Profit Slump

Yesterday, we wrote about how the equity-risk premium was a headwind for stocks, hurting the prospects for a continued rally this year.

As we continue navigating Q2 earnings season, an expected decline of roughly 7% year-over-year in S&P 500 companies’ earnings adds to those headwinds.

💬 The alternatives to stocks are getting more attractive, and in the aggregate, companies’ profits are deteriorating. Yet, the S&P 500 just closed out its fifth-straight month of gains (happy August, by the way.)

— Shawn, Matthew, Weronika

Here’s the rundown:

Today, we'll discuss the three biggest stories in markets:

• How warmer weather is poised to increase borrowing costs

• Congress calls out BlackRock over China investments

• More oil giants report profit slump but keep rewarding shareholders

All this, and more, in just 5 minutes to read.

CHART OF THE DAY

IN THE NEWS

🌡️ Are Risks From a Warmer Climate Being Overlooked by Markets? (Bloomberg)

Heat waves continue in many parts of the world, so it’s worth considering another economic impact of a warming climate: Increased borrowing costs for cities, countries, and companies.

• As the world deals with more heat waves, droughts, and fiercer storms, there’s growing concern that credit rating analysts are misreading climate risks. For starters, a study by a Federal Reserve economist indicates that extreme weather events may restrict some governments’ ability to issue debt.

• Fifteen years ago, credit rating agencies like S&P Global, Moody’s, and Fitch misjudged the subprime mortgage market that sparked the 2008 financial crisis. In 2023, they’re now under fire for possibly underestimating potential climate losses. The companies say they account for climate risks, but it’s a tricky forecast.

Sectors facing high or very high environmental credit risk now account for $4.3 trillion worth of debt assessed by ratings agencies, which has doubled in the past eight years. Yet it’s believed more sectors and companies in high-emitting industries were “highly exposed to environmental risks, including climate change.”

Mounting pressure: Economists say credit rating companies need to be better and quicker about adjusting their ratings to account for environmental factors. Noted one from Cambridge University: “They’re inching forward, but the icecaps are melting faster.”

Why it matters:

It’s not just overseas. Marc Painter, an assistant professor at Saint Louis University, studied 20,000 long-term bond issuances, finding that a U.S. county facing even a 1% increase in climate risks pays an average of $1.7 million more annually in underwriting fees and initial yields.

That’s because if a company, city, or country’s finances are negatively impacted by climate costs, the risk of lending to them and not being paid back in full is elevated, pushing investors to demand a higher interest rate in compensation for providing them with funds.

• In the Caribbean, some forecasts say the frequency of high-category hurricanes could rise 29%, with 49% greater intensity. That could drive credit spreads on bonds to increase by more than 30% for governments there. (Widened credit spreads = more credit risk; tightening or contracting spreads = less credit risk.)
  

• Noted another economist: “Extreme weather restricts governments’ ability to issue debt,” and “extreme weather events and natural disasters are poised to become even more sizable in the coming years.”

BlackRock and other large asset managers have said they’re already designing products or selecting bonds based on climate risks that aren’t necessarily captured in credit scores.

• BlackRock is building products to “meet the growing interest from clients to mitigate risk and capture opportunities associated with climate the transition to a low-carbon economy,” according to its global head of sustainable indexing.

Precisely which credit markets will be most impacted – and exactly when – remains unclear. But S&P Global and Moody’s have acknowledged climate change’s likely impact on debt markets is coming – fast.

• As one analyst put it, “If you go out even 15 years, we know very significant things are likely to be happening.”
  

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📞 Congress Calls Out BlackRock Over Chinese Investments (WSJ)

Is the world’s largest investment manager, BlackRock, “undermining American values”? A U.S. Congressional committee thinks so.

The House of Representatives Select Committee on the Chinese Communist Party recently notified BlackRock of probes into its activities after an early review found the company was directing Americans’ money into investments supporting more than 60 Chinese companies flagged for national security or human rights concerns.

• The Congressional notice claimed BlackRock was allocating “massive flows of American capital” to these Chinese firms.

Millions of Americans use BlackRock’s mutual funds and iShares ETFs for their investments, entrusting the company to manage over $9 trillion worth of others’ assets.

