Conditions have been difficult for ESG investing this year. Is the long-term thesis therefore called into question?
Answering this question means answering the big questions about the factors at work in environmental, social and governance (ESG) and sustainable investing in 2022 and beyond.
How has the message conveyed around sustainable investing and ESG evolved since the beginning of the year?
Equity markets have faced serious challenges this year, and for ESG investing it has been a real test. The conflict between Russia and Ukraine, rising inflation, slowing growth, the behavior of central banks, and the ongoing repercussions of the pandemic have caused great uncertainty at the macroeconomic level. These elements were accompanied by a shift in the markets towards a strongly anti-growth and less favorable ESG positioning, which translated into a better performance of sectors that are not generally associated with sustainable investing, such as the energy, defence, tobacco and raw materials. The good news, however, is that we see this development as a natural correction and a logical result of the excesses of the ESG bubble that formed in the markets last year.
The year 2021 was marked by a very strong bullish trend for everything related to ESG and growth stocks that told a story. These “story-bringing” stocks have generated unprecedented excitement, and the promise of what the future holds has outweighed current cash flow and profitability. This phenomenon has been particularly visible in the demand for SPACs (Special Purpose Acquisition Companies), those shells created to raise funds through an IPO to buy another company, often with a ESG prism. These include companies related to solid-state batteries, hydrogen, plastic recycling, fuel cells and new electric vehicles.
These “story-bringing” stocks have generated unprecedented excitement, and the promise of what the future holds has outweighed current cash flow and profitability.
While these stories could potentially sound exciting, our approach was to avoid all SPACs. We believed this was a huge ESG speculative bubble and, consistent with our historical approach, we did not participate in it. We saw this bubble burst with a bang in 2022.
Although the current environment is challenging for growth and ESG factors, it actually reinforces the medium-term trends that we are focusing on. Energy security, economic resilience and the relocation of supply chains are all topics in line with the themes of sustainable development that we favor. Regulators and governments have also confirmed their interest in ESG and have taken steps to support the migration to a more sustainable global economy. Among the latest news related to sustainable development is the latest report from the Intergovernmental Panel on Climate Change, which reveals that global warming is happening at a faster rate than expected and that the need for action intensifies. At the same time, the Taskforce on Nature-related Financial Disclosures (TNFD) published the first version of its risk management framework, the US Securities and Exchange Commission announced that it plans to strengthen transparency requirements climate data, and the European Union has decided to introduce a carbon tax on imports of highly polluting products such as steel, cement and fertilizers from 2026.
The short-term difficulties faced by ESG investing are notable, but the long-term dynamic remains unchanged, if not accelerated. We therefore see volatility as an expected response to the excesses of the system and as support for the promising trends in sustainable investing on which our team focuses.
What has been the impact of rising energy prices and inflation on sustainable investing?
Energy stocks have been among the big winners this year and sustainable investing approaches, like ours, which are not exposed to oil and gas companies, have suffered. Sustainable development is closely linked to innovation and we are looking for companies that transform the world to make it a better place. An obvious example is the renewable energy sector and related development projects. With the rise in oil and gas prices, the number of projects likely to generate acceptable performance increases. More broadly, we are seeing an increase in demand for many renewable energy projects.
“While this is a handicap for ESG and sustainable investing in the short term, we believe that rising oil and gas prices will accelerate the adoption of products and services from companies offering sustainable solutions. »
As for inflation and the pace of rising interest rates, which are currently worrying the markets, we believe that this should be seen as a return to normalcy. We therefore continue to view these levels as favorable conditions for growth.
At the moment, we often hear in the media that growth stocks are suffering in a context of rising rates. This assertion is not based on facts. Since the early 1990s, the US Federal Reserve has carried out four interest rate tightening cycles and, in three of these four cases, growth stocks have outperformed value stocks. What’s more, technology has frequently been the best sector to invest in during these four periods. It is possible that growth will not outperform value this time around, but we believe it is important to stress that this scenario does not correspond to recent history.
Has the landscape of ESG investing fundamentally changed?
It is important to remember that we are long-term investors, which means that we do not react to short-term trends, in particular sector movements and the rotation of styles that we are currently experiencing. Globally, we see that the fragility of supply chains, economic resilience, the relocation of production, the relocation of supply chains and energy independence raise many concerns. These elements are part of the trends related to sustainable development on which we are emphasizing. We therefore see volatility as an opportunity to take advantage of a market marked by fear of the short term. This has resulted in the integration of stocks whose long-term investment thesis seems convincing to us.
In our view, the sustainability challenge revolves around four megatrends, which will continue to drive the global economy of tomorrow:
- Resource limitation
- Population growth
- Climate change
- The ageing of the population
Source: United Nations, un.org
Many sustainable companies have strong growth potential as they provide solutions to key societal and environmental challenges. They also have the potential to perform well in an inflationary environment. Most of them enjoy pricing power and offer solutions that in many cases are deflationary. Technological innovation is a good example of this, since it allows for efficiency gains in the production of goods and services on a large scale. The lower cost of energy from renewables is another example of a deflationary advantage.
Has 2022 shaken your beliefs about sustainable investing?
It is very important to distinguish between the short, medium and long term. There is no doubt that we are experiencing some of the most adverse investment conditions of the past ten years. However, looking at the first quarter, this stands in contrast to what we see and hear from the companies in which we invest. If we analyze the strengths and weaknesses of companies from a fundamental perspective, we are currently seeing many positive signs, strong growth and good resilience of economic models.
At the state level, governments are increasingly focusing on investing in renewable energy and encouraging the relocation and establishment of supply chains.
This shows how important it is to focus on the actual health of businesses today, rather than the “stories” of tomorrow. The short-term challenges faced by ESG investing are notable, but in our view, the long-term dynamic remains unchanged. If the “climate” continues to weigh on the markets, we welcome the longer-term opportunities this will present.
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