The recently passed Inflation Reduction Act (IRA) is poised to have a significant impact on the US economy, especially in the renewable energy sector. The Act includes provisions that incentivise the growth of the renewables sector, creating a "supercycle" of investment and development. Australia is well placed given our close relationship with the US and our resources of critical minerals vital for decarbonisation.

So, what is the Inflation Reduction Act?

The Inflation Reduction Act of 2022 (IRA), was enacted into law in August of the same year. It is one of three pieces of legislation that has been passed since 2021 with the goal of enhancing economic competitiveness, innovation, and industrial productivity. The IRA aligns with the priorities of the Bipartisan Infrastructure Law (BIL) and the CHIPS and Science Act, resulting in the introduction of US$2 trillion in new federal spending over the next decade.

The IRA encourages investment in renewable energy, enhances energy efficiencies, and helps companies tackle climate change via tax credits, incentives, and various additional provisions. The pathway to decarbonisation is expected to be enhanced since the IRA will increase demand for electric vehicles (EVs), clean technologies, and low carbon materials/construction.

The IRA allocates approximately US$394 billion in federal funding towards clean energy, with the primary objective of reducing the nation's carbon emissions by the end of the decade. This is primarily accomplished through a combination of tax incentives, grants, and loan guarantees (see Figure 1).

Figure 1: Funding the Inflation Reduction Act (US$b)

Source: McKinsey & Company

The majority of the $394b in energy and climate funding is dispensed in the form of tax credits. Corporations are the largest beneficiary, receiving an estimated $216b worth of tax credits. This funding mechanism is aimed at increasing investment in clean energy, transport, and manufacturing in the US. 

Consumers can take advantage of roughly $43b of these tax credits by investing in EVs, energy-efficient appliances, rooftop solar panels, geothermal heating, and home batteries (see Figure 2).

Figure 2: Selected tax credit modifications in the IRA

Source: McKinsey & Company

Many of the tax incentives offered by the IRA come with conditions related to domestic production or procurement. For instance, to receive the full EV consumer credit, a certain percentage of the critical minerals in the vehicle's battery must either be recycled in the US or sourced from a country with a free-trade agreement with the US. The battery must also have been manufactured or assembled in the US.

Europe powers up in response to IRA clean energy push

The European Green Deal established in December 2019 was set up to make Europe the first climate-neutral continent by 2050. The goal of reducing net greenhouse emissions by at least 55% by 2030, compared to 1990 levels, is a bold target. The REPowerEU Plan was launched in response to the Russian invasion of Ukraine, with the purpose of hastening the transition away from fossil fuels and mitigating the economic effects of rising natural gas and electricity prices.

As anticipated, the European Union (EU) has raised concerns that the US IRA will lure investment in crucial green economy manufacturing away from EU-based companies. In response, the European Commission (EC) has introduced a new "Green Deal Industrial Plan" aimed at fostering an environment that attracts net-zero investments by supporting EU manufacturing of green technologies and products. This plan explicitly mentions photovoltaic cells, heat pumps, wind turbines, hydrogen electrolysers, batteries, and carbon capture.

Despite its grand ambitions, the Green Deal Industrial Plan has yet to be fully fleshed out, as very limited additional funding has been proposed at this stage and the plan has not yet been discussed by the member states. The plan is built around four key elements: (i) a simplified regulatory framework, (ii) better access to funding, (iii) upskilling, and (iv) open trade to strengthen supply chains. At present, the EC's primary proposal is to loosen its stringent state aid constraints until 2025, allowing member states to match incentives from other countries (eg. USA). The expectation is that further incentives and improvements to the plan will emerge with negotiations and discussions with the member states.

Supply chains will shift

Car makers in the US will need to eventually eliminate China from their supply chains. POSCO Chemicals and Samsung SDI recently signed a 10-year cathode supply deal, showcasing the shift towards supply chain re-organisation. Value chains will migrate toward the US or nations with trade agreements in place (e.g. Australia and South Korea).

Since the passage of the IRA, several clean ammonia projects have been announced, nearly all located on the US Gulf Coast. The attractive IRA tax credits for hydrogen are driving the growth in ammonia production. For example, Linde has committed US$1.8b to supply clean hydrogen to OCI NV's greenfield blue ammonia project in Texas. This is an example of two non-US companies taking advantage of the IRA by developing projects in the US.

Ford will invest US$3.5b in an EV battery plant in Michigan with technology support from CATL, the world's largest EV battery manufacturer. The factory is due to open in 2026 and will produce enough batteries for 400,000 EV's a year.

