solutions but also a reduction in the physical material associated with information technology.
Focus on Sustainability Through the Cycle
We see sustainability as a secular driver of performance, providing ample opportunities to strengthen investment portfolios regardless of what point in the business cycle we find ourselves.
Environmental risks and opportunities are particularly significant, as we’ve outlined. While the Trump Administration has been busy trying to bring back coal and roll back clean air and water regulations, astute investors are addressing climate risk in their portfolios and identifying opportunities in resource efficiency, emissions reduction and clean water.
Despite elevated market valuations on the heels of very strong equity performance in 2019, the aforementioned opportunities are examples of where we see long-term value drivers and tailwinds from the transition to a more sustainable economy.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net,” which includes dividend reinvestments after deduction of foreign withholding tax.
The Bloomberg Barclays US Aggregate Bond Index is a broad base index, maintained by Bloomberg L.P., often used to represent investment grade bonds being traded in the United States.
The ICE BofAML U.S. High Yield BB-B (Constrained 2%) Index tracks the performance of BB- and B-rated fixed income securities publicly issued in the major domestic or eurobond markets, with total index allocation to an individual issuer limited to 2%.
Price to earnings ratio is the ratio for valuing a company that measures its current share price relative to its per-share earnings.
Alpha is a coefficient measuring risk-adjusted performance, considering the risk due to the specific security, rather than the overall market. A positive alpha reflects relative risk-adjusted performance of the Fund versus its benchmark.
One cannot invest directly in an index.
The statements and opinions expressed in media mentions are of the authors and as of the date of publication. All performance data quoted in media mentions represent past performance, which does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. See Pax World Funds’ performance for most recent month-end performance information. Holdings for the funds are subject to change. Please see the Pax World Funds’ holdings for current holdings information.