Nobody likes you when you’re ’23

9 Jan 2022 | Brace for turbulence (and market bifurcation) ahead.

Every time a year is characterised as being even more ‘unprecedented’ than its predecessor, somewhere in the world, faith in market forecasting (and the English language) dies.

It’s not easy to predict the trajectory of a complex adaptive economy, let alone one shaped by an ever-growing fistful of exogenous factors. Climate change, global pandemics, territorial wars: none is traditional market-data fare.

This January, at least, there’s plenty of evidence to support the consensus outlook, which tells us to strap in for a rough ride. Still, you can never discount the potential for shock events. Fortunately, that includes those on the upside.

All eyes on the Fed

Investors are bracing for one of the most anticipated recessions ever, as central banks double down on aggressive policies to tame inflation at any cost. Having slimmed down its balance sheet with the fervour of a January gym-goer trying to shed 10 years of accumulated weight, the US Federal Reserve is unlikely — at least in the near term — to let even peak inflation data derail its historic tightening campaign.

That’s bad news for growth stocks, which owe a decade of outperformance to low borrowing costs and a sprinkle of imagination. Price corrections are one thing, but an economic downturn would extend and exacerbate the terrible, horrible, no-good, very-bad year suffered by somewhat-less-Big Tech.

If the events of 2022 compound in 2023, so too will the specific challenges faced by sustainable investors. Gone are the easy victories, such as labelling as ‘sustainable’ any fund with a performance-boosting bias towards technology.

Investors must look further afield for positive-impact and above-market returns.

Cementing the dichotomy

Past consensus cast a sustained market downturn as the true test of sustainable investing. Current consensus agrees it will emerge from this one, albeit in a very different shape.

Coupled with escalating political attacks in the US, an economic crunch may prompt a retreat from explicit social and environmental objectives by larger asset managers: particularly those besieged, on the third front, by the growing threat of antitrust litigation. Real though they are to a specific market segment, however, headwinds are unlikely to drive sustainability off course within broader capital markets.

Every cycle is different. Baked into this one are a number of structural trends that may not only insulate sustainable finance but accelerate and — we hope — improve it.

“It was a rough year… that shed clear light on ESG’s limitations. [It showed] managers they cannot market all ESG funds as impact funds. If there’s one thing I hope for 2023 it’s more transparency around this distinction.”

Util CEO Patrick Wood Uribe speaking to the Financial Times

Be wary of corporate disclosures

Regulatory activity is ramping up on both sides of the Atlantic. While banks steel themselves for climate stress tests, companies are preparing for disclosure requirements.

  • 🇪🇺 In December, the European Financial Reporting Advisory Group (EFRAG) submitted the first set of draft EU Sustainability Reporting Standards (ESRS) to the European Commission. Marking a “major step” towards a reporting framework for companies operating in the bloc, the standards are expected to be finalised mid-2023 and apply from 2024.
  • 🗺️ That means many companies will have to comply with the EU rulebook ahead of the global counterpart being drawn up by the International Sustainability Standards Board (ISSB). ISSB plans to finalise two proposed disclosure rules for climate-related risks in 2023. Despite broadening its focus to include biodiversity, the guidelines will cover fewer topics: EFRAG, by contrast, has reportedly identified around 1,000 datapoints on which companies need to report.
  • 🇺🇸 In the US, the SEC is expected to introduce rules requiring companies to disclose material climate change risk and risk management. The Biden administration has, already, made clear its support in its biannual regulatory to-do list, issued on Wednesday. Prepare for a “robust response” from the anti-ESG Republican faction, led by Florida governor (and 2024 presidential candidate frontrunner for the GOP) Ron DeSantis.

Despite progress by regulators — and, as surfaced in a recent Deloitte study, company management — it’s the wrong time to get complacent about corporate disclosures. In 2022, greenhushing emerged as the new greenwashing.

Should the market or political landscape turn unfavourable, will disclosures continue to be a reliable proxy for data and transparency?

Regulatory requirements bound to bite

For investors preparing for (or adjusting to) their own regulatory requirements, it’s not an immaterial question.

  • 🇪🇺 In the EU, Level 2 of the Sustainable Finance Disclosure Regulation (SFDR), introduced last week, requires fund providers to identify and disclose the principal adverse impacts (PAIs) of financial products on sustainability factors. Building on the reporting obligations outlined in Level 1, Level 2 includes a new mandatory reporting template for 14 core and 31 additional indicators. Firms will need to report on all 14 core, plus 2 additional, factors.
  • 🇺🇸 In the US, after a year of cracking down on misleading claims (see: last year’s fines for GSAM and BNY Mellon), the SEC is expected to provide more clarity about what, exactly, fund groups need to do to market sustainable funds safely. The regulator has already proposed changes to its Names Rule, under whose expanded remit a fund could claim the term only if 80% of assets were invested sustainably. Again, however, any SEC action is bound to be challenged in court.

The threat of watchdog punishments prompted a retreat from sustainability in 2022, which provides some insight about what lies ahead.

US SIF calculated assets in US strategies totalled $8.4T in 2022 — or less than half of the $17.1T reported for 2020 — thanks to not outflows but stricter criteria. In the EU, funds representing more than $100B were downgraded from Article 9. With new research showing just 0.5% of Article 8 and 9 funds meet a “greenness” threshold of 50%, it’s safe to bet on more downgrades in the new year.

2023 heralds market bifurcation

And yet, demand for sustainable investments is booming. Per PwC, 81% of institutional investors in the US and 83% in Europe plan to increase their allocations to sustainable products over the next two years.

Meanwhile, companies are catering to customer and employee demand: the latter of which, as the Fed is discovering, may prove hard to disempower. (Particularly if ageing demographics are forcing the tight labour market, and particularly if the tight labour market is unalleviated by ongoing protectionist policies.)

If sustainable flows continue to soar while the funds market shrinks, we expect an absolute bifurcation between ESG and impact in 2023. If so, it will mark the culmination of a journey that began all the way back in December 2021, when Bloomberg shone the light on the chasm between ESG and impact.

The fact something so obvious caused such a stir — and just one year ago — seems extraordinary today. It will appear even more remarkable in 12 months.

“Many ESG ratings evaluate: “Does this ESG issue impact the profitability of the company?” We need a system that evaluates: “Does the growth of this company have a positive impact on the world?” This evolution of ESG needs to be championed by institutional investors, rating agencies, public companies and the general public. As the world needs to strive for a substantial positive impact, we won’t be referring to ESG. Instead, we’ll talk about Impact.”

Tesla Impact Report, 2022

The new nemeses of the GOP zeitgeist, defensive asset managers have been quick to paint ESG factors as material risk and ESG strategies as risk management. That may be true, and it may warrant ESG becoming the base setting for companies and funds. But it does little for an audience of investors, institutional and retail, clamouring for true sustainability.

For investment firms that can no longer rely on the competitive advantage of ESG at a time when their future depends on enshrining one, there are worse strategic ambitions than ‘impact’ in 2023. Moreover, with protectionist fiscal policy driving explosive growth among homegrown technology and energy industries, those fund alignment targets may begin to look not-so insurmountable, after all.

If nothing else, social and environmental data is indispensable to anyone trying to make sense of an economy shaped, increasingly, by exogenous shocks: climate change, global pandemics, territorial wars — plus whatever else 2023 has in store.