Market Insights and Education & Resources

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ring fossil fuel prices are testing the resolve of sustainable investors. But sustainable portfolios will deliver better long-term outcomes, argues Pendal’s MICHAEL BLAYNEY

  • Oil prices test resolve of sustainable investors
  • Expect better long-run outcomes from sustainable portfolios
  • Portfolio construction can smooth the ride

INVESTORS are understandably asking whether there’s a long-term cost to being in a sustainable fund when oil is trading above $US100 a barrel.

“The reality is that sustainable portfolios have had a more difficult time of it recently and people are asking whether investing in a sustainable fund might mean a long-term drag on returns because they can’t get exposure to certain sectors such as fossil fuels,” says Pendal’s Head of Multi-Asset Michael Blayney.

“The short answer is we don’t expect to get worse returns from sustainability over the long term.

“Indeed, we expect to get better long-run outcomes from sustainable portfolios.

“But you will see greater variation relative to a benchmark in certain types of environments.

“If you want a sustainable strategy -- and you screen out fossil fuels and weapons and tobacco and gambling and so on -- then you have to accept that sometimes you will outperform and sometimes you will underperform.

“We saw a sustainable strategy work really well during Covid. During that period oil prices collapsed.

“Also, many sustainable portfolios have a slight growth tilt to them. And 2020 was a really great environment for growth investors and much of 2021 was pretty good too.

“But if you look at one-year returns of sustainable funds as a category now, they’re not looking as great. And year-to-date has been very difficult.”

Portfolio construction critical

In this environment portfolio construction takes on even greater importance.

“If you look at other asset classes for economic exposures that you’re lacking in equities, that gives you an extra tool to manage through these periods,” Blayney says.

“While we encourage people to focus on the long term, the reality is people do think about the short term and they do think about peer comparisons.”

Investing across asset classes can smooth the road for sustainable investors.

“If your sustainability strategy gives you a slight growth bias then you might want to look for investments that fit your sustainability strategy but also gives you a value bias, for example in your alternatives.

“Or you might actively seek out a bit of energy price exposure and inflation hedging via commodity futures or certain types of renewable energy infrastructure.”

Beyond Aussie equities

Looking beyond the local equity market is also attractive.

Oil and gas companies have outperformed this year as oil prices have pushed beyond $US100 a barrel.

But oil and gas companies are less than 4 per cent of the MSCI World Index. So in global equities at least, there are plenty of opportunities for investors outside that sector.

“There is no reason to believe the oil and gas sector is going to outperform in the very long term. If anything, because of the decarbonisation economy it has big structural headwinds,” Blayney says.

All investors -- including sustainable investors -- need to have realistic expectation from the beginning.

“They need to understand that some equities in their portfolio might trail the market over the short term. But that is okay if they have the right strategy, structurally, for the long term,” Blayney says.

“To help them through some of those periods, they should think about sustainable balanced funds which hold some renewables, for example.

“To the extent that they can, investors should look at what they’re missing from equities and then use other asset classes to identify exposures which are consistent with what they are trying to achieve from a sustainability perspective.”


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Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

Find out about Crispin's Pendal Focus Australian Share Fund
Find out about Crispin's sustainable Pendal Horizon Fund

FIVE factors combined to drag down equity and bond markets last week, while commodity prices also fell:

  1. Further signals of aggressive Fed tightening, which saw US two-year government bond yields rise 21bps
  2. Concerns over Chinese economic growth with the Shanghai stock market and yuan both falling sharply
  3. Fears that supply chain problems will re-emerge as a result of Chinese lockdowns
  4. Some fear of a slowing US economy
  5. Selective US earnings disappointments – primarily from Netflix and Alcoa.

The combination of factors meant technology and cyclical sectors were both affected.

The S&P 500 fell 2.7% last week and is now down 10% year to date. The NASDAQ lost 3.8% last week and is down 17.8% for the year.

The S&P/ASX 300 (-0.7%) held up better, but the futures market suggests that effect will be lagged into this week. It is up 1.8% for the year.

