Developed Countries

Special Report

Executive Summary Spreads Near 2017-19 Average The main indicators that determine corporate bond performance are valuation, the cyclical/monetary environment and corporate balance sheet health. US corporate bond valuation is quite expensive. Spreads are off their post-COVID lows, but consistent with the 2017-19 average. The flat 2-year/10-year Treasury curve indicates that the cyclical/monetary backdrop is relatively poor. What’s more, the yield curve could easily invert within the next few months as the Fed tightens. This would send an even more negative signal for corporate bond returns.  Corporate balance sheets are currently in excellent shape, but their health will deteriorate within the next 12 months as profit growth slows and interest rates rise. Relative valuation favors high-yield over investment grade corporates, and high-yield has a track record of outperformance during periods of restrictive monetary conditions and strong corporate balance sheets. Bottom Line: Investors should cyclically reduce exposure to US corporate bonds while retaining a preference for high-yield over investment grade. We recommend downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5). Feature Chart 1A Rapid Recovery US corporate bonds have had a very good run since the March 2020 peak in spreads. Investment grade corporates outperformed a duration-matched position in US Treasuries by 23% during the first 12 months of the recovery, the best 12-month excess return since 2010 (Chart 1). That same period also saw an extremely rapid re-normalization of credit spreads. It took just 11 months for the investment grade corporate index option-adjusted spread (OAS) to reach 90 bps following its March 2020 peak, and the index delivered an annualized excess return of 26% during that period. In contrast, it took 109 months for the index OAS to reach 90 bps following the 2008 recession and corporates only beat duration-matched Treasuries by an annualized 4% during that time (Table 1). Table 1US Investment Grade Corporate Bond Returns From Spread Peak Until 90 BPs The outlook for US corporate bond returns looks much different today. Spreads are tighter and the Fed is rapidly removing policy accommodation. Against this backdrop, we decided last week to cyclically reduce our corporate bond exposure.1  Specifically, we recommended downgrading investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) and high-yield corporates from overweight (4 out of 5) to neutral (3 out of 5) within US bond portfolios. This Special Report discusses the rationale for our recent decision. First, we examine trends in the main indicators that determine corporate bond performance. These indicators fall into three categories: (i) valuation, (ii) cyclical/monetary indicators and (iii) balance sheet health. We then discuss the outlook for the relative performance of high-yield versus investment grade corporates. Valuation Starting with a simple examination of the average investment grade index OAS, we see that the spread has widened somewhat off its pre- and post-pandemic lows, but remains close to the average level seen between 2017 and 2019 (Chart 2). The index OAS is a reasonable gauge of value relative to recent history, but for a longer historical perspective we should adjust the index to account for its changing average credit rating and duration. To do this, we first re-weight the index to maintain a constant distribution between the different credit rating buckets. Next, we control for the index’s changing duration by calculating a 12-month breakeven spread. The 12-month breakeven spread is the spread widening that must occur during the next 12 months for the corporate index to perform in line with a duration-matched position in Treasuries. It can be approximated by dividing the index OAS by average index duration. Finally, Chart 3 presents the 12-month breakeven spread as a percentile rank since 1995. It shows that, after controlling for credit rating and duration, the investment grade corporate index has only been more expensive than current levels 24% of the time since 1995. Notice that the spread bounced off the 0% line in late-2021, indicating that it had reached all-time expensive levels. Chart 2Spreads Near 2017-19 Average Chart 3Investment Grade Valuation All in all, we can conclude that investment grade corporate bonds are quite expensive. Spreads aren’t so low that they would justify an underweight allocation in a supportive cyclical/monetary environment. But they are tight enough that it makes sense to proceed cautiously in a neutral or negative cyclical/monetary environment, like the one we are in today.   