BearBull Group Research: Interest Rate Cuts Will Relaunch Alternative Energies
BearBull Global Investments Group (DIFC)
BearBull Global Investments Group is a leading independent Swiss wealth advisory firm based in the DIFC
Key Points:
The energy transition is an essential theme penalized in the short term by rising interest rates
The theme of the energy transition was particularly favoured by investors in 2019-2020, when the S&P Clean Energy Index posted gains of +41.5% and +138.2%, and government determination to set concrete targets was supported by exceptional budgetary announcements. Recently, the rise in inflation and financing costs negatively impacted the investment climate and stock market performance of the sector even in 2023. Over a long period since 1999, the annualized growth of the sector has been +9.9% (S&P 500 +7.4%), highlighting the importance of participating in the development of green infrastructure. In recent years, extreme weather events with catastrophic effects have further evidenced the disastrous impact of climate change, becoming increasingly apparent to all.
The increasing climate disruptions, extreme droughts, and devastating floods further strengthen government resolve and the global goal of reducing CO2 emissions adopted by most developed countries. The targets set in Europe and the United States, while not being questioned, suffer from the damaging evolution of inflation and the highly punitive rise in interest rates and financing costs, affecting both demand and supply. The energy transition towards clean and renewable energies remains firmly on track without major risk of being called into question, but it is temporarily threatened by financial and economic parameters that have evolved negatively since 2021 and seem to have finally peaked with the top of interest rates in the United States in October 2023.
These regulations will durably affect value chains, which will also be strongly impacted by competition induced by various support measures adopted by governments. These measures will support the emergence of new technologies and the targeted development of various alternatives. However, they may also lead to the relocation of activities or the introduction of tariff barriers to protect exports from China to Europe and the United States. The energy transition will likely not occur linearly and without hiccups. Probably, some obstacles or changes in course and strategies will temporarily disrupt a trend that seems nonetheless clearly inevitable. There are already some reactions from political decision-makers who occasionally revise certain goals or the means to achieve them.
The transition to a sustainable energy model is undeniably underway but faces temporary challenges due to unfavorable financial and economic conditions that have evolved since 2021. Nonetheless, the overarching trend remains clear: the shift towards clean and renewable energy is essential and unstoppable.
Attractive but volatile investment opportunities
The energy transition remains one of the greatest structural challenges for the global economy, which must quickly and comprehensively rethink its energy ecosystem—from production to consumption, including the storage and distribution of new forms of energy. The amounts involved in implementing this transition are enormous, amounting to tens of trillions of dollars per decade to meet the set climate targets. In this context, it goes without saying that the investment opportunities are immense in many sectors related to the energy transition and for all current and future players who will actively participate in it.
In the stock market, the global alternative energy sector, including companies active in wind, solar, biofuel, and energy efficiency segments, has experienced extreme volatility over the past three years. Years of strong gains have been followed by periods of significant consolidations, creating performance volatility that can be difficult for many medium-term investors to endure. Over the past decades, this volatility has been expressed extremely through double-digit gains and consolidations. In the past twenty years, only three periods have recorded fluctuations below +-10%, while 14 years have achieved performances of +-15%, including seven years with +-45%.
Investment opportunities are indeed present, but they also seem highly volatile and closely tied to the evolution of financing costs. The challenge is navigating these fluctuations to capitalize on the substantial potential gains while managing the associated risks.
As the world continues to advance towards sustainable energy solutions, the inherent volatility in the sector presents both a challenge and an opportunity for investors. The key to success will be finding a balance between leveraging these opportunities and mitigating the risks posed by the ever-changing financial landscape.
Inflation disrupted the positive momentum in 2021
After a decade of annual inflation averaging between +1% and +2%, 2021 quickly emerged as a transition to a regime of significantly higher inflation, necessitating adjustments in monetary policies. The prospect of rate hikes to combat runaway inflation, which had already exceeded +5% by May 2021, caused a major revaluation of expectations as long-term rates rose above 1%, triggering massive profit-taking. Despite a -40% drop in indices, a period of stabilization followed in 2022, during which alternative energies (-6%) notably outperformed the MSCI World Index, which declined by -18%.
Following the drop in 2021, the implementation of restrictive U.S. monetary policy in March 2022 did not add further uncertainty. Investors remained convinced of the strength of the global phenomenon represented by worldwide energy transition projects and by the already attractive valuation levels of companies in the sector. During nearly eighteen months of horizontal consolidation amidst some volatility, investors remained patient and confident in the prospects of companies in wind, solar, and other sectors linked to the energy transition, waiting for the moment of recovery.
Ultimately, the second half of 2023 proved to dampen their enthusiasm. The effects of rising interest rates and the increased financing costs for projects, along with the drop in demand induced by these rising costs, impacted company results. Consequently, the S&P500 Global Clean Energy Index, the leading index for energy transition stocks, dropped by -30% at its lowest point in October.
Since July 2023, despite the decline in U.S. inflation, the Federal Reserve's monetary policy has remained stable. This stability has been enough to stabilize stock prices (well below the highs of 2020) but has not provided relief or enabled a sector rebound. Between December 31, 2019, before the pandemic outbreak, and today, the S&P Global Clean Energy Index (+35%) and our BBGI Clean Energy 100 Index (+41%) have nonetheless achieved annual growth rates of +7.2% and +8.1%, respectively.
