Our take on sustainable investing: It's gaining popularity, does not require sacrificing risk-adjusted returns, and can increase portfolio resilience.
The Federal Reserve and European Central Bank (ECB) each took another step toward normalizing their monetary policies.
- Major oil-producing countries may agree to ease up somewhat on output cuts, adding some supply back into the crude market.
A long-term strategy can help a portfolio weather inevitable market ups and downs. Sustainable investing - integrating environmental, social and governance (ESG) insights into portfolios - is one such strategy, and can now be implemented across most asset classes without giving up risk-adjusted returns over time, we believe.
Interest in ESG is growing. The average S&P 500 firm cites ESG-related terms in earnings calls nearly twice as often as a decade ago, our text analysis of transcripts shows. See the chart above. Meanwhile, regulation and investors' desire to do good, mitigate risk or access niche market opportunities is stoking interest just as new benchmarks and products are making ESG investing more accessible across asset classes and regions. Total assets in ESG-dedicated mutual funds and exchange-traded funds in Europe and the U.S. grew nearly 50% from 2013 to 2017, according to Cerulli Associates.
We find flows have picked up further in 2018. As more investors factor ESG considerations into their investment decision-making, there is good reason to believe the relationship between ESG and asset performance could further strengthen. We've found early evidence that a strong ESG focus may be linked to equity outperformance over time. See Sustainable investing: a "why not" moment.
No sacrifice required
We believe strong performance on ESG metrics can be a proxy for operational excellence: Companies and issuers that score highly tend to be more efficient in their resource usage - and more resilient to perils ranging from ethical lapses to climate risks. The quality bias in these entities suggests a focus on ESG may offer some cushion during market downturns.
We looked at traditional equity benchmark indexes alongside MSCI's ESG-focused derivatives. Annualized total returns of the ESG indexes since 2012 matched or slightly exceeded the standard index in both developed and emerging markets (EM), with comparable volatility, our study found. Early evidence also suggests that an ESG focus may offer the greatest rewards in EM, where issues such as shareholder protections, natural resources management and labor relations can be important performance differentiators.
In fixed income, credit investors typically need to sacrifice some yield to make their portfolios ESG-focused, since companies that score lowest on ESG metrics tend to carry the highest yields. Yet this tradeoff may be an illusion. Bonds with lower yields but higher ESG ratings have typically generated stronger risk-adjusted returns in the past decade, our analysis of the global high yield market found.
We see ESG-friendly portfolios keeping pace with traditional portfolios over a full market cycle - even if they sacrifice a little yield during the most risk-on periods. A new suite of ESG-friendly EM debt indexes - jointly launched by JPMorgan (NYSE:JPM) and BlackRock - could help steer more capital into ESG leaders over time - and incentivize laggards to lift their game.
There are challenges. ESG data are still patchy, and are not equally relevant. To seek alpha via ESG strategies, investors need to go beyond headline ESG scores to understand how and why individual score components - such as climate risks, labor issues and shareholder rights - can affect returns. This can differ across regions, industries and companies. Bottom line: We believe it is feasible to create sustainable portfolios that do not compromise return goals - and may even enhance risk-adjusted returns in the long run.
Week in review
The ECB said it would end its bond purchase program by year-end. Its indication that any rate increase won't happen before the second half of 2019 sent European government bond yields lower and the euro on its biggest daily fall against the U.S. dollar in two years. The Fed raised rates as expected and expressed confidence in the U.S. economy.
China's economic data disappointed. Surprisingly weak credit data highlighted Beijing's deleveraging campaign, but also raised concerns of its impact on growth. The U.S. announced tariffs on $50 billion worth of Chinese imports; China vowed to respond in kind.
- U.S. President Donald Trump and North Korean leader Kim Jong Un met in Singapore. The agreement they signed signaled intent to make progress on denuclearization but lacked details. Market reaction was muted as a result.
|June 18-20||Annual meeting of key central bankers in Sintra, Portugal|
|June 20||Bank of Japan monetary policy meeting minutes|
|June 21||Eurozone Consumer Confidence Index; Bank of England monetary policy announcement|
|June 22||Organization of the Petroleum Exporting Countries (OPEC) meeting; Japan, U.S., eurozone Purchasing Managers’ Indexes (PMIs)|
Some of the world’s major oil exporters may agree to add some supply back into the market at this week’s OPEC meeting. But they are expected to stop short of entirely lifting current production restrictions, which have helped reduce global oil inventories, sending crude oil prices to their highest in three years. Central bankers from the U.S., eurozone and Japan could provide some context to recent monetary policy decisions at their annual meeting in Sintra, Portugal this week.