Cyclical/Monetary Indicators The slope of the yield curve is the key variable we use to assess the current state of the cyclical/monetary environment. A very flat or inverted yield curve signals a relatively restrictive monetary policy backdrop, and we have shown that such a backdrop tends to coincide with poor excess corporate bond returns. Conversely, we have found that corporate bonds perform best early in the economic recovery when the yield curve is very steep. This steep yield curve signals that monetary conditions are highly accommodative, and thus supportive of credit spread tightening. Today, the yield curve is sending a somewhat confusing message. The 2-year/10-year Treasury slope briefly inverted last week, and it remains flat at 22 bps. Meanwhile, the 3-month/10-year Treasury slope is very steep, up above 200 bps (Chart 4)! Chart 4Conflicting Signals From The Yield Curve We discussed how to interpret the signals from different yield curve segments in a recent Special Report.2 We found that the 2-year/10-year Treasury slope sends the most useful signal for corporate bond excess returns, and we therefore view current cyclical/monetary conditions as negative for corporate bonds. In Table 2 we split each of the past six economic cycles into phases based on the 2-year/10-year Treasury slope. We define Phase 1 of the cycle as the period from the end of the prior recession until the 2-year/10-year slope breaks below 50 bps. Phase 2 of the cycle encompasses the time when the slope is between 0 bps and 50 bps. Phase 3 of the cycle spans from when the yield curve inverts until the start of the next recession. Table 2US Corporate Bond Performance In Different Phases Of The Cycle The table shows annualized excess returns for both investment grade and high-yield corporate bonds in each of the three phases, and those returns exhibit a clear pattern. Returns are best in Phase 1 when the yield curve is steep. They take a step down in Phase 2 when the slope is between 0 bps and 50 bps, though they usually stay positive. Negative returns are most likely in Phase 3, after the yield curve inverts. Chart 5Limited Room For Curve Steepening With the 2-year/10-year Treasury slope at 22 bps, we are firmly in Phase 2 of the cycle. However, we could easily see the 2-year/10-year slope invert within the next few months while a breakout above 50 bps seems less likely. In fact, there are only two ways in which the 2-year/10-year Treasury slope can steepen further from current levels. First, the market could bid up its expectation of the long-run neutral fed funds rate, pushing long-dated bond yields higher. Second, expectations for the pace of near-term Fed tightening could diminish, pulling short-dated yields down. At the long-end, the 5-year/5-year forward Treasury yield is already above survey estimates of the long-run neutral rate (Chart 5). At the front-end, the market is discounting a rapid pace of 272 bps of tightening during the next 12 months (Chart 5, bottom panel), but that pace has limited room to fall given current extremely high inflation readings. Turning back to a comparison of the signals from the 2-year/10-year slope and 3-month/10-year slope, it is worth pointing out that the 3-month/10-year slope is influenced by yield movements at the very front-end of the curve. Meanwhile, the 2-year/10-year slope is purely a function of rate expectations beyond the next two years. As a result, we can view the 3-month/10-year slope as sending a timelier signal about Fed rate hikes and cuts, while the 2-year/10-year slope gives a better reading of how the market views the ultimate economic impact of Fed actions. For example, the 3-month/10-year Treasury slope inverted in 2019 just before the Fed started cutting rates (Chart 6A). The 2-year/10-year slope, however, only briefly dipped below zero. The message from the market was that the Fed would cut rates, but those cuts would be sufficient to sustain the economic recovery. As a result, corporate bonds performed well during this period, consistent with the message from the 2-year/10-year slope. Another interesting example occurred in early 2000 (Chart 6B). This time, the 2-year/10-year Treasury slope inverted while the 3-month/10-year slope remained steep. In this case, the 3-month/10-year slope was telling us that Fed rate hikes would continue, while the 2-year/10-year slope was telling us that those hikes would eventually kill the economic recovery. Once again, corporate bonds took their cues from the 2-year/10-year Treasury slope and performed poorly during this period. Chart 6AStrong Performance In 2019 Chart 6BPoor Performance In 2000 Obviously, the current situation looks more like 2000 than 2019, but with the 2-year/10-year slope still positive there remains scope for positive excess corporate bond returns in the near-term. That said, with high odds of 2-year/10-year curve inversion within the next few months and spreads at relatively tight levels, it makes sense to scale back exposure today in advance of the worst phase of the cycle. Balance Sheet Health The final factor we consider is the health of nonfinancial corporate sector balance