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ESG Focus: Trigger Fingers Out For 2021 But For Which Classes?

ESG Focus | Feb 02 2021

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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

ESG funds ballooned in 2020, as investors sought safe havens from covid and the Saudi-Russia oil price war but 2021 is a different story. Vaccines are rolling out, the green-stimulus led transition is set to barrel down; and investors are reassessing their priorities.

ESG Focus: Trigger Fingers Out For 2021 But For Which Classes?

-ESG: 2020 in review
-Rotation on cards but long-term outlook is "exceptionally bullish" say heavyweights
-Best-in-class versus impact investments for 2021
-Massive green bond stimulus to flow to the worthy

By Sarah Mills

Credit Suisse, announcing its expectations of a supercycle for Chinese equities in 2021 late last year, also forecast a rotation out of ESG stocks in 2021.

There were very few specifics in the forecast to guide investors. For example, would the rotation be out of “best-in-class” stocks, or “impact” stocks. Or perhaps a combination of both, depending on whether the stocks in question are growth stocks given Credit Suisse also forecast a rotation from growth stocks into value stocks in 2021 (in line with many others).

FNArena hasn’t had much luck prising these details from Credit Suisse, but following are our observations.

ESG: 2020 in review

ESG stocks experienced a massive and record inflow of funds in 2020, aided by covid. Funds rose four-fold in Britain alone.

The area was perceived as a safe haven during a period of extraordinary circumstances and as a hedge against the collapse in oil prices following the Russia-Saudi price war.

Investors jumped out of airlines, oil and gas companies and financials, and into a range of stocks with low exposures to the most volatile sectors: strong “best-in-class” ESG credentials; and “impact” stocks serving less exposed sectors such as health and technology. 

Many of the ESG stocks were “growth” stocks, and “best-in-class” stocks also managed to post strong relative growth.

One could expect some of these gains to be reversed as economies return to normal, pending a successful rollout of vaccines.

The global landscape shifted in the last quarter of 2020 after the US election and the roll-out of covid vaccines globally raised the prospect of a return to business as usual. 

Many growth stocks backtracked in December, only to recover by early 2021.

Long-term outlook is exceptionally bullish – especially for transition investments

Despite forecasting a 2021 rotation, Credit Suisse stressed that it was very bullish on ESG long-term. This sentiment is echoed by other global heavyweights.

Blackrock CEO, Larry Fink, in an open letter in January, advised that the climate transition presented a “historic investment opportunity”.

He described climate investment in particular as a “Tectonic Shift” and forecast that ESG investment would accelerate.

"I believe this is the beginning of a long, but rapidly accelerating transition – one that will unfold over many years and reshape asset prices everywhere,” said Fink.

“We know that climate risk is investment risk. But we also believe the climate transition presents a historic investment opportunity.”

Meanwhile, some predict a US Biden administration will yield an unprecedented boom for ESG investments in 2021.

Biden pledged US$5trn to the environment in his election campaign. Add to that the trillion-dollar EU “green recovery” package and trillions of dollars from investment funds, it is clear the money will be flowing thick and fast through 2021. Exactly where to is the question?

The electric vehicle (EV) market is a likely recipient of some of the global stimulus funds given the market is approaching a critical juncture. Biden alone has promised to transform government fleets into electric vehicles.

Already in countries like Norway, aided by tax breaks, electric cars now comprise up to 54% of the market.

The tipping point of US$100/kwh for lithium ion batteries is expected to hit in 2021. This is when unsubsidised electric vehicles become economically competitive with motor vehicles. 

And from here, EV prices, theoretically at least, only go in one direction, although serious scale is not likely to be realised until 2023. Regardless, the transition could gain momentum depending on the mix of regulation and compensation brought to bear.

As Fink points out, the risks are high – Volkswagen’s CEO forecast his company had only a 50% chance of surviving the decade – but he believes the “historic” gains are worth it. 

Many investors perceive the soon-to-be disrupted industries as too risky and are preferring to support industries that feed the disruption industry – downstream and upstream stocks.

In particular, they are focusing on climate stocks with a circularity theme, Hazer Group ((HZR)) being one example; new narrowly focused technological advancements that either accelerate battery charging speeds and access, or increase battery power and efficiency, given both are critical for providing early momentum to the transition; or raw materials.

Even then, none of this is a sure thing. Dutch inventors, for example, launched The Lightyear One car in 2019 at the Goodwood Festival of Speed – the prototype for the world’s first all-electric solar car.

And it was impressive. It could travel more than 400 miles in the cloudy Netherlands without recharging. It is expected to be rolled out in 2021 at a rough cost of US$120,000. 

This is expensive, but given the rate at which the cost of solar technology is falling, and lighter materials are being invented, it could be half that in a few years. 

This sheds a whole new light on the market for charging stations and batteries for example; as does the use of plastic in cars on the future of steel, although much will depend on the will of big capital. 

And this is all just a drop in the ocean. 

But I digress, back to the 2021 ESG rotation –  a blip on the radar

All of the above and more suggests that ESG impact investments focusing on green transition are likely to continue to find support in 2021. 

And if there is a rotation, investors can expect willing buyers to jump in on well-priced, well-positioned stocks that continue to meet targets. However, given the pace of change, fuses are likely to be short for those that fail. 

Hazer, for example, entered the year heavily overpriced having posted huge gains in 2020. The stock has fallen roughly -20% in the past few days after posting an uninspiring quarterly activities and cash flow report.

It may prove a similar story for non-green ESG stocks in the health and broader social areas that have been attracting patient capital, only the fuse might be shorter.

