The Big Conversation
Episode 119: Are stock market rotations affecting ESG strategies?
This week Jamie McDonald looks at recent stock market rotations and whether ESG strategies might continue to suffer at the hands of surging commodity demand. Some indicators are warning of a potential slowdown which could have wide-ranging implications for both value and growth sectors. In the Chatter, Cornelia Andersson of LSEG discusses the global M&A landscape and whether the recent pullback in ESG strategies has dented institutional demand for sustainable investing.
The content and information (“Content”) in the video programs (“Video Programs”) is provided for informational purposes only and not investment advice. You should not construe any such Content, information or other material as legal, tax, investment, financial, or other professional advice nor does any such information constitute a comprehensive or complete statement of the matters discussed. None of the Content constitutes a solicitation, recommendation, endorsement, or offer by Refinitiv or any third party service provider to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature, is illustrative only and does not address the circumstances of any particular individual or entity. Refinitiv is not a fiduciary by virtue of any person’s use of or access to the Video Programs or Content. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of any information or other Content in the Video Programs before making any decisions based on such information or other Content. In exchange for accessing and viewing the Video Programs and Content, you agree not to hold Refinitiv, its affiliates or any third party service provider liable for any possible claim for damages arising from any decision you make based on information or other Content made available to you through the Video Programs.
The Content and information in the Video Programs has been obtained from sources believed to be reliable, but Refinitiv makes no representation or warranty as to the accuracy, timeliness or completeness of the Content. Any opinion or recommendation expressed in the Video Programs is subject to change without notice. Refinitiv does not recommend, explicitly nor implicitly, nor suggest or recommend any investment strategy. Refinitiv disclaims all liability for any loss that may arise (whether direct, indirect, consequential, incidental, punitive or otherwise) from any use of the information in Video Programs. Refinitiv does not have regard to any individual’s, group of individuals’ or entity’s specific investment objectives, financial situation or circumstances. Refinitiv does not express any opinion on the future value of any security, currency or other investment instrument. You should seek expert financial and other advice regarding the appropriateness of the material discussed or recommended in the Video Programs and should note that investment values may fall, you may receive back less than originally invested and past performance is not necessarily reflective of future performance
Jamie [00:00:00] A few weeks back, we shared the new concept of FAANG 2.0 that had been making the rounds on Wall Street. Fuels, Agriculture, Aerospace, Nuclear and Gold -the seemingly new ingredients for the 2022 portfolio which still looks to be holding true.
Jamie [00:00:19] In that episode, we discuss the handover in leadership from the 'Old FAANG' stocks such as Facebook (now Meta), Apple, Amazon, Netflix and Google, and what it means for your portfolios.
Jamie [00:00:31] But there's another aspect beyond just the major Technology stocks. This recent and potentially meaningful rotation has had a particularly dramatic effect on the performance of ESG strategies, that's Environmental, Social and Governance strategies, which tend to be coincidentally weighted towards Quality and Growth factors.
Jamie [00:00:52] The recent commodity surge and the ensuing Growth-to-Value rotation has sparked a debate about whether this is just a short-term cyclical blip... or something more structural that could be with us for years ahead? And that's today's Big Conversation.
Jamie [00:01:12] At the heart of this discussion is the current state or shape of the United States' yield curve as measured by the 10yr yield versus the 2yr yield. Having recently inverted, where the 2yr yield is higher than the 10yr yield, is the curve sending a warning sign of an impending recession? If so, perhaps all those arguing that the 'value' trade is just a short-term cyclical blip will be proven correct.
Jamie [00:01:38] But what if the recent commodity strength is just the beginning of a structural bull market in commodities?
Jamie [00:01:44] Well, oddly enough, and this is the difficult copper pill to swallow, the structural argument in favour of commodities and value over 'growth' is indeed the world's transition towards more sustainable investing. Lithium, cobalt, nickel, and many other raw and rare earth minerals are projected to experience a surge in demand to fulfil the very needs of renewable energy efforts like electric vehicles and better electrical grid systems.
Jamie [00:02:11] Take, for example, the fact that metallurgical-grade silicon which is used in solar panels, requires coal, oil coke and wood chips, amongst other materials.