Market paradoxes

Several paradoxes are facing the market, complicating portfolio positioning:

  • US growth is strong and earnings revisions positive — but the market is pricing in a slowdown as the mechanism for the Fed to reduce inflation
  • Measures of investor sentiment are negative — but flows into equity markets remain strong
  • There are signs inflation may be peaking — but bond yields continue to rise
  • Lockdowns are seeing sentiment towards Chinese growth sour — but commodities and resources have been strong.

We remain wary of the near-term outlook in this environment.

As mentioned in previous weeks, the tighter financial conditions needed to tame inflation require equity markets to remain flat at best.

Meanwhile we are seeing the twin headwinds of uncertainty over Chinese growth and the market’s need to deal with what is likely to be back-to-back 50bp rate hikes in the US.

US inflation and rates

A number of signs suggest US inflation has peaked:

  • Statistically we will see the biggest months of inflation growth in 2021 – April, May and June – rolling off the annual figures
  • Commodity prices are rolling over off recent peaks
  • The US dollar continues to rise
  • There are signs of supply chain pressures easing in the US. Shipping rates for freight and containers have begun to fall. There is also evidence of less pressure in US trucking systems.
  • Employment participation rates are creeping higher. There’s an argument the impact of inflation and running down of savings is slowly encouraging people back into the job market.
  • Company wage surveys have begun to ease. This reflects less pressure to raise wages, which have already been materially re-based. 
  • Company pricing power surveys are stalling, albeit at historically high levels

We can conclude that at this point inflation is unlikely to get worse. But before declaring victory on inflation it’s important to note three things:

  1. The labour market remains very tight, so some wage pressure is likely to remain
  2. Supply chain issues could be about to flare up as a result of lockdowns in China
  3. The US economy remains strong, though there is a shift in demand to services. Coincident indicators are robust.  Continuing unemployment claims are at 50-year lows, bank lending is rising 7% year-on-year and house prices remain strong.
Key question

The key question is: if inflation rates have peaked, where do they fall back to? This comes down to two unpredictable factors:

  1. At what point will the Fed tolerate inflation in order to avoid a recession?
  2. The Fed’s ability to control the economy

The Fed maintains a hawkish message.

Federal Open Market Committee member James Bullard mentioned the potential need for a 75bp hike in some remarks last week. Again, there was talk of an “expeditious” need to get back to neutral.

At this point we think back-to-back 50bp hikes are more likely — with the potential for a third — as well as a start of quantitative tightening.

The market continues to price in further acceleration of rate hikes. The consensus is now 2.75% by the end of 2022, versus 2.5% previously.

It’s been a long time since markets have had to face such a rapid tightening cycle. There is still a question over the degree to which this is priced in. This underpins our near-term caution.

There is also a view that Fed tightening cycles will continue until something “breaks” — such as the 2016 collapse in oil prices, the 2012 Eurozone Crisis or the Russia/Long Term capital management crisis in 1998.

This is also making some in the market cautious.

China

There has been a rapid deterioration in sentiment towards the Chinese economic outlook due to a combination of:

  • Lockdowns choking demand and supply chains
  • Currency appreciation relative to competitors
  • Global slowdown
  • Weak consumer confidence
  • Property market remaining fragile


It is estimated that 44 Chinese cities are under some form of lockdown. This equates to 25% of the population and 38% of GDP — of which around 16% is in strict lockdown.

Estimates indicate Chinese growth could slow from 4.8% in Q1 to less than 2% in Q2.

This risk is emphasised by a sharp fall in road freight volumes (a reasonable indicator of Chinese economic health) and a backlog of ships off Shanghai.

There were hopes that policy easing would see a moderate pick-up in the housing market. This is not yet showing any sign of coming through.

The rise of the US dollar — against which the Chinese yuan is managed — has left China in a difficult competitive position given the relative depreciation in the Japanese yen and Korean won.