sheets, and in fact, this is currently the lone bright spot for corporate bond investors. Our Corporate Health Monitor (CHM), a composite indicator of six key balance sheet ratios, is deep in “improving health” territory (Chart 7). This positive signal is driven by exceptionally high Interest Coverage (Chart 7, panel 2) and Free Cash Flow-To-Debt that is just off its highs (Chart 7, panel 3). Return On Capital is up sharply since 2020 but has not recovered its previous peak (Chart 7, bottom panel). Chart 7Balance Sheets Are In Great Shape While corporate balance sheets are in excellent shape right now, their health will certainly deteriorate going forward as profit growth comes down off its highs and interest rates rise. The only question is whether this deterioration will happen slowly or quickly. Turning to history, two relevant periods stand out (Chart 8). First is the mid-1990s when investment grade corporate bond excess returns peaked in July 1997, 16 months before our CHM moved into “deteriorating health” territory. Conversely, the CHM sent a negative signal before the excess return peak in 2007. But even then, investment grade corporates only outperformed Treasuries by an annualized 0.8% between when the 2-year/10-year slope fell below 50 bps in 2005 and when the CHM moved above zero in 2006. In other words, investors didn’t sacrifice much return by heeding the yield curve’s signal even when the CHM was deep in “improving health” territory. Chart 8Cyclical Corporate Bond Performance Investment Conclusions In summary, we view corporate bond valuations as expensive, and the flat 2-year/10-year Treasury slope suggests that the economic recovery is in its mid-to-late stages. Corporate balance sheets are currently in excellent shape, but they will deteriorate going forward as profit growth slows and interest rates rise. The above three factors suggest that corporate bonds could continue to outperform duration-matched Treasuries in the near-term. However, with spreads already at tight levels, we likely aren’t sacrificing much in the way of excess returns by turning cyclically defensive today. This move also ensures that we will not be invested when the credit cycle eventually turns and corporate bond spreads move significantly wider. Retain A Preference For High-Yield Versus Investment Grade While we recommend downgrading allocations for both investment grade (from neutral to underweight) and high-yield (from overweight to neutral), we think investors should still retain a preference for high-yield corporates over investment grade. To see why, let’s return to the 2005-06 period we looked at in the previous section. The yield curve dipped below 50 bps in 2005 when the CHM was still deep in “improving health” territory, and while investment grade corporate bond returns were low during the time between the signal from the yield curve and the signal from the CHM, junk excess returns were very strong (Chart 9). This makes some sense intuitively. Higher-rated investment grade corporates responded negatively to the Federal Reserve’s removal of monetary policy accommodation, but lower-rated junk spreads stayed well bid because actual default risk was benign. It wasn’t until after the CHM rose above zero that junk bonds started to underperform. In terms of present-day valuations, much like for investment grade, junk spreads are up off their 2021 lows. However, they remain close to their pre-pandemic trough (Chart 10). We also note that the differential between high-yield and investment grade spreads was much tighter in 2006-07. Given the similarities between that period and today, we wouldn’t be surprised to see junk spreads compress further relative to investment grade. Chart 9The Bullish Case For Junk Chart 10High-Yield Valuation Another way to approach high-yield bond valuation is through the lens of our Default-Adjusted Spread. The Default-Adjusted Spread is the difference between the junk index OAS and 12-month default losses, and we have shown that it has a strong correlation with excess returns (Table 3). Specifically, a Default-Adjusted Spread above 100 bps usually coincides with positive excess junk returns versus Treasuries, and higher spreads tend to coincide with higher returns. Table 3The Default-Adjusted Spread & High-Yield Excess Returns To estimate the Default-Adjusted Spread for the next 12 months we need assumptions for the default and recovery rates (Chart 11). To do this, we model the 12-month speculative grade default rate as a function of gross nonfinancial corporate leverage – total debt over pre-tax profits – and lagged C&I lending standards. We then model the 12-month recovery rate based on the default rate itself. Chart 11Default And Recovery Rate Models Corporate pre-tax profit growth was exceptionally strong during the past 12 months, and we expect it to slow significantly going forward. Profit growth can be modeled as a function