Q2 Reflections: Market Trends, the Debt Ceiling, and ESG Research

In contrast to the turbulence experienced in the first quarter, the second quarter seemed much smoother and less challenging. The initial shock caused by failing banks in Q1 subsided, and in Q2, there was only one Federal interest rate hike of 0.25%, which had a relatively minor impact.

During this quarter, the debt ceiling issue took the spotlight, leading to some drama and anxiety. However, despite the concerns, the situation was resolved without any catastrophic consequences. There was also an interesting new paper on whether or not “green” companies are inadvertently causing more pollution, and how different kinds of shareholder engagement can affect this.

We’ll delve deeper into the details below. Here are the performance charts for your review.

In the second quarter, stocks showed strong performance, while bonds experienced poorer results. However, the monthly performance of both asset classes varied significantly. Looking at the past year’s overall performance, US stocks performed remarkably well, growing by 18.95%, and Non-US stocks also showed very positive growth, rising by 12.47%.

As for bonds, their rolling one-year performance has been gradually improving, but it remains in negative territory. Despite the negative trend, there are signs of progress, suggesting potential for recovery in the bond market.

The Debt Ceiling Drama

As we moved into the second quarter of 2023, investors became increasingly concerned about the debt ceiling and the potential for default. On January 19, 2023, Janet Yellen, the Secretary of the Treasury of the United States, declared that the country had reached its debt ceiling. She warned that if a new limit wasn’t agreed upon and implemented by June 5, 2023, the U.S. would face the risk of defaulting on its obligations.

The debt ceiling refers to the maximum amount of money that the United States can borrow, which is a limit set by Congress. Given that the U.S. government operates on a deficit, it needs to borrow funds to cover its expenses. 

Historically, the United States has never experienced a default on its debts, but such an event would undoubtedly lead to far-reaching consequences, with potential financial market turmoil being a major concern. Up until this year, the debt ceiling has been raised, extended, or revised a staggering 78 times since 1960. Yes, that’s correct – more than once per year on average since 1960! Unfortunately, the growing extreme partisanship within Congress has transformed what used to be routine business into a contentious and divisive issue that can quickly escalate into a flashpoint of contention.

Fortunately, a deal was reached on Saturday, May 27th, to lift the debt ceiling through January 2025. The bill was then passed in the House of Representatives on May 31st, and the Senate approved it on June 1st.

After all the discussions about the pending crisis, the question arises: How did the market react to the debt ceiling drama? Did a significant rally follow suit? Let’s take a look. Exhibit 4 below is a chart showing an exchange-traded fund (ETF) that tracks the Russell 3000 Index, a broad proxy for the U.S. stock market.

In this case, the debt ceiling agreement was officially reached while the market was closed. As measured by the ETF, the market closed on Friday, May 26th at $240.27 and opened Tuesday, May 30th (Monday, May 29th the markets were closed for Memorial Day) at $241.59 – an increase of 0.55%. The market was essentially flat through June 1st and opened 1.03% higher on June 2nd after the Senate passed the bill. Overall, from the market’s close on Friday the 27th to its opening on June 2nd, the market went up 1.43%. 

While analyzing the market’s response, it’s important to approach it with a degree of caution. There were likely several other events that occurred during that week that impacted the market. Considering the significance of the debt ceiling issue, it likely had some form of positive effect. However, it’s not unreasonable to think that the market’s reaction appeared relatively subdued compared to the headlines. A 1.43% increase is undoubtedly a good performance for the markets in a single week, but given the months of anticipation surrounding the pending crisis, some might have expected a more pronounced response.

The key takeaway here is that a potential crisis, even if deemed unlikely, is great for business if you are part of the press. If investors as a whole believed a deal was unlikely to be reached, we would have seen the market trade down as the deadline approached. That simply didn’t happen. Despite all the headlines, the market believed a deal would be reached and a crisis would be avoided. The markets got this one right. 

