Market Thinking is subtitled ‘making sense of the Narrative’ because markets are as much about the stories we tell ourselves as any of the so called fundamentals. Indeed, the fundamentals we focus on are always the ones that fit the current narrative, and that narrative has clearly shifted to one of Commodities, inflation and moving to shorter duration assets (see March Market Thinking). This is causing some problems for investors tied heavily to momentum and tech as value and cyclicals switch places in terms of favourites for the new narrative. Interestingly, one group in particular caught the wrong side of this switch will be the newly anointed legions of ESG managers.
An accidentally hilarious article in the FT yesterday morning reported on how Tesla may now be excluded from ESG indices on the back of its *underperformance* purchase of bitcoin. As noted on many occasions, the much vaunted performance justification for ESG was based almost entirely on the fact that ESG factors essentially created a long tech/short energy portfolio. Ten years ago when energy was over 12% of the benchmark, no ‘normal’ fund would be allowed to be 100% underweight the biggest sector of the market, as it would be deemed to be taking too much benchmark risk. As an important aside, the perennial criticism of active managers that they don’t out-perform the benchmark is heavily connected to the fact that they are rarely allowed to take any meaningful benchmark risk. Take similar risk, get similar return. Not so with ESG, they were free to advertise their return without acknowledging the risk they took to get it (albeit mostly in back-testing).
The problem for the ‘ESG outperforms’ angle had become that by the end of 2020, the entire energy and materials sector had a market cap less than Microsoft, so the ability to outperform (via this trick at least) had been taken away by the market cap effect, there simply wasn’t the ability to be underweight one big (underperforming) sector any more. And that was before Tech just went down 30% and commodities rose by a similar amount. Indeed, apart from Kathy Wood at Ark, (see previous article on Concentration Risk) the managers probably most nervous about the fact that Tesla is down almost 40% from its January highs as well as the fact that Apple, Facebook and Netflix are hitting three month lows (with the latter two sat at long term support) are likely to be the freshly minted ESG teams at all the major investment houses. Meanwhile with the other big internet ‘winners’ like Amazon and Zoom having broken down through long term support, the technical selling looks likely to accelerate further from here.
The other side of the coin has seen Mining stocks hitting new highs as well as Oil majors like Chevron rallying 30% year to date (with a nice 5% yield thrown in) as Oil hits $70. This is not to say that the ESG bandwagon is under any kind of existential threat of course – Bond managers have rather more to be worried about in that regard – it’s just that they will struggle to justify their stance on the basis of relative performance. Fortunately for them, and the real reason why the big Investment firms have embraced ESG so whole-heartedly, the political imperative remains very strong and any pension fund, sovereign wealth fund or other investment company connected with government effectively insists on ESG. Regardless of performance. Large insurance companies too and anyone else where political lobbying can over-ride performance requirements.
We should also remember that the Climate Change activists are already highly adept at shifting the narrative (it used to be called global warming after all – until it stopped actually warming. Now it’s climate change) and the most likely result will be to adopt Sustainable Benchmarks, effectively using the filters agreed to determine who is in and who is out. The big Investment businesses will be forced to go along with this, even though it ultimately removes their ability to claim any performance fees. The obvious next step will then be to simply passively follow those benchmarks, for a very low fee.
Thus the Climate activists will essentially have taken control of trillions of $ of investment capital, which was their plan all along. Whether this will be any worse than regulations forcing those funds to hold large amounts of low yielding bonds ‘for risk purposes’ remains to be seen. In the meantime watch how the ESG industry twists and turns to try and justify ‘buying stocks that go up’.