of nominal GDP growth and unit labor costs (Chart 12). If we assume that nominal GDP growth comes in at 7.3% this year (the Fed’s median 2.8% real GDP estimate plus 4.5% inflation) and that unit labor cost growth rises to 6%, then profit growth will fall to 0.5% during the next 12 months. If we assume that corporate debt growth remains close to its current level (Chart 12, bottom panel), then we calculate that gross leverage will rise to 6.5 during the next 12 months. Chart 12Profit Growth Will Slow Significantly Table 4 shows the output from our default and recovery rate models under the base case assumption described above. It also shows results for an optimistic case where leverage is 6.0 and a pessimistic case where it is 7.0. The Default-Adjusted Spread is fairly low in the base and pessimistic cases, but it is comfortably above the key 100 bps threshold in all three scenarios. This suggests that junk bonds should deliver positive excess returns versus duration-matched Treasuries during the next 12 months. Table 4Default-Adjusted Spread Scenarios   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Portfolio Allocation Summary, “The Beginning Of The End”, dated April 5, 2022. 2 Please see US Bond Strategy / US Investment Strategy / US Equity Strategy Special Report, “The Yield Curve As An Indicator”, dated March 29, 2022. Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations

Special Report

Dear client, In lieu of April 18 publication, I will be hosting our quarterly webcast. Our regular weekly publication will resume Monday, April 25. Kind Regards, Irene Tunkel Chief Strategist, US Equity Strategy   Executive Summary R&D Is Paying Off What Is Renewable Energy: It consists of  new utilities companies that generate electricity using clean technologies including wind, solar, hydro, biomass, geothermal, nuclear and other. Currently, renewables are becoming a dominant source of new power generation as their costs becoming comparable to the ones of traditional fossil fuels.  Industry Breakthroughs: Increased renewables adaptation is possible due to several technological advancements including improved battery storage, implementation of smart grid networks, and an increase in carbon capture activities. Renewables And Cleantech Investment Characteristics: The majority of renewable energy and cleantech companies tend to be smaller than established utilities. As a result, they are highly correlated with the small-cap growth indices. Key Macroeconomic Drivers: Just like small caps, renewables are highly sensitive to economic growth and monetary conditions. Currently, rolling over global PMIs as well as tightening liquidity conditions spell trouble for the sensitive green-tech stocks. Fundamentals Overview: The industry is characterized by extremely volatile fundamental data, once again underscoring its small-cap growth-like nature. That said, margins are healthy, capex growth is in the positive territory, while valuations are on the expensive side. The policy backdrop is also favorable, as we will show in a sequel to this report. Bottom Line: On a structural basis, renewable energy and cleantech companies are at the core of the global push to diversify energy sources and mitigate climate change. They enjoy a temporary tailwind from the US administration and a more lasting tailwind from the geopolitical need for energy security. However, over the near term, renewables face headwinds from tighter monetary policy and slowing growth. Feature Introduction Climate change is at the forefront of many investors’ minds. BCA Research has covered some of the key trends and challenges in the Climate Change Special Report, published three years ago, and in its coverage of the Biden administration. But this subject is just as relevant today. For much of the past decade, renewable energy and clean technology companies have flourished, enjoying tailwinds from a secular push towards green and renewable energy (Chart 1). However, in February 2021, the group collapsed with many clean energy stocks down more than 50% off-peak. Recently, renewables have rebounded on the back of the war in Ukraine and the surge in energy prices and diversification (Chart 2). Chart 1The Industry's Performance... Chart 2...Is Very Volatile In this report, we conduct a “deep dive” into various types of renewable energy and clean technologies, to gauge their commercial potential and investment attractiveness. We will try to get to the bottom of the question of whether “green and clean” is a lucrative investment theme, and when may be a good entry point. What Is “Green And Clean”? According to International Renewable Energy Agency (IRENA), 90% of all decarbonization in 2050 will involve renewable energy through a direct supply of low-cost power, efficiency, electrification, bioenergy with carbon capture, and green hydrogen. All of these technologies fall into one of the two intertwined