This exacerbates the existing pressure on China’s export engine from slowing global growth and a shift in consumer demand from goods to services.

Under pressure

This pressure seems to have forced a crack last week, with the currency breaking down relative to historical ranges.

It moved about 3% against the US dollar. While that may not be large in absolute terms, it is a four-standard-deviation event in historical terms.

The equity market was also pummelled. The rebound after the government’s comments in support of the market following concerns earlier in the year has proved short-lived, with some signs of outflows in foreign capital.

The policy response so far is regarded as too limited. The People's Bank of China announced a 25bp cut in the bank reserve requirement ratio from April 25.

The immediate impact is concern around commodity demand, which risks being crimped by slower growth and a weaker currency.

We think the structural story in commodities remains attractive. But there is a sense it is a very long position among investors at the moment.

Aggressive Fed tightening — plus slowing Chinese growth and a devalued yuan — may see a sharp near-term unwind in the sector.

This is also materialising in some recent Australian dollar weakness.

Markets

Most asset classes weakened in response to all this.

Some are pointing to negative sentiment measures as a possible support. We are not so convinced by this — we are still seeing positive inflows into equity markets.

This is the key week for US earnings.

Last week saw two high-profile disappointments which dragged on sentiment:

  1. Netflix: The US$100bn cap stock fell 38% in a week. Several issues (such as switching off the Russian subscriber base) were specific to the company, but they exacerbated market concerns regarding consumer demand. Combined with other issues outlined above, this seemed to be a negative catalyst for mega cap growth names which have previously supported the market overall.
  2. Alcoa: The alumina and aluminium producer fell 23% on concerns regarding costs – particularly around energy which is a large input into the refining and smelting process. This was compounded by the broader growth outlook.

Interestingly, despite a few major disappointments aggregate revisions to Q1 FY23 have been positive, reflecting what remains a strong economy.

For example, US airlines are seeing strong upgrades. At this point, earnings remain supportive of markets.

The ASX missed the big US fall on Friday, which is likely to emerge this week.

The local market was helped by the private equity bid for Ramsay Health Care (RHC, +30.6%). This supported the health care sector. Other than this, defensive sectors out-performed.

Mining was weak on a series of disappointing quarterly production report. Costs and production both disappointed, mainly due to the disruption associated with Omicron.


About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

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Almost 100 per cent of millennial investors say they are interested in sustainable investing according to a US survey by Morgan Stanley. Pendal Group’s ANDREW PARRY explains the opportunity

  • Inheritance is bringing younger clients to financial advisers
  • Younger generation has acute awareness of changing social norms and environmental concerns
  • Opportunity for financial advisers to educate their clients

MANY investors wrongly believe sustainable investing implies a trade-off that involves giving up returns, says Pendal’s Andrew Parry.

This misperception is an opportunity for financial advisers to educate their clients, says Parry, who heads up investments at Pendal’s Regnan and J O Hambro Capital Management divisions.

“This is one of the education matters that we're all going to have to deal with because we have to get over this barrier that integrating ESG considerations to your investment decisions costs money,” says Parry.

“I think a better way to frame it is that if you're not thinking about these issues, you can't have the complete picture and therefore you're more likely to introduce more uncertainty by not having the full information when investing.”

Integrating environmental, social and governance considerations in investing is of critical importance for advisers because younger investors are increasingly demanding their money is managed sustainably.

More than 40 per cent of advisers in Australia now offer responsible investment options, according to surveys by Wealth Insights. This number is forecast to grow to 51 per cent as soon as this year and 65 per cent in the next few years.

“That’s going to continue to grow largely because of consumer preferences,” he says.

And it’s not just greater awareness across society, but also a demographic shift in investors from older to younger generations, who have a more acute awareness of changing social norms and environmental concerns.

“We’re beginning to see generational shift that is going to continue for a long time,” he says. Almost 80 per cent of US investors and 99 per cent of millennial investors say they are interested in sustainable investing according to research by Morgan Stanley in December 2021.