Jamie [00:02:21] This raises the question... Is the recent rotation towards 'value', which includes many names in the oil and gas and metals and mining sectors, purely a stock market rotation? Or is this a space that can see large scale institutional activity in the future? And let's be clear, this would not be institutions voting for less clean energy; it would be the necessary portfolio rotation required by them so as not to miss the surge in demand and therefore performance. Now, if this is a blip, then major rotation is less likely. But it's important to recognise that the longer commodity prices stay elevated, the more institutions need to chase price and so the virtuous circle begins.
Jamie [00:03:08] Now let's pause for one second there and look at this from another angle. Historically, high commodity prices have brought about a flurry of M&A activity and increased capital expenditures for the new mines all the way from copper through to gold. Today, we're seeing a much slower reaction function, as depicted by the slow and reluctant rise in new oil and gas rigs.
Jamie [00:03:32] The same can be said for the broader mining industry, which has its own complicated history of environmental impacts and human rights issues.
Jamie [00:03:39] Well, stocks like Peabody Energy, which is up nearly 24x since the November 2020 bottom, see increased institutional demand, should there be a persistent need for coal as a primary source of electricity? Will, capital markets - particularly in credit - be willing to provide billions of dollars in financing for new mine projects? And let's not forget that reopening mines is no small task.
Jamie [00:04:06] Or will investors require even higher commodity prices to entice increased supply?
Jamie [00:04:11] These are all questions we should be and need to be asking ourselves as we look out into 2022 and beyond.
Jamie [00:04:19] And as I mentioned before, if the yield curve is correct in predicting a recession somewhere around the first half of 2023, perhaps the recent 'value' rotation will quickly lose steam.
Jamie [00:04:31] And if 'value' does begin to lose steam, perhaps the recent rotations were just a cyclical blip within a longer-term structural trend towards 'growth'. And if so, and that's what you believe, then the recent correction in ESG strategies, along with a re-rating of many higher-multiple Quality and Growth stocks, seemingly does present an attractive opportunity.
Jamie [00:04:53] More importantly, this washout could prove to be a great time for long-term investors to increase their exposure towards sustainable investing via high-quality companies with stronger corporate governance and ESG compliance.
Jamie [00:05:06] To gain more insights on this topic. I sat down with Cornelia Andersson, Head of Sustainable Finance and Investing for LSEG...
Jamie [00:05:19] Hey, Cornelia, thanks for joining us. Welcome to the Big Conversation.
Cornelia [00:05:22] My pleasure, Jamie
Jamie [00:05:23] So we've been talking in recent weeks about this shift away from growth and towards value. And one of the approaches I want to address this issue from is M&A. And I know that's something you know a little bit about. I think M&A is a really important way of looking at markets because it's one of the truest forms of price discovery. And I know M&A was such a had such a bumpy year in 2021. So I want you, if you don't mind, just to go into a little bit of a background about what you're seeing in capital markets and M&A and a and a better perspective of what it was like last year.
Cornelia [00:05:57] Yeah, absolutely. Happy to, right? So look, I've been active in the dealmaking community for for many, many years now, both in the private equity side, but also for Refinitiv LSEG, being a very keen observer of market trends and engaging actively with our key participants. So if we take a look at what's happening in M&A, which is really the heartland of corporate finance and a big driver of market activity across the board, we can see a really interesting story, and we've seen some significant change over the last 18 months or so, right? So including in Q1, a very large drop in the year on year volumes, which will surprise some observers. So but let's let's take it back to basics, right? So Q1 of 2022 was yet another trillion dollar quarter. In fact, it was the 7th in a row, which does indicate a relatively healthy dealmaking market, but it was also a 20% drop compared to the previous years. At the end of 2021, after nearly 2yrs of ongoing pandemic crisis mode, but also booming capital and M&A markets dealmakers were in an optimistic mood, focussing maybe on economic fundamentals on business and investor needs and local factors, and any concerns of external factors and adverse influences. It hit really historic lows and this is very unusual, and it was proven out in January and February as dealmaking in the first 2 months of 22 hit record breaking levels. And in fact, the first 2 months of 22 saw the largest opening year for global M&A in modern times, exceeded only by the final stretch of the dot com bubble in 2000. So more than 740 billion M&A transactions were announced in January/ February, but volumes of then fallen to to a slowdown in February and suddenly through March. So the question then is what what do we expect to see going forward here in terms of what investors are seeing?