tracks: Renewables and Cleantech. Renewable Energy Companies Are The New Utilities Renewable energy is mostly represented by the companies in the Utilities sector that generate power from sustainable sources, such as solar photovoltaic (PV), wind, hydropower, and renewable hydrogen in fuel cells. These companies then sell that electricity at either market or contracted rates. Despite the novel technologies they leverage, from an investment standpoint, these companies are not much different than traditional utilities in terms of their business model. However, a whole ecosystem has developed around solar and wind energy-producing companies: Producers of raw materials, manufacturers of solar batteries, wind turbines, and systems and components, along with companies that offer installation and maintenance services. Many of these companies may be described as Cleantech. Cleantech Is A High Tech Take On Solving Climate Change Cleantech uses nascent technologies to reduce the carbon footprint of mundane human activities, such as heating homes, driving, and growing food supplies. Technologies being developed are energy storage batteries, smart grid implementation, carbon capture, energy efficiency, and many others. In addition, the Cleantech sector includes renewable energy equipment manufacturers that produce such components as wind turbines, solar panels and cells, and solar inverters. Clearly, Cleantech has a broad reach and spans a wide range of sectors, such as Technology, Material, and Industrials (Table 1). Cleantech offers more tech-like higher-risk, higher-reward potential payoffs than renewable energy production. Let’s take a close look at these technologies. Table 1Renewables Performance Statistics Versus S&P Sectors Renewable Energy Renewable Energy Sources Are Replacing Fossil Fuels Over the past 20 years, this country has made significant strides in shifting its energy generation toward renewable sources away from fossil fuels, increasing the share of clean energy from 3.7%  in 2000, to 10% in 2020 (Chart 3). Non-hydro renewable generation, which includes wind, solar, geothermal, and biomass sources of power, accounted for 65% of US renewable electricity production in 2020. Chart 3A Structural Trend New Installations Are Dominated By Renewables Chart 4Share Of New Electricity Capacity Renewables are becoming a dominant source of new power generation. In terms of new electricity capacity installations, over 80% in the US and 72% globally are renewables, and their share is growing steadily over time (Chart 4). In terms of growth, wind and solar dominate the category, with production increasing nearly exponentially over the past decade (Chart 5). Chart 5USA Renewable Energy Sources Breakdown Power Generated By Renewables Is Cheaper Than Power Generated By Fossil Fuels The key reason for the proliferation of green energy generation is that renewable electricity is becoming cheaper than electricity produced by fossil fuels – according to IRENA, 62% of the added renewable power generation capacity had lower electricity costs than the cheapest source of new fossil fuel-fired capacity. Costs for renewable technologies continued to fall significantly over the past year:1 Concentrating solar power (CSP) fell by 85 percent Onshore wind by 56 percent Solar PV by 85 percent Offshore wind by 48 percent  This trend is bolstering the economic case for transitioning to cleaner energy resources (Chart 6). Chart 6R&D Is Paying Off Higher Production Translates Into Lower Prices Why are the prices of renewable alternatives falling so fast? Like traditional utilities, renewables require a massive upfront investment and, as a result, enjoy substantial operating leverage. However, with such high upfront costs, to achieve profitability, these companies need high production volumes. In addition, high production levels help these relatively young industries move up the experiential learning curve towards operational efficiencies. From 2010 to 2020, capacity increased nearly 4x for wind, 17.5x for solar PV,2 and 22x for lithium-ion batteries. With the rapid scaling of these technologies, cost declines range between 65-and 90%.3 Solar PV cumulative capacity vs price dynamic is a perfect illustration (Chart 7). Chart 7Solar PV Module Prices Versus Cumulative Capacity Key Challenges Of Solar And Wind While solar and wind are the fastest growing and most promising renewable technologies, they are also facing some significant challenges, which imperil their wider adoption. There are limitations in grid connection and flexibility, fluctuations in amounts of energy these sources generate, and a dire need for technological innovation in battery storage and digital tools for demand-side management. Outlook For The Renewables Industry IRENA expects renewables to scale up from 14% of total energy today to around 40% in 2030. Global annual additions of renewable power would triple