Low carbon technology is mineral intensive

Low carbon technologies and enabling infrastructure are significantly more mineral intensive compared to traditional fossil fuel technologies. For instance, an onshore wind plant requires nine times more mineral resources than a gas fired power plant (see Figure 3), while an EV requires six times the mineral inputs of a conventional car (see Figure 4) according to the International Energy Agency (IEA). Both the IEA and World Bank warn that current mineral supplies and investment plans fall far short of what is required for these technologies to reach their full potential.

Figure 3: The mineral intensity of low carbon energy (kg).

Source: IEA, Credit Suisse

Figure 4: The mineral intensity of low carbon transport (kg)

Source: IEA, Credit Suisse

Implications for Australia

The current trend sees nations competing to secure supplies of critical minerals required for global decarbonisation. In many ways, it is starting to resemble a global renewables trade war that will be fought both in technology and supplies of critical minerals.

It is obvious that China will react to the IRA and Europe's Green Deal. China has been strategically acquiring supplies of critical minerals through investments in Australia and Africa, as they are the largest manufacturer of wind, solar, and batteries.

As we mentioned in a recent article, an instance of a nation's efforts to secure the development of critical minerals can be seen in the Australian Federal government granting a non-recourse loan of $1,250m to Iluka Resources to develop the Eneabba Rare Earths Refinery in West Australia. The funding is from the Commonwealth Government's $2b critical minerals facility. Additionally, lithium-boron develop Ioneer has been one of the early beneficiaries of the IRA, with the US Dept of Energy (DOE) offering a conditional US$700m loan for approximately 10 years to develop its Rhyolite Ridge project in Nevada.

Australia is in a pivotal position given it has a free trade agreement with the USA and is also rich in resources of critical minerals. The IRA - and perhaps eventually the new Green Deal in Europe - support our view that we are entering into a renewables supercycle that will keep the prices of critical minerals elevated for many years to come.

Author: Brad Potter, Head of Australian Equities

Equities were broadly weaker in February. In the US, the S&P 500 fell -2.6%, the Nasdaq was down -1.1%, whilst in the UK, the FTSE 100 outperformed, rising +1.4%. In Australia, the ASX All Ordinaries Accumulation Index fell -2.5%. Defensive sectors such as Utilities and Insurance outperformed whilst Mining was the worst performer due to concerns around the state of the Chinese economy and strength in the US dollar, which typically is a headwind for commodity prices. Growth stocks outperformed value stocks in the month.

In bond markets, the US 10 year bond yield increased +43 basis points to close at 3.95%, whilst its Australian counterpart rose +30bp to finish at 3.86%. The driver of higher bond rates was continued data showing inflation around the world remains stubbornly high, which in turn is leading to expectations that central banks will have to continue to further increase interest rates in order to bring inflation back to acceptable levels. During the month, the RBA increased interest rates by 25bp to 3.35%. The RBA has now increased the cash rate by +325bp over the last 12 months. Whilst the timing is uncertain, we remain of the view that at some point this year, we will see the domestic economy begin to cool given the impact of the rate rises, which in turn should see the current pace of rate rises moderate. 

Commodities were generally weaker in February. Thermal coal continued to slide, falling -26%, iron ore -2%, copper -3%, gold -5%, whilst brent crude oil declined -1%. The A$/US$ fell -5% to US$0.67.

Kapstream's Portfolio Manager, Dan Siluk, explains why the Federal Reserve (Fed) opted to raise rates and highlights the threat posed by persistently high inflation despite recent upheaval in the banking sector.

Key takeaways:

• While acknowledging the recent developments in the banking sector, Fed Chairman Jerome Powell emphasized that the central bank's primary focus continues to be guiding inflation toward its 2.0% target.
• Although relatively hawkish, the Fed's move was likely tempered by tightening credit conditions weighing on consumers' and businesses' ability to borrow, which could act as an economic headwind.
• A bullish pivot likely doesn't await investors, but by delivering a 25 basis point (bps) rate hike, the Fed may have decreased the chance of a policy error that could send bond yields markedly higher.

After nearly two weeks of speculation, with a few pointed sentences Federal Reserve (Fed) Chairman Jerome Powell reaffirmed that the Federal Open Market Committee's (FOMC) highest priority remains price stability, while also acknowledging that recent banking sector upheaval and its impact on credit availability are developments they cannot dismiss. By shifting the focus back to inflation and a tight labour market despite indications of a slowing economy, Chairman Powell provided the context for the FOMC's 25 bps rate hike to a range of 4.75% to 5.00%.

