As COP27 comes to a close, policymakers and investors try to figure out what the main consequences and policies will be following this important event. So far, 2022 has been a particularly difficult year for ESG and therefore for those investors that have aligned their investments with their values.
If we look at the performance YTD of conventional and sustainable indexes across the main geographies we can find a significant performance differential in favor of the former, and, in some cases, the differences are significant.
As Morningstar indexes show, although Global stocks have lost 7.4% since the beginning of the year up to the end of October in GBP terms, the Morningstar Global Sustainable index which includes the best stocks from an ESG perspective, has lost 9%. As anticipated, this is consistent across different geographies. UK stocks are down 4.3%, while UK sustainable stocks are down 11.4% and Japanese sustainable stocks have underperformed by 3.8%. The only market where the underperformance has been somewhat more limited has been the US, where more sustainable stocks have underperformed by roughly 20bp.
Two main reasons for underperformance
ESG indexes have underperformed for two main reasons that have been the source of their outperformance in the previous years: sector composition and valuations.
If we look at which industries and sectors have delivered a positive performance in 2022, it is not surprising to find the energy sector. Along with it, tobacco stocks have delivered interesting gains and, on the back of strong expectations for global defense spending after the Russian invasion of Ukraine, Aerospace and Defense has been another industry with strong positive returns. It is well known that ESG indexes have strict exclusions on weapons producers, military contractors, tobacco producers and big polluters such as energy companies and therefore they had small or no exposure at all to these sectors. The lack of exposure of ESG indexes to these stocks have removed one of few sources of positive returns in 2022.
As for valuation, at the beginning of the year, with the exception of the US market, they were higher across all geographies in sustainable indexes and this was true across a range of different metrics, such as P/E, P/B and P/S. Therefore, not only sector deviations had an impact but also valuations played a role in explaining the performance differential in a year where interest rates have hit ‘longer duration’ and more expensive stocks.
Recession risk and defensiveness
The significant increase in interest rates and the expectations of tighter monetary conditions going forward may increase recession risk. Generally cyclical stocks, including energy, tend to suffer in these conditions as the price of commodities falls and consumer confidence and spending drops. Even though investors might think that this is somewhat positive for ESG indexes, they should rethink this in light of the fact that sustainable indexes tend to have lower exposure to consumer staples and utilities which historically have performed well in recessionary environments.
The reason lies in the fact that within consumer staples we can find so called ‘sin stocks’ such as tobacco producers and beverage companies with alcohol products, whereas within utilities we can find some of the biggest emitters. Therefore, portfolio construction remains critical to balance portfolios and avoid unintended negative consequences. In this regard, healthcare stocks may play the role of providing defensiveness to ESG portfolios and, in addition to that, exposure to sustainable themes such as better health and well-being.
Always darkest just before the dawn
Even though this has been a tough year for ESG investors, this does not mean ESG is doomed or it has no future, quite the reverse in fact. And, if on one side nothing prevents prices to go even lower from current levels and the night may get even darker, we need to remember that the night is darkest just before the dawn. This applies also to investments: when valuations get very depressed it is the moment when expected returns are highest. As we know, expected returns are not only a function of growth and income, but also of valuations and, with valuations falling in ESG stocks, these look now significantly more attractive on a forward looking basis compared to only 12 months ago.
This article was written for Portfolio Adviser by Nicolo Bragazza, senior investment analyst at Morningstar Investment Management.