Is BlackRock really in the wrong? It’s unclear still, but the logic says probably not, at least not entirely. See, BlackRock’s biggest investment funds track passive benchmarks created by index providers like MSCI, who formulate global stock indexes meant to represent different asset classes, and in this case, a country’s (China’s) stock market.

• BlackRock added, “The majority of our clients’ investments in China are through index funds, and we’re one of 16 asset managers currently offering U.S. index funds investing in Chinese companies.”
  

• That’s why the Congressional committee also sent a letter to MSCI, which selects the companies behind the stock indexes that index funds from companies like BlackRock commit to follow.

Bigger picture: This comes as the select committee on China is ramping up its reviews of U.S. companies and financial institutions’ role in supporting China’s rise. At the same time, the Senate appears almost ready to pass legislation requiring certain American firms to notify the government before investing in technology in countries deemed adversaries, such as China.

• Where the committee has previously targeted venture capitalists directly investing in Chinese tech, the investigation into asset managers and index compilers shows that efforts to reduce U.S. investments in China are zooming out.

Why it matters:

While MSCI and BlackRock, and others like them, would typically have little to no relationship with the companies in their portfolios or indexes, they play a critical role in handling how Americans’ retirement savings are invested.

• The committee claims, “as a direct result of decisions” made by BlackRock and MSCI, Americans are “unwittingly funding” Chinese companies at odds with America’s national security.

Just political theater? Given China’s economic model, where private Chinese companies are more directly influenced by and connected to the government than in the U.S., the committee’s concerns raise bigger questions about what it means for Americans to invest in China at all, since financing any Chinese business may indirectly support the Chinese Communist Party.

• As the U.S. government increasingly views China as an adversary, financial relations between the two countries become more and more complicated.
  

• The optics of investing in China, once considered a sound strategy for diversifying globally, are now being publicly challenged.

MORE HEADLINES

🧑‍⚖️ Musk's X sues nonprofit that fights hate-speech

🏡 Home insurers are charging more and insuring less

🚗 California opens Privacy Probe into who controls & shares the data your car is collecting

🍿 Cineworld, the world's second-largest movie theater chain, emerges from Chapter 11 bankruptcy

😅 Uber makes first operating profit after racking up $31.5 billion in losses

🛢️ BP Oil Giant’s Profits Fall 70%, Still Raises Dividend (CNBC)

Ouch. London-listed oil giant, BP, registered a 70% year-on-year decline in second-quarter profits. The results align with a trend throughout big oil in 2023: lower fossil fuel prices.

• The British energy company (BP) recorded a second-quarter underlying replacement cost profit — a proxy for net profit — amounting to $2.6 billion, which is substantially worse than the projected $3.5 billion.

Since energy prices soared after Russia’s invasion of Ukraine, major oil companies have been hit by lower prices in 2023.

Amid the challenges, BP raised its dividend by 10% to $7.27 cents per share for the second quarter. That’s its fourth hike since the pandemic alone and continues a broader industry trend of repaying shareholders instead of investing in more production capacity.

• Similarly, Exxon & Chevron have continued churning out cash for shareholders (we covered this on Friday.)

Stock buybacks: BP plans to further compensate shareholders by repurchasing $1.5 billion worth of its shares within the next three months, reducing the number of remaining shares.

• “We’re delivering for shareholders — growing our dividend and announcing a further share buyback. This reflects confidence in our performance and the outlook for cash flow, as well as continued progress reducing our share count,” said Bernard Looney, BP’s CEO.
  

• Looney confirmed that the company aims to use 60% of this year's surplus cash flow to buy back shares and return them to shareholders.

Why it matters:

In line with our first story today on a warming climate, oil giants don’t see a long-term future for their fossil fuel operations, leaving them more interested in giving cash to shareholders than investing in new oil production.

• But they aren’t doling out all of their cash. Instead, oil giants are increasingly investing in green energy, hedging their reliance on fossil fuels.

Forging a new direction: BP is a company to watch for the future. It’s leading the transition to green energy, recently announcing a deal to pay $7 billion for the rights to build two large wind farms off Germany.

• For now, though, oil still pays the bills. Oil prices have risen about 20% since mid-June, and Looney says “demand for oil has been incredibly strong.”
  

• He added: “Despite a lot of uncertainties in the world, you’d have to believe that prices are going to be strong over the coming months.”

See you next time!

That's it for today on We Study Markets!

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