What Does The Fed’s Financial Stability Report Suggest About CleanTech?

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The progress that cleantech has made in the 21st century is substantial. A massive transition with global implications is underway across many different segments of cleantech and renewable energy. Solar and wind are two of the fastest-growing employment sectors in the past decade, according to a 2020 Deloitte report. Other energy sources and technologies like the electrification of buildings, energy efficient infrastructure, zero emissions transportation, renewable energy transmission and storage, and removing carbon dioxide from the atmosphere are capturing popular imaginations and investment portfolios. The financial stability report of cleantech around the world is solid, right?

President Joe Biden plans to invest $2 trillion in clean-energy initiatives over the next 4 years and to shift the US to net-zero-emissions by 2050. While dependent on Congressional support, these green energy initiatives have analysts hopeful that the energy on which we depend will become a whole lot greener — soon.

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Renewables are projected to become the largest source of energy by 2025, supplying nearly one-third of electricity worldwide, according to the International Energy Agency (IEA). This global transition from fossil fuels to cleaner, renewable sources of energy signaled quite the cleantech market growth trend in 2020, and many investors small and large ended the year with broad smiles on their faces.

Then came 2021 — a new US President, a fossil fuel industry concerned about profits, possible corporate income tax rate hikes, rising inflation fears, and wallop! The cleantech stock market did a nose dive. Investors, it seems, have grown wary of fast price rises. Fan fave Tesla is volatile, Vestas wind has lost a bunch of value, even the rising star of electric work trucks, Workhorse has plummeted.

What’s a cleantech investor to do?

Slow Down & Study The Traditional Sources

When times seem uncertain, the best approach is to take a step back, breath deeply, and consider different information sources. An example is looking to the Financial Stability Report, which was published in May, 2021 by the US Federal Reserve Board. Its purpose was to promote public understanding and increase transparency and accountability for the Federal Reserve’s views on the resilience of the US financial system. This seems is a likely place to get some kind of idea where the cleantech market is headed.

The framework on which the report is based focuses primarily on monitoring “vulnerabilities,” which are the “aspects of the financial system that are most expected to cause widespread problems in times of stress.” Vulnerabilities tend to build up over time.

The Financial Stability Report emphasizes 4 broad categories:

1. Elevated valuation pressures are signaled by asset prices that are high relative to economic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibility of outsized drops in asset prices.
2. Excessive borrowing by businesses and households leaves them vulnerable to distress if their incomes decline or the assets they own fall in value. In the event of such shocks, businesses and households with high debt burdens may need to cut back spending sharply, affecting the overall level of economic activity. Moreover, when businesses and households cannot make payments on their loans, financial institutions and investor incur losses.
3. Excessive leverage within the financial sector increases the risk that financial institutions will not have the ability to absorb even modest losses when hit by adverse shocks. In those situations, institutions will be forced to cut back lending, sell their assets, or, in extreme cases, shut down. Such responses can substantially impair credit access for households and businesses.
4. Funding risks expose the financial system to the possibility that investors will “run” by withdrawing their funds from a particular institution or sector. Facing a run, financial institutions may need to sell assets quickly at “fire sale” prices, thereby incurring substantial losses and potentially even becoming insolvent. Historians and economists often refer to widespread investor runs as “financial panics.”

So, how did the US financial systems fare in the first few months of 2021 against these parameters?

• Prices of risky assets have generally increased since November, 2020 with improving fundamentals, and, in some markets, prices are high compared with expected cash flows. In this setting, asset prices may be vulnerable to significant declines should risk appetite fall.
• Debt owed by businesses was effectively flat in the second half of 2020, remaining at a high level relative to gross domestic product (GDP). Improving earnings, low interest rates, and ongoing government support have increased the ability of businesses to service these obligations. Debt owed by households remained at a moderate level relative to income. Households have received significant government support—including from forbearance and fiscal programs—and as interest rates have remained low. Even so, some businesses and households remain under considerable strain.
• Banks remain well capitalized, and leverage at broker-dealers is low. Amid elevated investor risk appetite, issuance of collateralized loan obligations (CLOs) and asset-backed securities (ABS) has been robust.
• Funding risks at domestic banks remain low, because these banks rely only modestly on short-term wholesale funding and maintain sizable holdings of high-quality liquid assets. However, the market turmoil at the onset of the pandemic highlighted structural vulnerabilities that persist at some types of money market funds (MMFs) as well as bond and bank loan mutual funds.

What’s in the fine print of the Financial Stability Report? 

• Looking ahead, asset prices may be vulnerable to significant declines should investor risk appetite fall, progress on containing the virus disappoint, or the recovery stall. Some segments of the economy—such as energy —are particularly sensitive to pandemic-related developments.
• On February 25, market liquidity deteriorated following a disappointing 7-year Treasury note auction and an accompanying sharp increase in Treasury yields. Some liquidity metrics, such as market depth, deteriorated significantly. An interagency effort to understand key causes of the Treasury market disruptions and to enhance market resilience is underway. (Note: These fixed-income instruments possess differing levels of sensitivity to changes in rates, which means that the fall in prices occurred at various magnitudes.)
• Forecasts of corporate earnings have risen roughly in line with equity prices, so the ratio of prices to forecasts of earnings remains near the top of its historical distribution.
• In contrast to the mixed signals from price-based measures, a number of nonprice measures suggest that investor appetite for equity risk is elevated relative to history. The pace of initial public offerings (IPOs) has increased to levels not seen since the 1990s. In addition, a rising share of IPOs is supported by special purpose acquisition companies (SPACs), which are nonoperating corporations created specifically to issue public equity and subsequently acquire an existing operating company.
• While delinquencies have generally been flat, some uncertainty remains about whether the credit quality of bank loans will hold up after loss-mitigation programs end and government support runs out.
• Mutual funds that invest substantially in corporate bonds and bank loans may be particularly exposed to liquidity transformation risks, given the option of daily redemptions and the relative illiquidity of their assets.
• Less than anticipated progress with respect to the pandemic could pose risks to the financial system.
• Stresses emanating from a lingering pandemic in Europe also pose risks to the US because of strong transmission channels.
• Adverse developments in emerging market economies spurred in part by a further rise in long-term interest rates could spill over to the US.

While it seems self-evident that cleantech stocks are the way of the future, these summary details from the Financial Stability Report should make us at least slightly wary.

Conclusions After Reading The Financial Stability Report

When markets become volatile, a lot of people try to guess when stocks will bottom out. This article isn’t intended to give anyone insight into the crystal ball of cleantech investment; rather, it’s meant to offer information from a reliable source of financial research. Yes, cleantech stocks are volatile right now, and daily investors are right to be cautious. As large numbers of shares change hands and prices fluctuate, we need to be measured and calm, identifying our levels of risk versus possible reward.

As Forbes suggests, May historically is one of just 3 months when the S&P 500 declines slightly. As earnings season winds down, news from Washington on potential legislation related to taxes or infrastructure could move the market—as well as inflation and interest rates. It pays to be prudent and sensible, even when our beloved cleantech stocks are the topic of investment conversations.