12 May 2020
While the global market sell-off in March appeared indiscriminate, our proprietary ESG ratings highlighted that higher-rated companies outperformed their lower-rated peers. Andrew McCaffery, Global CIO, Asset Management, and Ned Salter, Head of Equities, assess recent market movement and outline why the focus on sustainability issues will continue to grow as we emerge from this crisis.
The ideas and conclusions here do not necessarily reflect the views of Fidelity’s portfolio managers and are for general interest only. The value of investments can go down as well as up, so your clients may not get back what they invest.
As we emerge from this crisis, we expect that investors - as well as society in general - will require firms to consider the welfare of their employees, communities and suppliers ahead of short-term profits as part of ensuring the long-term sustainability and resilience of their businesses.
ESG is integral to our bottom-up investment approach. Just as we rate securities based on financial metrics, so too do we rate them on ESG measures. We use a forward-looking proprietary ESG rating system that scores companies from A to E, with A being the best and E the worst.
Adjusting for market dynamics, our analysis of the March sell-off found that, of the 2,600 companies we looked at, those rated higher for ESG outperformed those rated lower, on a relative basis. For equities, the performance differential between best and worst rated company was around 10%, and in credit, the gross difference in spreads was around 300 basis points.
While bond ratings in the study were adjusted for beta (or risk level), for equity ratings, there was a quality element at play. A proportion of our A-rated stocks were aligned with some of the highest quality companies in the portfolios. However, our bottom-up approach goes beyond “quality” as a style factor and evaluates companies holistically, meaning those with higher ratings should outperform over the longer-term, not just when quality as a style is in vogue.
While most sectors demonstrated a robust linear regression in performance from best to worst rated companies, in one sector - energy - lower quality companies did perform better on a relative basis during the sell-off. This was due to several factors, including the level of exposure to the oil price as the oil supply shock hit alongside the Covid-19 demand crisis.
But the linear relationship between the ratings held up as markets rallied again, following huge central bank intervention, though not as neatly as on the way down. This highlights the biggest issue faced by asset managers at this pivotal moment in the adoption of sustainable investing.
Even before this crisis, supply chain management had been a key ESG theme for us. Peak globalisation and the US-China trade conflict had already begun to alter global supply chains. Now the pandemic has laid bare their vulnerabilities and pushed them up the national security agenda.
Consumers and governments are much more concerned about where goods come from, so we expect greater emphasis on the “S” in ESG, in the coming years, specifically on employee wellness. Companies will no longer be able to arbitrage relative disparities in wages around the world and will need to adhere to local standards as supply chains shorten and border restrictions increase. As human capital often becomes more highly valued after a pandemic, wages overall could rise once we are through the worst of the deflationary shock - eventually translating into higher prices.
The sheer scale of government intervention is likely to bring new ways of funding it. Policy measures to date have dealt primarily with the liquidity crisis, and must now address how to maintain solvency. We expect greater engagement with individual investors, whether for example in Italy, where investors are used to buying government bonds but could now be encouraged to buy equities, or in the UK, where the government may seek to broaden stock ownership across the country via discounted share sales as companies are transitioned from levels of public support and ownership.
For now, regional initiatives such as ‘coronabonds’ in Europe appear to be off the table, but countries with free floating currencies will continue to issue bonds at very low rates. Nonetheless, even averting widespread corporate insolvency through heavy intervention could play back into country risk. Therefore, sustainability and community engagement will remain paramount for governments and companies in order to emerge from this crisis - they are no longer a nice to have, but a need to have.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.