Jamie [00:08:01] So this lull in M&A activity we've seen in the first quarter isn't so much that M&A volume is low. It's really just relative to such a bumpy year in 2021. So that begs the question for me, what are the reasons why we're seeing this lull, is the credit market tightening up and you know particularly for the some of these commodity related stocks, are they finding it harder to access capital markets?
Cornelia [00:08:24] Yes, it's a very good question and there's a number of drivers for that. There's an element of dealmakers and corporates become comfortable with operating in the new normal after a pandemic. So when the pandemic hit in 2020, that really pushed M&A volumes to almost grind to a halt. What then happened was a process of retrenching, of really reviewing corporations, shoring up balance balance sheets and focussing on growth strategy. So that then naturally led to an increase in both divestment activity as well as acquisitions as companies continued to pursue their strategic growth and options. Combine that with some really fundamental healthy conditions for M&A making, such as, such as thrive and capital markets, particularly on the fixed income side, combined with low interest rates. And they really are the perfect conditions for fairly extensive M&A markets and dealmaking. And we also see right is a willingness at the C-suite level of really engaging with large scale M&A transactions. So interestingly, what we've seen is a growth in what we call megadeals, so the very large transactions have increased significantly over the last 2yrs as well.
Jamie [00:09:43] Ah Cornelia, thank you because that's a perfect segue way into the topic of ESG investing. So there has been a bit of a lull in ESG investing generally, and I want to know what you're seeing in terms of the funding of ESG strategies?
Cornelia [00:09:55] Sure, absolutely. Well, the first thing I would like to comment on there right is that when you look at the returns, there's always a big debate right, around is this an ESG bubble? And are some of those returns that we're seeing? Not really, you know, not really exceeding what you would get investing in non ESG stocks or assets. And I think the key point to it right is that, generally, longer term success here is based not on the short term investment horizon, where often on ESG stocks can perform better. But if you look at a slightly longer time horizon, so say 3 to 5yrs, we generally see that funds tend to outperform. ESG funds tend to outperform non ESG funds. And really, what we're seeing here, there's a number of different things, but investors generally, so whether we're talking about institutional investors or corporates or even private equity are waking up to the idea that sustainability is not a short term trend, but it's a significant change in the real economy. And that therefore there are real sustainability risks, as well as opportunities that may be material. So sustainable investing now is very much becoming, not about necessarily a quick term when, but it's about securing those longer term financial returns. It's about mitigating risk as well as, of course, aligning with investor demand. And I think it's safe to say that many of our investors, from from retail investors to the largest institutional investors, they're now very clear on their desire to see the capital invested in a way that aligns with with core values, and that is very much reflected in fund flows, for example. So Refinitiv Lipner provides in-depth research on fund flow data and analytics, and they've looked at flows into ESG funds to certainly been in three strong year, with inflows to green funds going going up steadily and very interestingly as well, if we take a look at February's mutual funds/ flow numbers and ETFs, there's been a loss right, so lost about 10 billion collectively, but with the exception of ESG funds, right which have seen positive inflows. So there's certainly a continued investor trend of wanting to invest into ESG. So, you know, you can discuss whether it's a short term bubble or not. My view is that it's it is not. We're dealing with. We're dealing with a change share, which is sort of both by a a push factor and a pull factor. So the push factor very much comes from the regulatory side of things, right? So regulators across the world are introducing new measures around corporate reporting in particular, which are focussed on ESG and sustainability. The pull factor comes from both investor and client demand, which is very much focussed on seeing products and services aligned to ESG core values. And we see this reflected not only on the fund float side, but also both on M&A and in the capital markets. So green bonds, for example, has really dominated the green finance space and has increased very dramatically over the last decade. So we're we're now at a point where we saw a trillion dollars issued in in green finance last year, which is a fairly significant amount. And increasingly, there's interest in investors in terms of how to allocate capital meaningfully to projects and businesses that are going to continue to drive that transition to net zero.
Jamie [00:13:23] Cornelia, thank you so much for your time. We talked some about some really important issues there. Once again, thank you very much.
Cornelia [00:13:30] Thank you, James.