Outperformance of Clean vs. Global Energy
Companies in the wind and solar sectors have thus suffered significantly from rising financing costs. After massively outperforming traditional energy stocks in 2020, the S&P Clean Energy Index (-43%) has substantially underperformed the S&P Global Energy Index (+182%) over the four years of rising inflation and interest rates. The oil prices remaining above $70 per barrel have allowed oil companies to achieve very significant profits and effectively leverage their equity. This, in turn, enabled them to easily handle the rising financing costs, which was not the case for energy transition companies, which were in a phase of massive investment and often had insufficient short-term revenues. This dynamic is on the verge of shifting in favor of alternative energies.
Key reasons for the sharp price collapse
Monetary policy and rising financing costs are the main factors behind the collapse in stock prices. Interest rate hikes affect the present value of future profits. In the case of alternative energies, short-term results are often weak compared to long-term expectations. Consequently, the discounting of these growing profits is reduced, which weighs on stock prices.
On the other hand, some alternative energy stocks, such as "utilities" that distribute green electricity, are often viewed as investments offering attractive income. As a result, an increase in bond yields, such as that observed in 2023, has diverted capital away from this sector in favor of higher yields and lower risk in the bond markets.
Moreover, the significant investments needed by most companies in the sector to develop their offerings and expand their presence in this rapidly growing ecosystem are strained by rising financing costs and increasingly difficult access to credit. The demand side is also affected by the short-term impacts of higher interest rates. The demand for photovoltaic installations is subject to these risks, making it more difficult to proceed with substantial investments in times of rising financing costs, which are becoming increasingly burdensome.
Finally, rising raw material and production costs have also weighed on margins before stabilizing. As mentioned earlier, the renewable energy sector has been particularly vulnerable to higher interest rates, partly because many companies enter into long-term contracts that set the price at which they will sell energy before developing their projects. The inflation-related rise in costs, combined with the contrary movement in financing costs, has clearly affected margins. The solar and wind sectors have been the most impacted by rising operating costs. The negative impact of rising rates has unfortunately overshadowed the positive expectations from announced inflation programs. It may become essential to provide new tax incentives to sector companies, which have been hard hit by inflation and rate increases, to help them cope with the adverse effects of these factors. Some may even find it necessary to renegotiate higher electricity sale prices with the public sector.
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Investor fatigue creates opportunities
The extreme caution of the Federal Reserve, which has kept its key interest rates at a high level of 5.5% for over twelve months despite the drop in inflation, has undoubtedly contributed to investor fatigue and disengagement from this highly promising investment theme. Companies in the alternative energy sector often still generate limited profits and need to invest to increase volumes and become more profitable. During this development phase, financing costs are a crucial factor. The Fed's high rates in 2024 did not allow for an improvement in valuation levels.
Initially, investors remained convinced of the long-term benefits of participating in the energy transition. Since 1999, the sector, measured by the BBGI Clean Energy 100 index or the S&P Global Clean Energy index, has outperformed the S&P 500. Fund flows into Clean Energy ETFs had been substantial until 2021 and remained relatively stable until the second quarter of 2023.
Thus, it is less the rise in key rates to 5.5% than their prolonged maintenance at this high level during the inflation decline that has caused investor fatigue. Investors have grown weary of waiting for a rebound over the past eighteen months. The number of shares in the main iShares Global Clean Energy ETF has indeed been reduced by 40%, highlighting investor disengagement at the worst possible time, just as conditions for a sector rebound appear to be emerging.
The need for alternative energy solutions remains pressing and continues to benefit from ambitious government plans.
The first-rate cut will revitalize alternative energies
While the cycle of tightening monetary conditions, which has been negative for alternative energies, has already reached its turning point in the Eurozone, it is now very close to reversing in the United States. A cycle of interest rate cuts will mean a decline in financing costs and a reduction in the capitalization rate. In June, the Consumer Price Index recorded its first contraction of -0.1% month-over-month since the price drop in May 2020, thus more broadly opening the door for the Federal Reserve to begin a cycle of monetary policy adjustment. After raising its key rates eleven times since 2022, the Fed is preparing to make its first cut. We estimate that this could occur in September and may exceed -0.25%.
For the alternative energy sector, which is highly sensitive to interest rates, the start of a rate-cutting cycle is an extremely favourable "game changer." After several years of penalizing conditions, the outlook for the sector appears to be brightening. Additionally, at current valuation levels, companies in the sector are clearly not overvalued. According to us, the current levels may represent an extremely interesting entry point for those who recognize that the fundamental factors for the sector's listed stocks will benefit from this development in 2025.
Particularly attractive valuations
The "bear market" of the global index and the transition energy stocks has significantly adjusted price levels to reflect the current realities of rising rates and financing costs, while potentially underestimating the long-term prospects of these same companies.
In terms of valuation, it is now believed that the extreme pessimism which caused a drop in solar, wind, and hydrogen stocks has led to a significant undervaluation of the long-term earnings potential of these companies. Despite the current challenges, these companies are expected to be major beneficiaries of the ongoing and irreversible energy transition process.
The overall valuation level of the S&P Global Clean Energy Index has dropped from a particularly high P/E ratio of 74x observed for 2022 to just 22x for the current year and 16x for 2025. Compared to broad indices like the S&P 500 (20.4x) or the Nasdaq (27x), the alternative energy sector now offers a discount of 22% to 40% relative to these major indices.
Between the estimates for 2022 and those for 2025, the sector's fundamental data have improved. Gross margins have increased from 27% to 33%, operating margins from 6.6% to 14.8%, net margins from 2.6% to 9.3%, and ROE has progressed from 2.9% to 9%.
In terms of future prospects, profit growth for 2024 is already expected to rise by 26.6%, with potential further growth of 23% in 2025. Compared to the S&P 500 index, the growth dynamics of alternative energies are significantly higher, with overall growth rates of 12.7% for 2024 and 8.1% for 2025.