ESG Investing in the Current Market

Written by: Aegon Asset Management

Investors are increasingly looking to “do good” with their investments, which has led to money flocking into responsible investment (RI) funds in recent years. Global ESG (Environmental, Social and Governance) AUM reached a record of $2.5 trillion in 2022, per Morningstar. Despite general market volatility and weaker performance from RI funds in 2022, the sector still attracted $37 billion of net new money in the fourth quarter of 2022. The ongoing popularity of these funds shows that in a world where short-term thinking is all too common, many investors are taking a longer-term view.

Popularity aside, it is important to put the recent weak performance of RI funds into context. Since late 2021, we’ve seen a significant rally in value stocks and sectors that have been out of favor for some time. Globally, energy was by far the best performing sector of 2022, returning an incredible +34.5%. To put that in context, the next best performer, utilities, returned -3.9%. Other relative outperformers included staples and financials. None of these are typical hunting grounds for ESG investors, underlining the challenge faced last year.

The main driver of this move has been the emergence of a strong inflationary environment, which is typically seen as bad for growth stocks, even though the underlying fundamental strength of many of these companies has not changed. Most RI funds tend to have a growth, rather than a value, style and recent performance has suffered as a result. This trend has affected the whole growth investing landscape, ESG or otherwise, so we think it’s important to avoid thinking this is solely an RI issue.

But, looking at such short-term performance numbers ignores the true, long-term opportunity in RI. These opportunities not only address climate change but also other issues where the potential to make a real difference is significant. Consider the following small sample:

  • $4.2 trillion: estimated annual investment in the energy transition required each year between 2026 and 2030 to meet the Paris Accord goals.
  • 8x: number of times higher the infant mortality rate is in Africa than Europe.
  • 10 million: estimated cancer deaths globally in 2020.
  • $369 billion: spending on energy transition recently earmarked by the U.S. government under the Inflation Reduction Act.

These challenges will not be solved this year — or even this decade in many cases. We believe the longer-term outlook, however, is exciting and highlights the need for investors also to adopt a multi-year horizon.

We should also factor in the costs of not taking sufficient action. Research shows that natural disasters are increasing in both frequency and severity. Indeed, 2021 was one of the costliest years on record for catastrophe insurers and it has been estimated that if the planet warms by 1.5 degrees by 2030, as is widely expected, losses could increase by 68% compared to the 2021 number. The cost of not taking action is simply unthinkable, in our opinion.

Despite the recent market volatility noted above, it’s important to emphasize that the structural tailwinds for ESG investing continued to accelerate, not weaken, in 2022. Governments and corporates are increasingly aware of the pressing need to address sustainability challenges and the consequences of not doing so outlined above. There is perhaps no clearer example of this than the Inflation Reduction Act in the U.S., which earmarks well over $350 billion for spending on renewables. The European Union is now looking to follow suit with its own support package and an “arms race” between the two to support spending in the area can only be a good thing, in our view, both for the planet and for companies that stand to benefit from this spending.

With recent signs that inflation and interest rate expectations are moderating, a significant overhang to markets could be removed. This may lead to stock prices focusing back on fundamentals, rather than the macro factors that have dominated the past year. This would likely provide a meaningful boost to RI stocks, where valuations have come down sharply, despite the improving fundamental picture outlined above.

The trend toward sustainability reminds us that in a world often obsessed with short-term thinking, it is important to recognize the longer-term potential opportunities of responsible investing. We believe we can ill-afford not to.

Related: Heineken: Higher Prices Drive up Sales