Q4 2021 Equity Manager Report: ESG funds swell to 10% of global fund assets at year-end
Was 2021 the year environment, social and governance (ESG) issues leapt to the forefront for investors?
The numbers sure say so.
Over $649 billion flowed into ESG-focused funds last year¹ as investors increasingly pushed conversations about climate change and social justice with companies and regulators alike. By the end of 2021, the massive influx of capital led to ESG funds comprising roughly 10% of worldwide fund assets. Unsurprisingly, the year was marked by several significant movements on the ESG front amid a rise in shareholder engagement and an increasing call-to-action by governments worldwide to combat the intensifying climate crisis.
2021 also wrapped up on a volatile note for markets, with the emergence of the omicron variant of COVID-19 and ongoing uncertainty over inflation, rate hikes and the growth slowdown in China dominating the headlines. However, these fears masked what turned out to be a strong, positive quarter for most equity regions outside of emerging markets.
The fourth quarter was also a more favorable environment for global ex-U.S., U.S. small cap, Canada, emerging markets and Australia equity managers, while proving more challenging for U.S. large cap, Europe, UK, Japan and long/short equity managers. Low-volatility and quality were the best-performing factors of the quarter, while the growth factor underperformed in most regions and the value factor saw mixed results. Importantly, style was less of a driver of performance throughout the quarter, with stock selection being of greater importance.
Information technology, utilities and materials were the clear winners across most regions. Meanwhile, higher growth/valuation sectors such communication services, health care and consumer discretionary - which have largely been beneficiaries during the pandemic - lagged in performance due to profit-taking and ongoing concerns around inflation and the extent of potential rate hikes.
Our fourth-quarter survey reveals that while managers remain generally optimistic about the economy, they are increasingly more discerning on the breadth of the recovery. This is leading to a preference for stronger balance-sheet businesses with pricing power, given the stickiness of inflation. Managers also note that year-over-year earnings improvement will potentially be more challenging in 2022 relative to 2021, given the base effects.
Drawing on our distinctive relationship with underlying managers, we’ve compiled these and other insights from specialists across the manager universe into an easy-to-read report. Listed below are the chief tactical observations from key equity and geographic regions around the globe during the fourth quarter of 2021. We’ve also added a special section on ESG investing at the top that shares the key trends our manager research team foresees in the year ahead.
ESG trends for 2022
Emphasis on Scope 3 emissions disclosure
- Scope 3 emissions represent 65-90% of all emissions at many companies.
- Radical transparency to assess impact of company on the world, not the impact of the world on the bottom line.
Private capital focus for green deals
- Industry figures suggests large private equity groups have room to increase renewable energy exposure.
- This signals growth potential in environmental portfolios.
- Private capital is looking at investments in climate tech.
- Larry Fink is championing private company disclosure of environmental data.
- The green bond market will continue to grow, with investors being more critical as to what qualifies as green.
- Post-COP26, governments look to utilise current (European Union) and new (China) carbon markets to limit greenhouse gas emissions.
- Carbon credit prices have been rising, yet still aren’t high enough to prevent significant emissions.
- Global standards are solidifying, using the Task Force on Climate-related Financial Disclosures (TCFD) as a guide in the UK and the EU, as well as the International Financial Reporting Standards (IFRS). In the U.S., the Securities and Exchange Commission (SEC) is expected to chime in later in 2022.
Emphasis on the S in ESG
- The pandemic has increased the focus on labor and human rights matters.
Change in capex mix supports inflation being transitory
- Soft capital expenditures (capex) are now the greater component of total capex, becoming 52% in mid-2021. Soft capex creates less demand-pull inflation than hard capex, as the inputs are easier to source and not finite. Restricted movement due to the pandemic has temporarily increased consumer demand for physical goods, temporarily spiking demand-pull inflation. Some expect this to reverse in mid-2022 as movement returns to pre-pandemic levels, supporting their overweight to the information-technology (IT) sector.
- Analysis has shown the efficacy of the two largest sources of offset is questionable. Renewable energy projects (33% of carbon offsets) are likely to go ahead without offset funding due to the lower cost of renewables and avoided deforestation (32%) - the trees may have stayed anyway. Managers are considering this when both offsetting their own emissions as well as the impact to companies, as beneficiaries or utilisers of offsets.