by 2030 as recommended by the Intergovernmental Panel on Climate Change (IPCC). Solar and wind power will attract a lion’s share of investments (Chart 8). Chart 8Renewable Energy Investment Breakdown Breakthroughs In Cleantech Over the past few years, we have seen broad-based commercialization of novel climate-friendly technologies for fueling—no, charging our cars; warming our homes; and cleaning up greenhouse gases resulting from human activities. The following are just a few of the most prominent ones. Battery Storage Renewables like wind and solar are considered variable energy sources as the amount of energy they generate fluctuates over time. Energy supplies could be stabilized if excess supplies of energy could be stored quite literally for a rainy day. Utility-scale lithium-ion battery storage, which has gotten cheaper over time with battery prices decreasing on average by 18% annually from 2010 to 2019, is emerging as a viable option for storing excess energy for future use. Pairing lithium-ion batteries with nearby solar plants is known as “solar plus storage.” The dollar value of the US energy storage market is expected to grow more than twentyfold to nearly $11.5 billion by 2026, from an estimated $513 million in 2018, according to Wood Mackenzie, a global research and consultancy firm. Hydrogen Fuel Hydrogen is a clean fuel that, when consumed in a fuel cell, produces only water. Hydrogen can be produced from a variety of domestic resources, such as natural gas, nuclear power, biomass, and renewable power such as solar and wind. These qualities make it an attractive fuel option for transportation and electricity generation applications. It can be used in cars, in houses, for portable power, and in many more applications. Hydrogen is an energy carrier that can be used to store, move, and deliver energy produced from other sources.4 Today, hydrogen fuel can be produced through several methods. The most common methods are natural gas reforming (a thermal process), and electrolysis. Other methods include solar-driven and biological processes. A hydrogen fuel cell combines hydrogen and oxygen to produce electricity, heat, and water. As hydrogen is high in energy and produces almost no pollution, it can be used as fuel. Fuel cells are similar to batteries in that they produce electricity without combustion or emissions. Unlike batteries, fuel cells do not run down or need to recharge—as long as there’s a constant source of fuel and oxygen. Carbon Capture And Storage Carbon capture and storage (CCS) is the process of capturing carbon dioxide (CO2) before it enters the atmosphere, transporting it, and storing it (carbon sequestration) for centuries. Usually, the CO2 is captured from large point sources, such as a coal-fired power plant, a chemical plant, or a biomass power plant, and then stored in an underground geological formation. The aim is to prevent the release of CO2 from heavy industry with the intent of mitigating the effects of climate change.5 CCS efforts are targeted to neutralize emissions from manufacturing and power generation industries, which together account for about 70% of the world’s emissions.6 Companies like ExxonMobil are exploring direct air capture technology to scrub emissions out of the air and carbonate fuel cells to capture industrial emissions from flue gas streams of power plants or manufacturing facilities. Once considered fringe climate change mitigation methods, these processes are seeing wider acceptance as effective complements to conventional interventions. Smart Grid The smart grid is a planned nationwide network that uses information technology to deliver electricity efficiently, reliably, and securely. It's been called "electricity with a brain," "the energy internet," and "the electronet." Unlike today's grid, which primarily delivers electricity in a one-way flow from generator to outlet, the smart grid will permit the two-way flow of both electricity and information.7 Smart grid development will require investment across a wide range of technologies (Chart 9). Chart 9Smart Grid Investments Breakdown Renewables And Cleantech Investment Characteristics The majority of renewable energy and cleantech companies tend to be smaller market cap-wise than established utilities or industrial companies and tend to inhabit small-cap and mid-cap indices. Life span-wise, these are younger companies, many of which are commercializing novel technologies and have high growth potential. It is not surprising that they are highly correlated with the small-cap growth indices (Chart 10). As quintessential growth companies, they reinvest aggressively into their business: Capex growth, while volatile, is high (Chart 11). As a result, many of these companies are highly indebted, although recently many of them have cleaned up their balance sheets (Chart 12). Chart 10Renewables Often Behave Like Small-cap Growth Stocks Chart 