2017 Q2 letter: A threat to human civilization

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Dear Friends,

The 2nd quarter saw the Fed continue its strategy of withdrawing stimulus from the US economy. Since December 2016, the Fed has raised rates three times, bringing the target rate up to 1.25%. Their most recent statements suggest the target rate will continue to rise if unemployment and inflation stay relatively stable. There have been several statements this month from Fed governors indicating the central bank plans to begin selling or rolling off the 3.6 Trillion dollars in bonds it has acquired since the financial crisis of 2008/2009. The Fed’s decision to increase its bond holdings by 400% during the financial crisis was an unprecedented action, and the reduction to more normal levels has been expected for some time.

The net effect of these moves for investors will be a rise in interest rates, a reduction in liquidity, and a less attractive environment for risky assets. Bond investors should see rates continue to rise towards more normal levels, a relief since bond yields have been historically low for the past several years. The sale of the Fed’s bond portfolio will also reduce the amount of money in circulation (the money supply) as private investors purchase the assets the Fed sells. This is expected to put further pressure on stock prices and riskier assets as funds are directed into these purchases.

Over the past few days, we have also seen the risk of political instability in the US rise to remarkable levels. It seems increasingly likely that the various investigations underway may lead to very senior members of the Trump administration and campaign facing a variety of charges.

From a valuation perspective, stock prices continue to look overvalued. Remarkably, the top five components of the S&P 500 (Apple, Alphabet/Google, Microsoft, Facebook and Amazon) are all technology companies. What’s even more surprising is that with the exception of Apple, they are all trading at prices over 30 times earnings. Much of that gain has been recent, four of the  five have seen gains of over 20% in the past six months (the exception is Microsoft). Taken together, these five companies represent almost 12.5% of the index.

Overall market valuations are extraordinarily high, with the current P/E ratio for the S&P500 over 25. A longer term measure, which looks back at ten years of earnings (Cyclically Adusted or Shiller P/E) is illustrated in the chart below, alongside interest rates. Cyclically Adjusted P/E is at levels that have only been exceeded twice; before the tech-wreck of 2000 and Black Tuesday in 1929. This is partly because interest rates remain at historic lows. As discussed above, that is changing.

As a result of these factors, we continue to maintain a defensive posture and recommend clients an underweight allocation to high-risk assets.

Data source: Robert Shiller – Yale University

We would like to use the rest of our quarterly letter to discuss a longer-term risk, one that impacts not just the markets, but all of human civilization.

For several decades now, scientists focused on studying global warming and climate change have shared their increasingly dire findings about the impact of human activity on the Earth’s biosphere. It is now abundantly clear to all, except the intentionally obtuse and dishonest among us, that human activity has impacted the Earth’s climate in a significant way. Our species’ use of fossil fuels has released an extraordinary amount of greenhouse gases into the atmosphere, raising the average temperature across the world by 0.2° Celsius (0.36° Fahrenheit) each decade.

Economists have long understood that markets can mis-price public goods or services that have concentrated benefits for a few while costs are diluted among many. Within the economic literature, this is called the “tragedy of the commons”. The classic example is shepherds grazing their flocks in a meadow that is commonly owned. In standard political and economic theory, the government is meant to intervene to enforce a solution that furthers the general good and recognizes and allocates the true costs of such activity.

At this point, we should admit that US political institutions have failed to deliver on addressing climate change. The vast majority (85%) of greenhouse gases released into the atmosphere have been generated since World War II. Over that period, the United States has been, by far, the largest greenhouse gas emitter. So, much of the responsibility for climate change lies with us. Yet, we have been for decades, and still remain, the chief impediment to decisive action on climate change. The Trump administration has made a very bad situation even more dire by announcing a withdrawal from the Paris agreement.

Nature, of course, couldn’t be less concerned about human politics. The content of greenhouse gases like carbon dioxide and methane has continued to rise, driving surface temperatures higher. This has manifested itself in a variety of ways. Glaciers have retreated across the world. The five hottest years in recorded history occurred within this decade, and 2016 set a new record. Coral reefs across the world are bleaching as water temperatures rise, stressing the marine eco-system. Hotter summers are impacting humans as well, with extreme temperatures rising causing heat-strokes, dehydration and deaths.

Most climate change models have assumed a 0.2°C increase per year in surface temperatures will leave the Earth’s with an average temperature 2°C (3.6°F) higher by 2100. Those assumptions now look woefully inadequate. Since we have not measurably reduced our greenhouse gas emissions, and the Paris agreements seem to have collapsed, 2°C degrees is an underestimate and the case for a 3-4°C rise becomes stronger.

As climate change and research into it has advanced, the risks of a runaway feedback loop have become clearer as well. Permanently frozen ground in the arctic regions of Asia and North America traps a large amount of methane. As the ground gets warmer, this methane leaches into the atmosphere. As temperatures rise and water becomes scarce, plant life across the world will be stressed. The risk and incidence of forest fires increases, and the loss of trees leaves more CO2 in the atmosphere. If rising temperatures, fire and drought impact major CO2 sinks like the Amazon forest, temperatures will rise even faster.