Investment opportunities down the market cap spectrum
- The number of benchmark constituents continued to rise in the quarter, resulting in growth of nearly 10% over the year.
- The median manager’s active size exposure has been trending downwards, demonstrating increased interest in smaller capitalisation companies.
- Increased interest is supported by attractive valuations, opportunity for productive ESG-oriented engagements and better liquidity.
Favorable environment for banks
- Increased lending activity, recovering consumer fees revenue, uptick in capital markets (mergers and acquisitions) activity, sizeable cash positions, healthy dividend yields and attractive price multiples are all tailwinds for banks in 2022.
Expected year-over-year dividend growth
- Strong earnings growth through 2021 is resulting in larger cash positions, improvement in shareholder-friendly capital allocation decisions - particularly in the energy sector - and easing regulations on dividends, all of which support a favorable environment for dividend growth.
COVID-19 + inflation + interest rates = volatility
- Continued uncertainty around the impacts of COVID-19, non-consensus views on inflation and mixed central-bank tapering plans are creating confusion, irrational investor behavior and periods of extreme volatility.
- Managers expect higher volatility to continue through the first half of 2022, which creates an opportunity for active management, particularly in more heterogeneous pockets of the market like the industrials sector.
Emerging markets equities
Clouds lifting for a China recovery
- Policy stabilisers and reacceleration measures have provided reassuring liquidity support, attracting some investors back to China - in contrast with the global tapering picture.
- Anti-carbon regulations that stalled last year’s factory production have been relaxed, paving the road for an industrials revival.
- Easing credit access is alleviating property-developer balance sheets. Assets look attractive as the market stabilises.
- Investors are slowly rotating back to derated Chinese internet, with attractive forward growth and regulatory risks now priced in.
- Stimulus policies continue to shield Chinese renewable energy, battery chemicals and the electric vehicle (EV) space from pandemic uncertainty.
Steering around political headlights
- Investors are trimming Russia exposure on sanctions risk, due to Ukraine border escalations with a U.S.-led NATO (North Atlantic Treaty Organization) coalition.
- Managers are approaching Brazil with caution given political volatility over the election cycle. Attractively valued opportunities abound, and currency remains attractive.
Bottom-fishing out at sea
- Bulk and container shippers are benefiting from continued demand and a tight supply chain. Industry dynamics look set to persist through 2022.
- Unloved areas such as energy are attractive with rich dividends, buffered by healthy spot prices and a potent reopening upside.
Actively covering for inflation expectations
- Investors are taking profits in both high-growth and deep value segments of the market, due to the volatility caused by anticipated U.S. rate hikes and negative sentiment.
- COVID-disrupted areas in hospitality and retail have seen increasing wage inflation. Managers are positioning in resilient names that benefit from a deflationary reopening effect, and the normalization of emerging markets’ long-term secular consumer story.
Europe and UK equities
Value opportunities are diversifying
- The value opportunity set is expanding outside of the depressed travel and auto names. Managers are considering not only cyclical names, banks and insurance companies, but also areas such as defensive stocks.
Europe: Earnings-per-share (EPS) expectations for 2022-23 remain depressed
- Broad market consensus is for the current recovery in company earnings to be short-lived. EPS expectations for 2022 and 2023 remain below historical averages and are not in line with general GDP (gross domestic product) growth consensus.
Europe: Inflation is here to stay
- The sharp rise in input costs is only gradually being passed through by companies, and we expect price hikes to continue throughout 2022. This, combined with continued supply chain woes, should maintain inflation at higher levels and benefit cyclicals.
UK: Cyclical value
- Valuations in the UK remain attractive. Managers are adding to cyclical value names that should perform well in an environment of higher inflation and interest rates.
UK: Environmental thematic
- Some managers are increasing exposure to environmental thematic plays. These companies had a difficult 2021 given rising bond yields, supply-chain disruptions and spiking input cost inflation. However, these managers believe these headwinds are transitory, and are buying back into these at what they see as attractive valuation entry points.