11Volatile Capex Chart 12Improving Balance Sheets And it is worthwhile to point out that while many renewable energy companies fit squarely into the “utilities” category, don’t expect them to be boring, i.e., be a low volatility investment, or to pay dividends. Sales And Profitability Renewable energy generation and cleantech are good businesses with companies in the Wind index enjoying double-digit margins (Chart 13). Their earnings are also expected to grow at more than 30% per annum, which is consistent with IRENA’s high growth rate forecasts for the industry. Chart 13Steady Margins Valuations Chart 14Cheaper, Yet Still Pricey Valuations have come down substantially from the peak (Chart 14) but remain elevated. Trailing PEs for all renewable ETFs look rich (Table 2). High expected earnings growth and elevated valuations are highly consistent with the small-cap growth profile of these stocks.​​​​Table 2Cheaper, Yet Still Pricey Therefore, we believe that fundamentals are unlikely to be a driver of the performance of these stocks, while macroeconomic and political backdrops are truly important. Key Macroeconomic Drivers As we have established, renewable energy and cleantech stocks are small-cap growth and, like the rest of their brethren, must be highly sensitive to economic growth and monetary conditions. As providers of alternative energy, they are also highly sensitive to the price of oil. Economic growth The pursuit of new technologies requires deep pockets. Without a benefactor, such as the government, renewables need strong economic growth that translates into strong sales and earnings growth to pursue lucrative new projects and develop their business (Chart 15). However, lately, global PMIs have turned down, signaling growth deceleration, which does not bode well for the industry. Chart 15Global Growth Headwinds Coupled With... Monetary Conditions The survival and prosperity of renewable energy stocks are also tied to their ability to access cheap capital. As a result, their market performance is closely linked to liquidity (Chart 16). The industry is still in the early stages of its innovation cycle and requires significant Capex outlays to develop its offerings. As financial conditions tighten and liquidity shrinks, renewable companies can no longer access cheap funding and may have to postpone projects. Many of these companies are heavily indebted and may struggle to meet their financial obligations without cheap funding. As a result, these companies’ growth prospects and immediate bottom line may take a hit. Withdrawal of liquidity will also hurt highly inflated multiples of the group. Since the US is in the early innings of a steep tightening cycle, we consider monetary conditions a major headwind for renewables. Chart 16...A Liquidity Drought Spells Trouble Cost of Oil And Alternative Energy Sources Oil and other fossil fuels are substitute goods from a renewable energy standpoint, providing customers with alternatives (Chart 17). Since resulting electricity is highly commoditized, customers are inclined to choose a cheaper option. Also, at times of shortages, either type of energy provider may be able to step in and pick up the slack. A recent spike in the performance of alternative energy stocks on the back of an energy crisis triggered by the war is a case in point. As long as supply disruptions in the energy space continue, renewables will outperform. However, the price of oil is a geopolitical gamble, and the probability of a downside move is higher than the probability of an upside move. Especially if geopolitical tensions are reduced or resolved faster than the market expects. Chart 17Keep An Eye On Energy When Investing In Renewables How To Invest In Cleantech? There is a host of ETFs that offer investors a wide range of choices for access to renewable energy and cleantech themes (Table 3). These ETFs differ in geographic span, industry focus, liquidity, and cost, but all are viable investment options. Table 3Clean Tech ETFs Investment Implications Renewable energy and cleantech companies are at the core of the global push to increase energy security and contain climate change. They enjoy a substantial tailwind from China and the EU, as well as a temporary tailwind from the Biden administration, which has put its weight behind a goal of swift transition of the economy to clean sources of energy. However, stocks of these companies fall squarely into the small-cap growth style bucket, and the macroeconomic backdrop characterized by slowing growth and tightening monetary conditions is highly unfavorable for the group. The surging price of oil is the only pillar supporting the recent outperformance of the group – however, a change in a geopolitical backdrop may send the price of oil spinning, taking renewables with it. While we believe that on a structural basis, renewables and cleantech present a tremendous opportunity to partake in a monumental energy transition, we also believe that over the short investment horizon, the probability of downside risk in performance is elevated. Bottom Line: “Green and Clean” are at the forefront of the global transition to renewable energy and clean technology and expected growth rates are unparalleled. However, over the near term, the group faces headwinds from tighter monetary policy and slowing growth, while the price of energy is a hostage to geopolitics and presents a downside risk if geopolitical tensions are reduced faster than expected.