“People are beginning to ask their investment advisers for advice on how to make the change — 75 per cent of millennial investors are planning to change the way that they invest to reflect their sense of social justice.

“There is a vast amount of money that is going to be inherited over the next 10 to 20 years.

“This is something that is going to reshape the demand for these products for many years to come.”

Parry was speaking at a recent Pendal webinar titled How making a difference can make money.

Andrew’s presentation can be viewed along with other recent Pendal webinars at pendalgroup.com/webinars (free registration required).

The past three years have seen an explosion in interest in sustainable investing which is showing no signs of stopping.

“On certain projections it’s expected that some $50 trillion of assets will be invested with some form of ESG target or integration by 2025,” Parry says.

“It’s not about ESG as a label — it’s about ESG as an input into all our decision-making.

“Why wouldn't you think about the environmental influence on business models and on economic activity?”

“Why wouldn't you think about the social consequences of how COVID is recalibrating the ability of companies to attract workers?

“By missing out these inputs, you may be missing valuable and material information.

“ESG is not about the label — it’s simply finance 101.”


About Andrew Parry

Andrew is Head of Investments for Pendal Group’s sustainable investing business Regnan as well as our UK-based asset manager J O Hambro Capital management.

He has more than 30 years of asset management experience with a focus on equities, investment strategy, business development, leadership and strategic client relationships. Over the past decade Andrew has developed a special focus and indepth knowledge of sustainable and impact investing.

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Bond yields have been rising and fixed income investing is gaining advocates. But not all income funds are in the right position to take advantage. Pendal’s head of income strategies Amy Xie Patrick explains why.

You can also listen to this podcast on Apple or Spotify
An excerpt from this podcast

Two-year yields in Australia have risen well over 200 basis points, even just in the last year.

One year ago, to invest in risk-free bonds in Australia, you were getting paid virtually nothing. And now you're getting paid nearly 2.5%.

For most income funds in Australia, within the fixed interest asset class, our income targets are relatively modest, around 2% to 3%. You can get most of the way there now without even having to take credit risk, or equity risk.

But if you don't have the flexibility within your portfolios to take advantage of this higher-yield environment, then this is a really large prize that you are being forced to forego in this environment.

The reason we highlight this today, on the podcast, is simply to say to investors that you need to look at what kind of income fund you're getting into.

Is it a buy-and-hold, steady as she goes, let's not do much about it, kind of income fund?

Or has your income fund actually been incredibly active to insulate you against the rising interest rate risks, the rising macro risks, that have occurred over the last 6-to-12 months?

The latter is definitely the one positioned with more flexibility, and more dry powder, to take advantage of the higher yields that we have today.

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Fossil fuel companies are paying a “brownium” penalty to raise money in fixed interest markets — and are now trading on lower earnings multiples in equity markets. Pendal’s MURRAY ACKMAN explains what it means for investors

  • Energy companies’ performance muted due to ESG
  • Bond investors risk getting caught with securities they don’t want.
  • ESG is a long term thematic, high energy prices are shorter term.

WITH high energy prices and oil and gas company revenues soaring, shouldn’t the big fossil fuel companies be outperforming in credit and equity markets?

Yes. But the large fossil fuel-based companies have to pay a ‘brownium’ penalty to raise money in fixed interest markets — and are trading on lower earnings multiples in equity markets, compared to previous years says Pendal ESG credit analyst Murray Ackman.

It’s a demonstration of how fundamental ESG (environmental, social and governance) factors are now to investment decisions, Murray says.

“When investing, everyone needs to do their fundamental analysis and ESG integration is now a big part of that analysis, just like financial analysis. If you are looking at downside risks, ESG factors can significantly destroy a company’s value.

“Of course, you can win on short-term trades, but the long-terms might be problematic.”

It’s important for investors to understand this underlying change in the energy sector, he says.

“In the bond world, an investor could feel uncomfortable buying some energy bonds and holding them till maturity because the world in seven years or so will be very different,” Ackman explains.