Managers greeting the new year with more caution
- Pandemic conditions and expectations are still shifting rapidly, driving volatility in the market. Meanwhile, investors are increasingly wary of inflation, and earnings face difficult year-over-year comparisons. Profit margins are already at very high - and in some cases, unsustainable - levels.
Inflation prompts the Federal Reserve to use its brakes
- A hawkish U.S. Federal Reserve (Fed) could dampen economic growth. Companies were able to pass on costs and expand margins last year, but slowing year-over-year growth and rising costs are likely to reverse this trend. On the margin, managers are de-risking and looking for idiosyncratic growth.
Style trends are muted, security selection carries the quarter
- Q4 2021 factor performance trends were muted and reflective of a year in which there were no clear winners. Investors leaned toward quality and low-volatility last quarter, signaling a cautious outlook. Security selection, not allocation, was the main driver for managers that outperformed their benchmarks.
- Despite the correction in highly valued stocks, managers acknowledge that markets remain narrow. Value investors continue to tout valuation spreads and economic expansion as positive indicators for value investing, but moderating economic growth may impede value investors once again.
Climate and energy trends create a complex opportunity set
- European regulators may label natural gas and nuclear energy as green in a pragmatic but controversial approach to the energy transition. This would have long-term capital implications.
- Climate goals face conflicting socioeconomic and geopolitical agendas. Governments and investors must contend with high energy prices that hurt consumers and the environmental impacts of mining for low-carbon products and energy systems.
Focus on Fed’s tightening policy
- Expectations that the Fed would begin tightening sooner than anticipated - due to strong inflationary pressures - resulted in a reduction in risk appetite. Small cap growth stocks were impacted the most.
- Many managers believe it’s a little early to buy small cap growth stocks, as rates are set to rise faster than expected, despite valuations becoming attractive. Value managers’ main concern surrounds the risk that policy tightening might hurt economic growth.
Mixed view on sustainability of inflationary pressures
- While some managers believe the relatively high CPI (consumer price index) growth is primarily attributable to supply shortages triggered by COVID-19 - which are viewed as transitory - others increasingly are of the mindset that it’s more structurally driven by under-investments in the 2010s, demographical trends and/or ESG friendly policies.
- Given the uncertainty, many market-oriented and growth managers have tried to diversify portfolios within the range of their investment preferences. Value managers increased defensive value stocks by reducing cyclical value stocks which performed well.
Reopening theme postponed but still in motion
- While the reopening theme was delayed due to the spread of omicron, managers have largely maintained their positions set to benefit, in anticipation that this will play out in the near-term.
- Managers who had less exposure to this theme are increasingly considering adding exposure to beneficiaries, such as retail, that are at attractive valuations.
Currency headwinds and inflation
- Some expect Japan’s core CPI to rise by more than consensus due to the yen’s depreciation. As a result, they are maintaining positions in financials which will benefit from future rate rises.
Significant deleveraging event causes wait-and-see approach
- Equity long/short (L/S) managers entered 2021 risk-on, maintaining high gross and net exposure levels throughout most of the year.
- Changes in the Fed’s outlook on inflation, coupled with new concerns over the omicron variant, triggered significant deleveraging and factor rotations in the market.
- Managers have become defensively positioned by reducing overall gross exposure as they focus on conviction and capital preservation.
Continued lag in long alpha, particularly in crowded names
- Short alpha quickly rebounded after the first quarter of 2021 and ended positive for the year, while long alpha lagged, partly due to the (market) factor rotation from growth to value. The growth versus value net exposure spread hit a five-plus-year low.
- December was the second worst month for long alpha since 2009, and crowded longs underperformed in all regions, especially in North America and Asia.
Custom short baskets
- Managers are increasingly using custom short baskets to hedge against specific sectors or factors.
Reduction from unprofitable/expensive tech
- After maintaining high exposure to tech throughout the year, managers have aggressively reduced exposure to unprofitable/expensive tech (currently at ~1.5-year lows).²
Real assets equities
Increased real estate M&A activity in 2021
- Last year saw 15 U.S. transactions with an average deal size of $6.6 billion at a 21% announced premium, split between privatizations and public-to-public trades.
- Managers see potential for more deals, particularly in the apartments sector.
Real estate trends
- Office: Uncertainty around space needs is lowering leasing and transaction activity. Singapore is benefiting from businesses relocating from Hong Kong.