There is a reasonable likelihood that temperatures will have risen by 4-6°C (7-10°F) by 2100. 90°F days will be 100°F days. 100°F days will be 110°F days. Phoenix saw temperatures rise above 118°F last month, grounding flights. What happens when temperatures approach 128°F? If such an extreme rise in temperatures were to occur, the world is looking at a series of major catastrophies that could largely destroy human civilization.

Drought and heat would cause widespread human suffering and deaths. Food stocks would be harder to grow with much of the world’s breadbasket regions in China, India, Central Asia and North America undergoing desertification. Much of the southwestern United States could become an uninhabitable desert. Tens of millions of people would need to be resettled. This pattern would be replicated across the world. A NASA study indicates the Middle East is suffering through a 20 year drought that is more severe than any in the past 900 years. There are indications that crop failure and rising food prices have contributed to societal upheaval in the region. The Mediterranean as a whole is susceptible to drought and desertification.

The impact on agriculture worldwide would be many times more severe than seen during the dust-bowl. Marine life and fisheries would be devastated as ocean temperatures rise. And yes, sea-levels could rise 10 feet or more, making most coastal cities uninhabitable without civil works on a scale we have never seen before. Much of New York, London, Mumbai, Shanghai, Sydney, Rio De Janeiro, Singapore, Dubai, Miami, almost all of Bangladesh, and many island nations, would be lost.

It is virtually certain that such extreme conditions will lead to widespread forced migrations and fuel conflict between nations and individuals. This is one of the reasons the US Department of Defense treats climate change as the largest strategic threat to the country. Governments and political structures will undergo immense stress and opportunistic charlatans could come to power across the world.

All of this would significantly impact incomes, growth rates, earnings and most importantly health and well-being. We do not intentionally seek to be alarmist. However, the data and projections we have seen demand urgent responses and are alarming. There is a grave likelihood that we leave our children with a world in crisis. Without urgent, concerted action, large portions of our planet will become inhospitable to human inhabitation within our children’s lifetime.

Clearly, these events will impact investors and markets in profound ways. As we engage in long-term, inter-generational planning for clients, we want our clients to know that we take these risks very seriously and will continue to keep these considerations in mind.

 

 

 

Regards,

 

 

Subir Grewal, CFA, CFP                                                                                              Louis Berger

Understanding the Risks of Crowdsourced Clean Energy Investing

Below is an article written by Louis about the recent trend in clean energy crowdfunding.  It was first published by Green Tech Media and the original article can be found here.

 

For clean energy investors, Title III of the JOBS Act could change the game.

Prior to its implementation, investing in clean energy startups or small-scale utility projects has been a pursuit reserved mainly for venture capital and private equity firms investing on behalf of their institutional and high-net-worth clients. The barrier to entry into these funds is high, with six- to seven-figure minimum buy-ins typically the norm. But in a post-JOBS Act America, we’re entering a crowdfunding-inspired era where barriers to entry are crumbling.

Take Mosaic, for example, where an investor with as little as $25 and an internet connection can fund a portion of a solar project via an online investment platform.

Sounds great, right? Well, it is. But as with any other investment opportunity, putting money to work in crowdsourced clean energy projects comes with risks. And as crowdfunding gains in popularity and scope, these risks may be glossed over or simply ignored by an enthusiastic investing public eager to put their money where their eco-conscious mouth is.

So what are the risks, exactly?

Let’s take a closer look at Mosaic — not because its offering is especially risky (compared to other crowdsourced investment opportunities, it’s not), but because it’s currently the poster child for this new business model.

In a nutshell, Mosaic helps investors of any size lend money to small-scale solar projects in need of capital. As a result, the solar projects get financing, Mosaic is paid a fee, and investors earn interest on their loan. Think of it as Kickstarter meets Kiva for solar project financing.

Here’s Mosaic’s pitch, in the company’s own words, taken directly from its website: “Mosaic connects investors seeking steady, reliable returns to high-quality solar projects. To date, over $5.6 million has been invested through Mosaic and investors have received 100% on-time payments.”

Below this statement is a list of Mosaic’s projects (all of which have been fully funded) showing annual payments of 4.5 percent to 5.5 percent. This number is net of Mosaic’s annual 1 percent management fee on loans that mature in five to twelve years.

Steady and reliable returns of 4.5 percent or more per year on your investment, plus pride in knowing your money is supporting a clean energy project. Sounds terrific. Everybody wins.

So what’s the catch? Is there a catch?

To answer this question, we have to take a closer look at Mosaic’s prospectus, a densely worded document that lays out the deal terms and accompanying risk factors in explicit detail. After all, the language found on the website is meant to sell prospective investors on Mosaic, not scare them away.