Some of the differences between investing in bonds and in equities are accentuated when buying into energy companies.

Liquidity is one difference, Ackman says. Buying and selling an energy company on the stock market is potentially easier than selling a corporate bond from an oil and gas company in the secondary market.

“Also bond people don’t tend to like taking as much risk. And bond investors look at the downside risk of ESG as pretty significant.

“You can buy a bond funding a gas pipeline that has a 20-year maturity. If you do that, you are making a call on the future. What if there’s a sudden policy change that no one saw coming. Pricing can be severely affected, and you don’t want to get stuck with a bond that you don’t want until maturity,” Ackman says.

Ultimately, it’s about how much return an investor gets for taking on the risk of buying a bond that finances fossil fuel companies.

“There is now a ‘brownium’ – energy companies are having to pay more and access to finance is getting trickier. Banks are under pressure not to provide finance to fossil fuel exploration. We are seeing more private investment in the sector.”

Ratings agencies are placing greater emphasis on ESG factors, which impacts pricing. And bond funds, like those that Ackman works across at Pendal, assess issuers ESG credentials.

“In our vanilla portfolios, if we think there’s an ESG risk but the pricing compensates for that then we might make a trade,” Ackman says. “But in our sustainable and impact funds, we probably can’t make those trades. And that’s why people invest in those funds.”

The bottom line for investors is that ESG is a long-term thematic play while energy price rises are much shorter term.

“This isn’t a linear process. There will be times when oil and gas outperform, but that doesn’t mean we aren’t heading towards net zero,” Ackman says.

“In the past few years at every company presentation, the highlights slide at the front almost always has a couple of ESG points. Businesses are becoming proud of their achievements in ESG. Investors are asking a lot more questions about it and it is now front of mind.”

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BEIJING’S public insistence on zero tolerance for Covid has put a question mark over China’s the economic outlook — and raised concerns the government’s growth targets are too ambitious.

  • COVID lockdowns threaten outlook
  • PMI data weakest since height of pandemic
  • Wait for policy response: James Syme

China’s economy grew at a better-than-expected 4.8% annual rate in the first quarter, despite pandemic lockdowns in major cities and the repercussions of a tightening of regulations on property developers.

But Pendal’s James Syme says a more telling figure may be the recent purchasing managers index (PMI) — a monthly survey of business activity — which showed activity falling to its lowest levels since the height of the pandemic.

“We can only focus on the data and the PMI is a powerful guide to how problematic things are in China,” says Syme, who co-manages Pendal Global Emerging Markets Opportunities Fund.

“The PMI was quite soft in the manufacturing sector and extremely weak in services.

“And remember these are national figures — if the national figure is at these levels than some parts of the country must be really weak.”

Syme says the problems for China’s outlook stem in a large part from the last year’s tightening of regulation in the real estate sector as Beijing enforced its ‘three red lines’ policy limiting developers leverage in proportion to their equity, assets and cash.

“China essentially delivered a huge negative shock to the economy,” says Syme.

“There’s lots of focus on other regulations in education and technology because those have more of the stock market impact, but those sectors are not particularly big in terms of the overall economy.

“It was the enforcement of the three red lines policy in real estate which had a really serious chilling effect on what is one of the was probably the largest sector in China.”

Syme says the effect was wider than property prices, impacting demand for building materials, construction equipment, white goods and furniture.

Now, COVID-related lockdowns and port closures in major cities are posing further threat to the economic outlook.

“Now this might be short term, as it was in February 2020,” says Syme.

“And clearly with vaccinations, China is in a better place than it was before.

“But the outlook for the Chinese economy is really quite uncertain at this time.”

What should China investors look for?

Market nerves about the outlook mean some of China’s most high profile and fastest growing companies are trading at lower prices than they have for years.

“Our policy has always been that cheapness alone is not a driver — you need signs of positive economic of political direction,” says Syme.

Syme says the most important thing is to wait to see Beijing’s policy response to the slowdown.