- Retail: Strong leasing volumes for open air centers into 2023. Malls have a nice recovery story off a low valuation base.
- Residential: U.S. coastal markets are challenged due to population out-migration to the Sun Belt and suburbs, and by rent control initiatives.
- Industrial: Continuation of e-commerce-driven demand for space.
- Property level fundamentals continue to improve. Long-term earnings growth is above average, with increasing estimates.
- A strengthening economy may drive rates higher and lead to inflation, but may also drive demand for many real estate property types, allowing landlords to raise rents.
Infrastructure lagging economic recovery offers opportunities
- Infrastructure is cheap relative to global equites, based on enterprise value/EBITDA (earnings before interest, taxes, depreciation and amortisation) multiples. The current spread is 0.2x versus the long-term average of 1.1x.
- Renewable energy deployment is accelerating, providing support for U.S. utilities. Electric grid updates have added to the investment thesis.
- Data growth is benefiting communications infrastructure.
- Airport recovery is expected to accelerate in 2022.
- Midstream energy companies are able to generate higher free cash flows, due to a supply/demand imbalance and by using a better business model.
U.S. large cap equities
Optimism for reopening-related industries
- There is a favorable outlook for consumer-related stocks and other industries that have suffered from pandemic-related slowdowns. Since the delta and omicron COVID-19 variants caused consumer spending to ebb and flow, reopening-related stocks offer relatively attractive valuations and considerable earnings upside.
- Investors expect demand to drive increasing spending in travel-related industries and autos. Medical device companies are also expected to benefit from increased activity.
Inflation and ability to pass price
- With inflationary pressures expected to persist, managers continue to emphasise companies with pricing power and an ability to maintain profit margins.
- The environment is creating a positive outlook for energy-related stocks, which have become more focused on cash flow and profitability following the 2015 crash in oil prices.
Favorable outlook for banks
- Managers continue to be bullish on banking stocks, as the outlook for rising interest rates will support improved net-interest margin for lenders. Since the beginning of the pandemic, large cap banks have also significantly reduced their cost structures through increased technology usage.
Software and internet stocks face difficult comparisons
- Strong growth in e-commerce and software-as-a-service companies is expected to persist. However, following the pandemic-fueled surge, these businesses will likely face difficulty in exceeding investors’ earnings expectations.
- Managers have become more selective regarding software and internet companies, and many are focusing on emerging mid cap names that are earlier in their growth cycle.
U.S. small cap equities
Muted outlook for small caps, positive outlook for active management
- Managers expect muted absolute returns for small cap stocks in 2022 with the Fed likely to be less accommodative. Importantly, small caps have rarely delivered double-digit returns four years in a row.
- Small cap managers believe a low-return environment has historically been favorable for active management.
Positioning in energy and banks is consistent across all styles
- With rising interest rates, managers across styles (including small cap growth) expect the favourable environment for energy and banks to continue into 2022.
Inflation and small caps
- While inflation and the omicron variant remain key concerns for most investors, small cap managers believe smaller companies tend to fare relatively better during inflationary periods, as their smaller size allows them to adapt more quickly.
Value managers become more discerning within cyclicals
- Value managers believe valuations in the early cyclical stocks, such as industrials and materials, are relatively full and the companies are close to hitting peak earnings.
- Value managers are rotating into later cycle areas with easier year-on-year comparables, such as in travel and leisure, autos, event management and office furniture companies.
Growth managers acknowledge stretched valuations in technology, but aren’t completely abandoning the sector
- Tech valuations continue to be above historical averages after peaking in November.
- Growth managers continue to highlight the strong fundamental growth in tech companies, and believe continued consolidation from strategic and private equity acquirers could provide support.
The bottom line
While managers are largely sanguine on the economic growth prospects for 2022, persistent inflation and rising rates mean that superior, risk-adjusted returns will likely be harder to achieve than in the past few years. Amid such an environment, we believe the views of specialist managers will be critical to identifying new opportunities and exploiting market inefficiencies. We look forward to continuing to share these insights with you as the new year unfolds.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
¹ Source: Refinitiv Lipper
² Data from Morgan Stanley Prime Brokerage