One of the more irritating features of the recent few months has been the constant chant from ESG enthusiasts that their more “sustainable” strategies are a better way of producing alpha for fund managers.
I challenged this idea a few weeks back in my FT column – https://www.ft.com/content/6cee0b48-7760-46a5-9759-243aaaff7f8a – and I still remain to be convinced. My general suspicion is that ESG funds have been lucky, in avoiding energy stocks choosing instead to pump money into more tech focused stocks. That is a sector play, not evidence that a new kind of business norm is emerging.
Then again maybe I am being a bit too demanding of what constitutes alpha. Perhaps just better sector picking is evidence of alpha?
Then again, a UK based academic has another take on this debate. Chendi Zhang, is a professor of finance at the University of Exeter Business School, and along with his co-authors he’s been measuring the performance of US stocks in the first quarter of 2020. They’ve found that “in the three weeks between the start of the stock market decline and the US government’s 18 March bail-out package, firms with high ESG (environmental, social and governmental) ratings outperformed those with low ESG ratings by 7.2 per cent….Examples of ESG policies include Microsoft’s pledge to become “carbon negative” by 2030, or Google’s commitment to promote social change at its supplier sites.”.
In effect the academics reckon that corporate level ESG policies “are as valuable in creating resilience as cash, which Professor Zhang described as “extraordinary”.
One potential clue to this out performance is that businesses with strong ESG scores did better because consumers know about those strategies i.e “credible ESG policies tend to attract more loyal customers and so face less need to compete on price. “For firms and investors, sustainability is an investment in a product differentiation strategy,” Professor Zhang reckons. This sounds a credible argument – and reinforces the idea that ESG equates to stronger brand quality which in turn turns ESG stocks into a new form of quality stock. Which then becomes over priced.
You can find the research paper, entitled Resiliency of environmental and social stocks: an analysis of the exogenous COVID-19 market crash was published in the CEPR’s Covid Economics paper series (issue 11). Its co-authors include Professor Rui Albuquerque, of the Carroll School of Management at Boston College, and Professor Yrjo Koskinen and Shuai Yang, of the Haskayne School of Business at the University of Calgary.
Euro Tech is big, bigger than Euro Banks!
Next up we have a simple observation from the European equities team at Morgan Stanley. The simple punchline is that Euro Tech is now worth more than Euro Banks. The chart below from the Morgan Stanley team shows “shows the weight of Banks in a broad European index over the last ~50Y. Before the financial crisis, Banks accounted for 20% of the European market, but this has now fallen to just 5.6%. Perhaps more surprising is the fact that Technology (7%) now accounts for a greater share of European equities than Banks for the first time ever.” How the mighty have fallen !
Follow the Money
Lastly back to the vexing subject of why stock markets seem so enthusiastic about a potential global recovery – and a vaccine – despite all the contradictory evidence. There are of course many layers to this debate, not least that an even smaller proportion of the US market is pulling away from the rest of the pack. Perhaps time to dust off the NiftyFifty idea and replace it with say a NiftyTwenty?
But sometimes the simplest explanations are the best, namely that we should follow the money. More central bank cash in the system is chasing a small number of exciting stocks, pushing valuations ever higher. Some of this cash also, eventually, finds its way into other less glamorous stocks as value managers finally get a bit more capital to play with.
This simple narrative – follow the money – comes through loud and clear in Cross Border Capital’s latest research note. The London based researchers remind us that equities are long-duration assets whose short-term fluctuations are dominated by changes in investors’ risk appetite and that investors’ risk appetite is still hugely depressed, especially on Wall Street.
So, if we accept that there is a psychologically based, risk appetite and that this is mean-reverting this will in turn be “driven by the availability of liquidity”, reckons Cross Border. “Given the huge on-going Central Bank QE, Global Liquidity could soar by 30-40% in 2020, pushing the equity/ liquidity ratio down to near historic lows. Based on liquidity and depressed investors’ risk appetite, equity prices should rise Money Drives Markets”.
The chart below from Cross Border nicely maps out this close relationship.
Don’t over think the rally.
Follow the money!