Now, you might be thinking, “Perhaps I shouldn’t have been so concerned,” but it’s completely understandable that you may have felt nervous. After all, when you see the stock market only went up by 1.43%, you may wonder if staying invested during all the perceived turmoil was truly worth it. At Abacus, our philosophy is firmly rooted in decades of research, and it emphasizes that attempting to time the market is an endeavor that tends to cost clients in the long run. 

As a thought exercise, let’s explore a scenario where you decided to get out of the market due to the news about the debt ceiling. The official date when the debt ceiling limit was reached was January 19th, 2023, and on that day, the market closed at $224.95 (referring to the Russell 3000 Index).

If you had pulled out of the market when the news initially broke in January and stayed out until the debt ceiling standoff was resolved, then reinvested on June 2nd when the market was at $245.26, you would have experienced a decline of over 9% compared to the investor who stayed the course.

This example highlights a significant difference and serves as an excellent way to understand the reward for remaining invested in the stock market despite the risks involved. It demonstrates the potential downside of attempting to time the market and underscores the importance of staying invested for long-term growth.

Could “Green” Investing Push Polluters to Emit More Greenhouse Gases?

Kelly Shue, a finance professor at the Yale School of Management, and Samuel Hartzmark, an expert in asset pricing and behavioral finance at Boston College, have authored an intriguing paper titled Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms. This research is interesting and has caught our attention as it aligns closely with our investment principles at Abacus. We are keen to explore the main themes of their paper and draw comparisons to our own investment approach.

The paper delves into the distinction between “brown” companies (less environmentally focused) and “green” companies (those that prioritize environmentally conscious business practices). A key finding of this research is that divesting from brown companies may inadvertently increase their cost of capital, making it more expensive for them to borrow money and potentially hindering their transformation into green companies. Conversely, investing in green companies lowers their cost of capital, but since they are already environmentally conscious, there may be limited room for further improvement.

This dynamic raises concerns about its long-term impact on environmental progress. The “cost of capital” refers to the expense a company incurs while raising funds. By divesting or selling a company’s stock, its stock price can decrease, prompting potential reconsideration of their business practices and potentially bringing change.

In essence, the paper highlights the complexities and implications of divestment strategies in relation to environmental goals and the importance of understanding the cost of capital in fostering sustainable change.

The assumption that divesting from a company can influence its cost of capital is still a subject of debate, as acknowledged by the authors of the research. At Abacus, we hold the view that divesting from companies doesn’t actually alter their cost of capital. This perspective is supported by in-depth research conducted by Jonathan Berk and Jules H. van Binsbergen in their paper, The Impact of Impact Investing.

According to their findings, socially conscious wealth currently represents less than 2% of the overall stock market wealth in the U.S. To make a substantial impact on the cost of capital, these socially conscious investors would need to account for over 80% of the investable wealth. In other words, there is currently an insufficient amount of socially conscious capital in the market to significantly sway the cost of equity.

Shue and Hartzmark’s research highlights a significant premise: the existence of a “dominant” environmental, social, and governance (ESG) strategy involving divesting from brown firms (the top 20% of the market in emissions) and investing in green firms (the bottom 20% of the market in emissions). While we cannot definitively confirm if this strategy is indeed the prevailing approach across the entire marketplace, we recognize that it may not necessarily be the best-in-class strategy.

At Abacus, we take a more nuanced approach by evaluating companies relative to their peers. For instance, we avoid making direct comparisons between low emissions producers like banks and high emissions producers like oil and gas companies, as it’s important to consider the specific context of each industry.

One significant idea from this research that resonates with us is the power of engagement for driving meaningful and impactful change. Within our portfolios, we collaborate with managers who diligently engage with companies, encouraging them to strive for continuous improvement and become better versions of themselves. We believe that active engagement with companies fosters transformation and reinforces our commitment to investing responsibly while creating a positive impact on society.

In Closing

Whether it’s inflation, the debt ceiling, bank failures, or trying to understand the true impact of green versus brown companies, decades of history and research shows us the path forward: to mindfully think about the long run. We encourage our clients to remember that history and award-winning research are far more reliable barometers of future success than what’s happening in the heat of the moment.