Water Fund Review February 2024

February’s market trends

At the start of the month, the market dynamics were influenced by a hawkish stance from major central banks, including the Federal Reserve, the European Central Bank, and the Bank of England, all signaling a reluctance to reduce interest rates immediately. Despite this, a robust labor market and steady economic growth supported positive market sentiment. Positive momentum started to be felt as earnings, especially those of the “Magnificent 7,” exceeded expectations by an average of 7% for the fourth quarter, surpassing long-term averages.

However, caution prevailed with warning signs such as relatively weak first-quarter guidance and indications that profit margins were reaching a plateau. Inflation moderation in both Europe and the United States increased pressure on central banks to consider rate cuts. Meanwhile, Japan’s market experienced a sharp rise, with the Nikkei 225 surpassing its 1989 all-time high, marking one of the longest recovery periods in history.

Emerging markets faced challenges, with China being a notable exception, rallying by 8% due to a government buying program and new regulations on short selling. On the other hand, political unrest impacted Mexico, while weak economic news affected Brazil, making them notable laggards in the global economic landscape during the month.

The Tareno Global Water Solutions Fund posted a performance of 7.02% (W-Euro Tranche).

Our month in water – the Matrix

In the first The Matrix film, the lead character Neo is offered a choice by Morpheus: take the red pill to uncover the harsh truth behind the Matrix, or the blue pill to continue living in its fabricated reality.

Looking at the major contributors to performance during the month, you could actually image yourself in a different reality: Emcor, a player in piping, plumbing and the construction of wastewater facilities +38%, China Water Affairs, a Chinese water utility, +35%, Ebara, a pump supplier from Japan +32%, Advanced Drainage Systems, a US supplier of stormwater drainage solutions +26%. Those performances came on the back of solid results, but the extent of the reaction to the positive surprises is remarkable. The red pill anyone?

While we are enjoying the positive sentiment in the markets, we are closely monitoring the fundamentals and remain vigilant.

Fundamentals remain a mixed bag

The top three water sector macro data points grabbing our attention this month include (1) municipal bond issuance bouncing back strongly from 2023 declines, (2) an intensifying sell-off in ag commodities, and (3) capacity utilization hitting a multi-year low, which is bearish for industrial channel demand.

1. S. municipal bond issuance has seen dramatic fluctuations, with a significant rebound recently, surpassing $300 billion in trailing twelve-month issuance as of January 2024. The return of strong credit market access suggests municipalities might continue to prefer it over federal funds, that are still slow to flow.
2. Corn prices have sharply declined, falling below $4 per bushel for the first time since 2020. This ongoing decline, which started in May 2022, is affecting farm profitability and capital expenditure, notably highlighted by a significant drop in irrigation sales reported by Valmont and Lindsay Corp.
3. S. industrial capacity utilization has reached a 28-month low, indicating a potential slowdown in broad capital expenditure cycles across the economy. Despite promising trends in 2022, the current dip to 78.5% utilization suggests tepid near-term growth for industries, even with several long-term growth drivers.

Play defense!

We took some profits where we felt it might be appropriate after the strong run they had in February. We trimmed positions in Emcor, Advanced Drainage Systesms and Ecolab. We used the proceeds to increase positions in companies where we feel they are left behind despite solid results. Franklin Electric, Kemira and ZurnElkay Water. The time seems about right to slowly get back into the utilities. They underperformed as interest rates stayed elevated and cyclicals were favored. This might not go on for ever and so we have again built a position in Essential Utilities. The company is managing the supply and treatment of potable water, mostly in Pennsylvania. The shares haven’t traded this cheap in over 12 years and the dividend yield of 3.5% offers protection.

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