Amy Clarke, Chief Impact Officer and Fred Kooij, Chief Investment Officer
As the year draws to a close, there are three key themes that have defined the investment year for us.
A strong sustainability sentiment
There’s been a clear continuation of the Environmental, Social and Governance (ESG) and impact narrative, against the ongoing backdrop of the Covid pandemic and the worsening effects of extreme weather directly linked to the climate crisis. Amongst investors and corporates, we’ve seen a material shift in market sentiment building on what was observed in 2020. This has been driven by the financial imperative to manage the potential risks within ESG factors. It’s been underpinned by more regulatory engagement: both at bloc level, most notably the EU’s Sustainable Finance Action Plan and delivery of the long-awaited taxonomy, and at state level, with commitments made by the UK government such as its ‘Greening Finance: A Roadmap to Sustainable Investing’.
The International Corporate Governance Networks’ (ICGN) letter to the OECD as they start a review of the Principles of Corporate Governance, showed how influential the B Corps movement and mission-driven business have become in shifting thinking. ICGN has asked the OECD to consider the addition of purpose statements and the amendment of Directors’ Duties to align with the best interests of the company, not the shareholder. Whilst not completely aligned to the tenets of being a B Corps, allowing companies to execute decisions in their best interests moves them to understanding stakeholder interests.
The International Sustainability Standards Board (ISSB) agreed at COP26 to develop a comprehensive global baseline of high-quality sustainability disclosure standards. It’s expected that this will deliver greater and improved disclosures about business’ externalities. Whilst 2020 was the year of ESG and market ‘correction’, 2021 could be the year that regulation and policy built the foundation for new governance.
An inflated economic rebound
2021 saw the rapid return of economic activity and confidence, despite periods of concern about emerging Covid variants. This led to the build-up of inflationary pressures which dominated markets and investor sentiment all year. In turn, this created a challenging environment for managing impactful, balanced, multi-asset portfolios, particularly with an investment process like ours that generally favours companies with higher, longer term growth expectations (“growth stocks”). An environment with higher inflation expectations can sometimes place a lower value on more distant earnings.
This is one reason why patient capital is important. Impact can only happen over extended periods of investment. This can lead to tougher short term trading conditions for those companies at the forefront of delivering long term, systemic change.
A strained supply chain
On a related note, the rapid snap back in demand for physical goods has caused many companies to face delays and complications in assembling products and fulfilling orders. This has had varying effects on the companies we invest in, with heavy industrials hardest hit, especially those with complex supply chains and those reliant on China (a country that continues to follow a zero Covid policy by enacting localised lockdowns).
This rapid snap back also contributed to the energy crises around the world. As lockdowns lifted, demand and the price of energy increased, particularly in Europe where the season change to Winter exacerbated the problem. In the UK this led to significant disruption as many smaller energy companies that were trapped by the UK government’s energy price cap, put in place to protect the consumer, folded due to extreme financial pressures. This served to highlight a number of challenges: the growing pressure around the price of energy and its different forms (black v green); how the transition and access to greener, cleaner and cheaper sources of energy needs to speed up; the need to reduce the instability of a national grid and strengthen resilience through more localised energy provision; and ensuring fuel poverty doesn’t become the narrative of the next decade.
Climate continued to be the over-arching theme that dominated the year in the run up to the long-awaited climate conference in Glasgow (COP26). Many of the issues around energy security, transition, poverty and equity were addressed as the global community came together to discuss how to deliver the Paris Climate Agreement. In a step forward, the new Glasgow Climate Pact strengthened the market response to the climate crisis. The rise of the price of carbon in the EU Carbon Emissions Trading Scheme showed a strong sign of how fast this response can be.
The view ahead
Inflation and how Central Banks will manage it will be a dominant theme in 2022. It will most likely be managed through a gradual tightening of monetary policy. Whilst it’s difficult to anticipate how high inflation could spike in Q1 2022, in the UK the Consumer Price Inflation (CPI) could reach 7% in April. However, we don’t believe runaway inflation to be a material risk. Inflation will naturally ease on a year-on-year comparison basis as we lap the higher CPIs of the second half of 2021 and gradual further loosening of restrictions will ease supply chain blockages. In these unprecedented times, we remain open to diverse possibilities – fiscally, politically, socially and environmentally. Diversifying risks and opportunities will influence our asset class positioning and will ensure that we’re focussed on finding the most impactful and resilient investments.
Structural changes to the global economy throughout 2021, notably the shortening of supply chains and lower workforce participation which led to higher wage demands, will continue to contribute to higher embedded inflation. We believe bond yields can continue to increase into next year, with yields moving inversely to the price of bonds. Therefore, we’re keeping exposure to the asset class low and, where we’re invested, we’ll be avoiding longer dated bonds, where price sensitivity is greater.
The use of bonds to stimulate investment into the green transition and the use of sustainability-linked bonds tied to performance measures will inevitably increase as both investors and business look to transition to new societies, ecosystems and economies. At the start of 2021, Moodys were anticipating a 32% increase in green bond issuance on 2020. This bodes well for those interested in the use of debt-based financing to drive change and, with the launch of the EU’s Green Taxonomy, higher quality bond issuance should come through. Even in a market where inflation will influence a lot of investor behaviour, fixed income can be a driver of real change and the asset class can support impactful, sustainable outcomes.
On a macro level, the valuation support for owning equities has weakened following the strong market rallies of 2021. Many stock markets in developed countries hit all-time highs in the last weeks of the year. The relative valuation of the asset class compared to bonds is at a marginally less attractive level than their average over the last 20 years. Nevertheless, our long term view on equities remains constructive, especially where we see secular growth and competitive advantage stemming from our environmental sustainability and responsible business practices themes.
We expect to see a continued focus on growth stocks in the impact investing world, specifically in clean tech, renewables and healthcare, but with more focus on biodiversity and ecosystem services, food quality and security, as well as emerging markets. Over 100 countries are calling for a global treaty on plastics and the UN Environment Assembly meeting in February will be important in agreeing whether a global Paris-style agreement for plastics can be reached.
2022 will be a year where diversifying risks and exposure will be more important than ever. Given higher inflation poses major risk to equities (especially growth equities) and bonds, finding investments which can hedge against this risk, or be resilient to it, will be key. It’s with this in mind, we enter the year with an overweight exposure to alternative investments. We define these as investments where revenues earned and financial performance should show relatively low correlation to the wider equity and credit markets.
A number of impactful alternative investments became available in 2021. These allowed us to broaden our exposure to include investments into solar power and wind projects both in the UK and in emerging markets, carbon trading, forestry, social housing and the UK social investment market. Not only do these provide us with clear UN SDG aligned investments, but also with the diversification we seek.
2021 saw another significant increase in capital flows across the asset classes to vehicles driving positive change, from broader ESG through to focused impact. Alongside this was a tightening of regulations to support the ongoing transition. This regulatory and policy environment will need to be built on and we hope 2022 will be the year finance really pivots.
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