ESG asset allocation and inflation

A question facing investors who seek to invest sustainably or are looking to align their capital allocation with their sustainable preferences and considerations is how their portfolios will perform in times of market stress. Recent events including the war in Ukraine have stressed markets and driven up energy prices, putting environmental, social and governance (ESG) factors under pressure.

Supply chain and geopolitical issues have driven US inflation to its highest level since the 1980s, propelling macroeconomic uncertainty higher as well. And the evolution of price pressures is likely to cause investors to consider a wide range of possible regimes in the near term.

Two ‘E’ and ‘S’ topics overshadow the current outlook and an inflationary environment further challenges the potential for investors to achieve sustainable returns over the long term. These are climate change and economic inequality, both systemic in nature and hence cannot be hedged or diversified away. Climate change has prompted mass action to transition to a net zero economy which requires structural changes to rewire the whole economy. Social inequality has been emphasized through the pandemic as the vulnerable were disproportionately affected. Recent times have shown that where we have social division we tend to have geopolitical difficulty. Higher inflation in addition to climate and social instability complicates the task ahead for investors.

That said, during recent periods of market stress, ESG indexes performed in line with traditional market benchmarks, despite great volatility in the energy sector. The main reason is that many ESG benchmarks are geared to perform as closely as possible to traditional benchmarks, while still overweighting assets that have high ESG ratings. While coal producers may be excluded from ESG indexes, the exposure to energy stocks is the same as that of traditional indexes because renewable energy firms are overweighted. As a consequence, the discrepancy between ESG and traditional indexes is low in terms of overall sector and regional exposures.

Our recent study on asset allocation for an ESG worldstudy on ESG asset allocation provides guidance in terms of how different ESG and traditional indexes can be. Investors are accustomed to considering risk and return as the two dimensions that guide asset allocation. In our study, we find that two additional elements – time and preference – are needed to augment this process in the world of sustainable investing.

The time element refers to the duration of the ESG transition underway as governments and companies enact regulations, new technologies, and investments to reduce pollution in line with the principles of the Paris Agreement and fulfill sustainable development goals relating to social responsibility and governance.

The preference element refers to the weight an investor places on prioritizing sustainability in an investment portfolio, either due to regulatory requirements or the objectives of the investor or organization and its board. For these investors, the issue is how to optimize portfolios to address risk and return in concert with ESG. The impact depends heavily on the magnitude of ESG constraints.

If the constraints are very restrictive, shrinking the investable universe materially, then investors must accept portfolios that are less diversified and hence may have less favorable risk-adjusted returns. If the constraints are less binding and allow factor exposure in line with the main ESG benchmarks, we believe the long-term impact on investment performance is minimal and may be positive in the short to medium term.

Specifically, the main ESG benchmarks are designed to match factor exposures with traditional benchmarks, so that the tracking error between ESG and traditional benchmarks is very small.

For decades, some countries have managed to sidestep the inflationary impulse of the bargaining power of labor by outsourcing labor and production to other regions, but that trend may have run its course: supply chains had been optimized for businesses prioritizing low costs and low inventories.

Now, reshoring and rebuilding inventories given multiple supply chain shocks are likely to be multiyear processes that contribute to rising prices. The probability of labor weakening relative to capital here is low, a dynamic which might weigh on profit margins somewhat over time.

On a similar note, fiscal policy is playing a much more robust role in stabilizing economic activity, after having been swept under the rug by austerity policies since the 1980s. The stimulus passed globally to mitigate the economic damage from the COVID-19-induced recession was two times larger than what transpired after the global financial crisis. This may provide a playbook for more muscular government action in the future.

Geopolitics add another facet to this higher inflation thesis, particularly in the near term, as Russia’s invasion has resulted in (temporarily) higher commodity prices, particularly for energy and agricultural products. Going forward, (costly) stockpiling of essential inputs is likely to become the norm.

In this higher inflation environment, the stock-bond correlation is likely to be positive even in developed markets, thus reducing the benefits of diversification, and we will need to provide more innovative solutions to help clients reach their investment goals.

One of the major inflation components during the COVID-19 crisis was given by the cost of new and used cars. Well beyond the effect of the initial factory lockdowns, the production of new vehicles was delayed because automakers canceled all orders for components in early 2020 as they expected car sales to plunge during lockdown. According to a study released by the US Department of Commerce, the median inventory of computer chips held by consumers - like automakers and medical device manufacturers - fell from 40 days in 2019 to less than 5 in 2021.

In a nutshell, chipmakers converted their production lines to make components for products used in home offices and home gyms, as people were more and more working from home. As a consequence, there was no production capacity for automobile components. This all but stopped car production around the world, triggering inflation as people in many parts of the world wanted to buy more cars to avoid using public transportation.

The governance component of ESG includes the need to have firms that are resilient and can adapt to natural and geopolitical shocks, rather than being leaner and leaner but inflexible. This is required not only to secure sustainable returns over the long term for shareholders but also to create sustainable conditions for all stakeholders including employees, customers and local communities.

Clearly, the events of 2020-2022 have shown that there is not enough slack in the structure of firms to allow them to absorb shocks from nature (for example rising ocean levels or pandemics) and from human action (for example wars).

A higher adherence to sustainability principles, in our opinion, is likely to create a more robust economy.