Burn technology company Polynovo ((PNV)) for example, lost nearly -40% at the beginning of January when it failed to meet its targets. Massively overpriced and due for correction, the miss was the excuse the market needed to move its money elsewhere. In the meantime, there were many willing buyers mopping up the stock at lower levels, prepared to buy and wait.

In contrast, imaging company Pro Medicus ((PME)) delivered news of a $40m seven-year deal with Intermountain, hot on the heels of a deal with MedStar Health, triggering a roughly 34% jump in the share price. 

Pro Medicus is also trading well above value and is a potential target for rotation on that basis alone, let alone if it in anyway disappoints the market in coming months.

This kind of activity could be the hallmark of activity in ESG impact markets over the next year, with performers attracting a rush of funds but equally vulnerable to sharp extractions, with investors unwilling to supply patient capital.

In particular, major investors could move out of companies requiring patient capital for the year and into industries that will be clear recipients of stimulus funds.

All of the above-mentioned are companies with either good business prospects or good government funding prospects, but forward-looking premiums could be withdrawn. 

Poor performing ESG-oriented growth companies and poor-performing non-ESG growth companies could fare much worse.

Outlook for “best-in-class” stocks 

Best-in-class stocks tend to be the big diversified companies, often in targeted industries such as mining, oil and gas and construction, that are leading the shift to more sustainable industry in their sectors. 

These are the companies that Fink describes as holding a “sustainability premium” given they are likely to emerge from the transition stronger than their less sustainable competitors.

Companies such as BHP Group ((BHP)) and Rio Tinto ((RIO)), for example, both of which have made significant financial and strategic commitments to improved sustainability, are in this category. 

Both defied market trends and cracked or tapped new decade highs in 2020. 

Nearly all industry leaders were careful to lead with sustainability in their annual reports in 2020.

While no forecasts on this sector have crossed my desk, I suspect this area could be subject to rotation, particularly for companies that are overvalued and sidling, and for companies with a low exposure to environmental themes or vulnerable to sharp moves in energy prices. 

Big global and domestic green utilities, which benefited from lock-in contracts during covid, are likely to lose their advantage over other utilities in that respect in 2021 should demand return to normal; although forecasts for normal are being pushed out to the end of 2021. But they are likely to benefit instead from the expected rise in demand for renewable energy. 

Similarly, oil and gas companies could recover should the oil price rise much further above the US$50/bbl mark but they are going to be constantly vulnerable to renewable subsidies and potential carbon regulation.

Companies in the construction sector are likely to be stimulus recipients and could benefit from green bond issuance.

Also, steel is a big input into the renewable energy market so ore producers, steel producers and other inputs into the renewables market could remain well bid. 

Much of the above gains have already been anticipated by the market (lithium producer Orocobre ((ORE)) for example, rocketed in the closing months of 2020) so investors need to keep a sharp eye peeled to demand dynamics and the strength of the global economy. Sharp convergences in demand could trigger sudden spikes and vice-versa. 

Regardless, any “best-in-class” withdrawals are unlikely to be as savage as they will be for overvalued growth stocks, with institutions likely to support the "best-in-class" stocks and provide a floor at lower levels, if nothing other than to provide stability during the transition. 

Hence investors could expect some band trading within a 10% to 20% range for "best-in-class" stocks in industries not as likely to benefit from the green theme being sidelined for the year. Higher volatility is likely to be the name of the game for those linked to the green theme.

Companies also may not need as much equity support given the huge opportunity in 2021 to tap the green bond market at extremely low interest rates for transitioning capital. 

Interest rates are forecast to stay low for the next four years – US five-year treasuries have been trading at roughly 0.42% with shorter-dated money even cheaper – despite "transient" spikes in inflation, according to the US Federal Reserve.

Trillions of dollars are flowing into the green bond market in 2021 and the “best-in-class” focus is likely to revolve around activity in that market, as investors try to figure out where these big recipients of largesse are likely to spend their money. Again, vehicle fleets are on the cards, as are building retrofits for lighting and heating, and infrastructure spend in resources industries.

The worthy "best-in-class" stocks are likely to be those which not only transition to new technologies but also demonstrate substantial reductions in energy and water useage (hence costs), thereby generating the greatly desired "sustainability premium".

Of course, all this assumes there will be no market crash in 2021, although there is no shortage of pundits calling it, given low levels of cash-on-hand and extended market values. 

If a crash does hit, pundits are tipping either the first quarter, or just after the first quarter 2021 results are released, should they disappoint. If so, it could represent the buy opportunity of the century, if Fink is to be believed, for those with funds.

Warren Buffet’s chiefs have advised they are keeping 20% of their powder dry.

A final word from Fink

Last but not least, Fink points to a maturing market as another reason ESG stocks will continue to find long-term investor favour.

In particular, he notes the rapid growth of sustainable indices and funds, and advances in technology that will not only improve transparency and allow for a more accurate targeting of funds, but further democratise the ESG investment process.

“… the creation of sustainable index investments has enabled a massive acceleration of capital towards companies better prepared to address climate risk …” says Fink.

Today we are on the cusp of another transformation. Better technology and data are enabling asset managers to offer customised index portfolios to a much broader group of people – another capability once reserved for the largest investors.

A deVere survey suggests 25% of investors are actively engaged in ESG investing. This should rise under Biden and, if Fink’s predictions about the democratisation of the ESG investment market manifest, the number of investors should continue to rise sharply.

While 2021 could prove a patchy rollercoaster ride for ESG if rotation kicks in, there will still be some big ESG winners. 

In conclusion, trigger-happy investors may fire short term, but the funds will flow long term.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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