Weekly and 12-month performance of selected assets
|Equities||Week||YTD||12 Months||Div. Yield|
|U.S. Large Caps||0.1%||4.0%||14.3%||1.9%|
|U.S. Small Caps||0.7%||10.3%||20.9%||1.1%|
|U.S. Investment Grade||0.2%||-3.2%||-1.0%||4.0%|
|U.S. High Yield||0.4%||0.7%||3.1%||6.2%|
|Emerging Market $ Bonds||-0.6%||-5.1%||-2.2%||6.5%|
|Brent Crude Oil||-3.9%||9.8%||56.5%||$73.44|
Source: Bloomberg. As of June 15, 2018
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.
Asset class views
Views from a U.S. dollar perspective over a three-month horizon
|Equities||U.S.||Extraordinarily strong earnings momentum, corporate tax cuts and fiscal stimulus underpin our positive view. We like the momentum and value style factors, as well as financials and technology.|
|Europe||We see a sustained global expansion supporting cyclical sectors. The moderation in domestic growth and rise in political risks pose headwinds for earnings, especially for banks.|
|Japan||Positives are improving global growth, more shareholder-friendly corporate behavior and solid earnings. We see Bank of Japan policy buying as supportive. Any yen appreciation would be a risk.|
|EM||Economic reforms, improving corporate fundamentals and reasonable valuations support EM stocks. Above-trend expansion in the developed world is another positive. Risks include a further sharp rise in the U.S. dollar, trade tensions and elections. We see the greatest opportunities in EM Asia.|
|Asia ex Japan||The economic backdrop is encouraging. China's growth and corporate earnings are solid. We like selected Southeast Asian markets but recognize a faster-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.|
|Fixed Income||U.S. government bonds||We see rates rising moderately amid economic expansion and Fed normalization. Shorter maturities offer a more compelling risk/reward tradeoff. They and inflation-linked securities can be buffers against rising rates and inflation. We like 15-year mortgages relative to their 30-year counterparts and to short-term corporates.|
|U.S. municipals||Solid retail investor demand and muted supply are supportive of munis, but rising rates weigh on absolute performance. A more defensive stance is warranted near term, we believe, though any material weakness due to supply may represent a buying opportunity. We favor a barbell approach focused on two- and 20-year maturities.|
|U.S. credit||Sustained growth supports credit, but high valuations limit upside. We prefer up-in-quality exposures as ballast to equity risk. Higher-quality floating rate instruments and shorter maturities are well positioned for rising rates, in our view.|
|European sovereigns||The ECB's negative interest rate policy has made yields unattractive and vulnerable to the improving growth outlook. We expect core eurozone yields to rise. We are cautious on peripherals given tight valuations, political risks in Italy and the prospect of the ECB reducing its asset purchases.|
|European credit||Recent spread widening driven by increased issuance has created some value, while ongoing ECB purchases should support the asset class. Negative rates have crimped absolute yields - but rising rate differentials make currency-hedged positions increasingly attractive for U.S.-dollar investors. Subordinated financial debt looks less compelling versus equities after a strong 2017.|
|EM debt||Recent price moves have improved the valuations of hard-currency debt, increasing the relative attractiveness both to local-currency bonds and to developed market corporates. Further support for valuations comes from slowing supply and strong EM fundamentals. Trade fears or geopolitical risks prompting a rapid tightening of global financial conditions represent downside risks.|
|Asia fixed income||Regional growth and inflation dynamics are supportive of credit. China's rising representation in the region's bond universe reflects its growing credit market. Higher-quality growth and a focus on financial sector reform are long-term positives, but any China growth slowdown would be a near-term challenge.|
|Other||Commodities and currencies||*||Declining global crude inventories underpin oil prices, with geopolitical tensions providing further support. We are neutral on the U.S. dollar. Factors driving its recent strengthening are likely temporary, but higher global uncertainty and a widening U.S. yield differential with other economies may provide support.|
* Given the breadth of this category, we do not offer a consolidated view.
This post originally appeared on the BlackRock Blog.