Even with the focus squarely on inflation, we believe the impact of the banking turmoil was already evident in Chairman Powell's statement. In his Congressional testimony only a few weeks ago, he hinted that rates would likely have to rise higher than the market anticipated. Taking him at his word, futures prices responded by implying the terminal rate would climb as high as 5.75% in mid-2023. Fast forward to Wednesday and his message morphed to a less certain "some additional policy firming may be appropriate."

All eyes on the mandate

Citing "robust" job gains keeping stickier drivers of inflation - e.g., wages - elevated, Chairman Powell emphasized that there is much work to be done in achieving the Fed's objective of 2.0% inflation. This meeting's update to the Summary of Economic Projections reflected the Fed's modestly hawkish thinking. Estimates for 2023 headline and core inflation were revised upward to 3.3% and 3.6%, respectively. The challenge facing the Fed is acutely illustrated in the incongruity of paltry 2023 gross domestic product growth of 0.4% and the year's unemployment rate being revised down to 4.5%.

While banking sector turbulence has sent 2-year Treasury yields lower, sticky inflation could reverse that trend
 
Source: Bloomberg, as of 22 March 2023.

Given the recent developments in the banking sector, we had suspected that the Fed could have considered a 2023 pivot as lenders' health can materially impact financial conditions. Chairman Powell, however, dismissed that scenario, noting that the FOMC does not see a rate cut occurring this year. In fact, the Fed's much ballyhooed DOTS survey revealed that respondents see the fed funds rate finishing 2024 at 4.3% - slightly higher than the 4.1% suggested in its December survey. We interpret this as the Fed being willing to leave rates at their cycle high for longer than what the market is currently pricing in. Such a pause would give the central bank time to assess the impact of previous rate hikes and other tightening initiatives.

We believe the Fed was correct in shifting the conversation back toward its battle with inflation. Even before most people had ever heard of Silicon Valley Bank (SVB), the Fed was faced with striking a delicate balance between reducing inflation and inflicting as little harm as possible on the economy. That battle has not gone away.

Breaking something

Arguably, the genesis of the current banking turmoil was last year's rise in interest rates, which led to the mismatch between SVB's assets and liabilities and resulted in the run on the bank. We often state that the purpose of monetary tightening is to break something. Typically, what gets broken first are the weaker business models and pockets of the economy that are dependent upon low rates. While regional banks with narrow customer bases may be the first segment to give way, they may not be the last, and investors must be wary of what else higher rates could expose.

In his statement, Chairman Powell emphasized that the U.S. banking sector was "sound and resilient." This is due, in part, to the action taken by the Fed in concert with the U.S. Treasury to shore up banks' access to funding. Thanks to the alphabet soup of policy prescriptions created during the Global Financial Crisis, the Fed has a full cupboard of facilities well-suited to addressing financial stability. This leaves the fed funds rate available for the task at which it's effective: addressing inflation.

Bringing this full circle, the stress to regional banks that initially caused a historic rise in rates may, in the end, assist the Fed in tightening financial conditions. Mr. Powell made a point to highlight that households and businesses are likely to face tighter credit conditions. This is in addition to higher rates already negatively impacting the housing market and business investment.

Narrowing rates' range of outcomes?

We think recent developments - and the Fed's decision - leaves much for investors to digest. In one respect, the added headwind of tightening credit conditions means that the near-term ceiling for interest rates may be lower than it was in early March. This could lead to lower volatility in shorter-dated bonds. Still, we see a disconnect between the yield on the 2-year U.S. Treasury of roughly 4.0% and the end-of-2023 DOTS projection of 5.1% for the fed funds rate. This disparity may reflect the Fed's concern that it's too soon to declare victory in its battle against inflation.

In contrast to the Fed's expectations for its benchmark rate, the futures market believes a dovish pivot is in the cards by the end of 2023
 
Source: Bloomberg, as of 22 March 2023.

Recent market and economic developments have no doubt tested the Fed. We appreciate that its focus remains on price stability, as imbedded inflation expectations can lead to long-lasting price distortions across the economy. By recognizing that it has the facilities at its disposal to address financial stability, the Fed can keep another 25 bps rate hike on the table should consumer prices remain uncomfortably hot and the labour market tight.
In choosing a circumspect hike rather than the pause many had called for, the Powell Fed, in our view, has passed the initial test of not blinking at the first sign of something breaking, which - as history has shown - only results in more difficult battles down the road in containing inflation and longer-term rates. 

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
The Federal Open Market Committee (FOMC) is the body of the Federal Reserve System that sets national monetary policy.
The FOMC dot plot is a chart that summarizes the FOMC's outlook for the federal funds rate.