So, onto the prospectus, where on page 2 of the offering memorandum, in capital letters, we get this: “These are speculative securities. Investment in the notes involves significant risk. You should purchase these securities only if you can afford a complete loss of your investment.”

Speculative securities; significant risk; complete loss of your investment. Not quite the sunny language we found on the website. So what exactly are investors getting themselves into here?

It turns out these loans are not made directly to the solar project. Rather, they are funneled through an intermediary (Mosaic), which deploys capital to the projects on behalf of investors. So when an investor lends money to one of these projects, what they’re actually getting is an unsecured note issued by Solar Mosaic LLC, which is meant to “mirror the terms of the corresponding loan.” This is an important distinction, as certain bondholder rights are lost in this structure.

This leads us to the most important risk factor for investors to consider.

Default risk

What’s the risk that the issuer will fail and be unable to make interest payments or pay back your principal? Unlike bank CDs (insured by the FDIC), Treasury bonds (backed by the full faith and credit of the U.S. federal government), or municipal bonds (which often carry third-party insurance), Mosaic notes are uninsured, unsecured corporate bonds.

The repayment of principal with interest hinges on the success of the solar project and its ability to generate the necessary cash flow. Because of the way these notes are structured, investors will have two entities to worry about: the borrower (solar project) and the issuer (Mosaic). If the solar project fails, the investor will not receive interest payments and risks losing the invested principal. If Mosaic goes bankrupt (even if the solar project is successful), the investor also may not receive interest payments and risks losing the principal.

Oh, and by the way, if things do go south, the investor “will not have any recourse to the borrower under the loan.” If the solar project fails, you’re relying on Mosaic to recoup your principal through litigation, and the investor “will not have any security interest in any of MSI’s (Mosaic Solar Investments) assets.” That means if Mosaic goes belly up, don’t expect its other assets to cover your losses.

Since the performance of each note is tied directly to the success of the individual solar project, the next factor to consider is credit risk.

Credit risk

How can you quantify which projects are in the best position to repay the loan? Remember, if the project fails, it’s the investor’s capital at risk, not Mosaic’s (although the company’s reputation would likely take a hit). Most publicly traded bonds carry a credit rating from one or more of the major ratings agencies like Moody’s, S&P or Fitch. While these ratings should not be considered gospel (just ask anyone invested in “AAA”-rated mortgage-backed securities in 2008), they can provide a useful marker to help investors gauge the default risk of the borrower.

While Mosaic is working with Standard & Poor’s via truSolar to develop a scoring system for solar bonds, there currently isn’t any third-party analysis of the credit quality of the borrowers. Investors can conduct some limited due diligence on their own, but most will be relying on the judgment of Mosaic’s underwriting team, which have only been at this since 2012. So while there may have been 100 percent on-time payments to date, this is based on a very limited track record.

Since the notes are only available on Mosaic’s platform, another factor to consider is liquidity.

Liquidity risk

What happens if you need access to your principal before the loan matures? With publicly traded bonds (treasuries, corporates, municipals), there’s a secondary market where investors can sell their bonds prior to maturity. With Mosaic’s notes, there is no secondary market.  Also, there isn’t a mechanism in place for investors to redeem their notes prior to maturity. So if your note matures in twelve years, your money will be tied up for the duration. Think of it as a bank CD: you’ll be able to withdraw interest payments, but your principal is illiquid.

This lack of liquidity on a longer-term bond can expose investors to interest rate risk.

Interest rate risk

Right now, we’re living in a time of historically low interest rates. As anyone who holds money in a checking or savings account can tell you, yields on cash are virtually nonexistent. This is a result of the federal funds rate (the rate at which banks borrow money from each other) being set at essentially 0 percent. This impacts rates across all loans, keeping them low — until rates go up again.

And make no mistake, rates will rise. It’s not a question of if, but when and by how much. A twelve-year Mosaic note paying 5.5 percent per year may look great today, but if interest rates are substantially higher a few years from now, you’ll be stuck in an illiquid investment paying below-market rates.

In addition, there are a few other risks to consider.

Technology risk

Will the solar technology being used in this project still be viable twelve years from now? What happens if there’s a major breakthrough in panel performance that causes the panels used in your investment to become obsolete? Or what happens to the warranty on the solar panels if the manufacturer goes out of business?

Catastrophe risk

With climate change impacting weather patterns, what happens if a natural disaster (hurricane, tornado, flood) wipes out the solar farm you’re invested in? Mosaic requires borrowers to carry property insurance, but how would the lack of cash flow during repair work impact interest payments?

Do all these risk factors mean investors shouldn’t put money to work into Mosaic or other crowdsourced clean energy projects? Not necessarily. In fact, these types of investments can make a nice addition to a diversified portfolio. And Mosaic deserves a lot of credit for successfully building out this business model and proving it’s viable, not to mention wildly popular amongst clean energy investors.

However, just like any other investment opportunity, investors need to carefully consider all the risks involved prior to putting their money to work.