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Appendix: Types Of Renewable Energy Solar Energy Photovoltaics (PV), also called solar cells, are electronic devices made of semiconducting material that convert sunlight directly into electricity. Solar panels were invented in the US in 1954 at Bell Labs. Today, PV is one of the fastest-growing renewable energy technologies. Solar PV installations can be combined to provide electricity on a commercial scale or arranged in smaller configurations for mini-grids or personal use. The cost of manufacturing solar panels has plummeted dramatically in the last decade, making them not only affordable but often the cheapest form of electricity. Concentrated solar power (CSP) uses mirrors to concentrate solar rays, which heat fluid into steam to drive a turbine and generate electricity. One of the main advantages of a CSP power plant over a solar PV power plant is that it can be equipped with molten salts in which heat can be stored, allowing electricity to be generated after the sun has set. Looking at solar power, the installed capacity of solar energy sources increased by 17.6x (1,763%) between 2010 and 2020 and is expected to increase sevenfold by 2030. The lifetime costs of solar modules are continuing to fall as innovations in PV cells continue to improve efficiency, which has improved by about 200% since the 1950s to around 15-16% today for commercially available panels. Lab results show cells can achieve efficiencies of over 40%. Wind energy is when the wind is harnessed to produce electricity using the kinetic energy created by air in motion. This is transformed into electrical energy using wind turbines or wind energy conversion systems. The output is proportional to the dimensions of the rotor and to the cube of the wind speed. Wind turbine capacity has increased over time. According to IRENA, global installed onshore and offshore wind generation capacity has tripled in the past decades. In 2016, wind energy accounted for 16% of the electricity generated by renewables. The wind will be one of the largest generation sources by 2030, supplying 24% of total electricity needs.8  Much of this recent growth can be attributed to innovation and the rapidly decreasing costs of underlying technologies. In 2019, 75% of the new onshore wind projects commissioned had a Levelized Cost Of Electricity (LCOE)9 lower than the cheapest new source of fossil fuel-fired power generation as, over the past 10 years, the LCOE of wind power decreased by 55%. Growth of wind power generation is expected to continue as economies of scale, greater investment, supportive policies, and market forces further reduce the cost of components, installation, and operation of wind energy sources. Hydropower The basic principle of hydropower is using water to drive turbines. Hydroelectric sources like dams and run-of-the-river power generators represented the lion’s share of renewable power generation. Hydroelectric power represented 82% of all renewable power generation in 2010; however, this share has contracted in recent years. The installed capacity of hydro has remained flat over the past decade, largely because energy sources are restricted by location and an already-prominent reliance on hydroelectric power limits its growth. This is the slowest growing renewable energy segment. Other Renewables Over the longer-term, bioenergy, geothermal, and ocean energy may also be important sources of renewable energy. Yet, at present these technologies account for no more than 5% of the renewables market; strong R&D efforts will be needed in the coming decades to bring their costs down and expand their share. IRENA expects these technologies to grow sixfold by 2030.     Footnotes 1     IRENA, “World Energy Transitions Outlook 2022” 2     IRENA, “Installed Capacity Trends” 3    European Commission, “Lithium-ion batteries for mobility and stationary storage applications,” 2018. 4    Hydrogen Fuel Basics | Department of Energy 5    Carbon capture and storage - Wikipedia 6    Helping decarbonize industry with carbon capture and storage – Energy Factor (exxonmobil.com) 7     Smart Grid: A Beginner's Guide | NIST 8    Ibid 9    LCOE refers to the revenue required to build and operate a power source over a specified cost recovery period   Recommended Allocation   Recommended Allocation: Addendum