To date, Beijing has not intervened with a loosening of monetary policy or fiscal stimulus and appears to be seeking to export the nation’s way back to growth.

“But that’s probably not going to be enough in itself,” says Syme.

“We've seen the Chinese trade balance just continue to grow and if you think of a country's trade balance as what it produces minus what it consumes, a stronger trade balance is really just more evidence of economic weakness.

“At some point, there's going to have to be some kind of stimulus — but then we go back to the problem that Chinese policymakers have that they want to constrain debt to GDP.

“But if you want to use stimulus you have to grow debt faster than GDP.”

And longer term?

“There’s only so long that China can grow much faster than the rest of the world,” says Syme.

“Those six and half percent growth rates simply couldn't be maintained forever.”


About James Syme and Pendal Global Emerging Markets Opportunities Fund

James Syme is a senior portfolio manager of Pendal’s Global Emerging Markets Opportunities Fund with Paul Wimborne.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

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ring fossil fuel prices are testing the resolve of sustainable investors. But sustainable portfolios will deliver better long-term outcomes, argues Pendal’s MICHAEL BLAYNEY

  • Oil prices test resolve of sustainable investors
  • Expect better long-run outcomes from sustainable portfolios
  • Portfolio construction can smooth the ride

INVESTORS are understandably asking whether there’s a long-term cost to being in a sustainable fund when oil is trading above $US100 a barrel.

“The reality is that sustainable portfolios have had a more difficult time of it recently and people are asking whether investing in a sustainable fund might mean a long-term drag on returns because they can’t get exposure to certain sectors such as fossil fuels,” says Pendal’s Head of Multi-Asset Michael Blayney.

“The short answer is we don’t expect to get worse returns from sustainability over the long term.

“Indeed, we expect to get better long-run outcomes from sustainable portfolios.

“But you will see greater variation relative to a benchmark in certain types of environments.

“If you want a sustainable strategy -- and you screen out fossil fuels and weapons and tobacco and gambling and so on -- then you have to accept that sometimes you will outperform and sometimes you will underperform.

“We saw a sustainable strategy work really well during Covid. During that period oil prices collapsed.

“Also, many sustainable portfolios have a slight growth tilt to them. And 2020 was a really great environment for growth investors and much of 2021 was pretty good too.

“But if you look at one-year returns of sustainable funds as a category now, they’re not looking as great. And year-to-date has been very difficult.”

Portfolio construction critical

In this environment portfolio construction takes on even greater importance.

“If you look at other asset classes for economic exposures that you’re lacking in equities, that gives you an extra tool to manage through these periods,” Blayney says.

“While we encourage people to focus on the long term, the reality is people do think about the short term and they do think about peer comparisons.”

Investing across asset classes can smooth the road for sustainable investors.

“If your sustainability strategy gives you a slight growth bias then you might want to look for investments that fit your sustainability strategy but also gives you a value bias, for example in your alternatives.

“Or you might actively seek out a bit of energy price exposure and inflation hedging via commodity futures or certain types of renewable energy infrastructure.”

Beyond Aussie equities

Looking beyond the local equity market is also attractive.

Oil and gas companies have outperformed this year as oil prices have pushed beyond $US100 a barrel.

But oil and gas companies are less than 4 per cent of the MSCI World Index. So in global equities at least, there are plenty of opportunities for investors outside that sector.

“There is no reason to believe the oil and gas sector is going to outperform in the very long term. If anything, because of the decarbonisation economy it has big structural headwinds,” Blayney says.

All investors -- including sustainable investors -- need to have realistic expectation from the beginning.

“They need to understand that some equities in their portfolio might trail the market over the short term. But that is okay if they have the right strategy, structurally, for the long term,” Blayney says.

“To help them through some of those periods, they should think about sustainable balanced funds which hold some renewables, for example.

“To the extent that they can, investors should look at what they’re missing from equities and then use other asset classes to identify exposures which are consistent with what they are trying to achieve from a sustainability perspective.”


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