Quarterly update – March 2022

Russia’s invasion of Ukraine caused a global shock. Now more than ever we see a role for ethics in investment decisions.

ESG in the crosshairs

The start of 2022 has also seen escalating criticism of ESG. Following years of growth, ESG now finds itself at a critical junction. Amid growing concerns about greenwash, Russia’s war in Ukraine has also exposed investment managers’ failings to assess ESG risks properly while most ESG portfolios have significantly underperformed thanks to their low exposure to the energy sector.

So, what does this mean for ESG?

There are some who suggest further expanding the definition of ESG to incorporate Russia-like risks, with ESG scores awarded to countries with political freedom. But when ESG tries to measure everything, it ends up measuring and meaning nothing.

We see investors’ reliance on ESG data as part of the problem. Third party data has replaced individual detailed analysis in too many instances. And yet the situation in Ukraine shows that it’s time to stop thinking that data and measurement will solve everything. We cannot just measure our way out of all the challenges the world faces.

Ethical, not ESG, is the future

Now more than ever we see a role for ethics in investment decisions. As investors, we do not operate in a vacuum. Every investment decision has an impact on the world around us and a truly responsible investor will be as concerned about the social and environmental impacts of their investments as they will be with making a financial return.

Australian Ethical began more than three decades ago and was founded on the premise that financial decisions should not be separated from ethical considerations. This has never been so clear as what we’re seeing in Ukraine, which has shown that all too often investors’ ESG considerations have nothing to do with morals and everything to do with avoiding risk.

We would argue that investors who are divesting from Russia when it’s all but impossible to make money there are not concerned with ethics. Divesting from Russia in 2008 when it invaded Georgia or in 2014 when it invaded Crimea would have been an ethical decision. But an ethical choice that is only made when the financials align, is a financial choice first and foremost. And with the financial risk in Russia so obvious, can divestment be viewed as anything but financial?

Russia’s invasion of Ukraine caused a global shock, and the grave human implications fed through into markets.

What does this mean for a low carbon future?

The war first and foremost is having a devasting consequence for millions of people, but it’s also having a dramatic effect on sustainability. It has precipitated a global energy crisis forcing countries to look for ways to wean themselves off Russian oil and gas. Until then, the global surge in demand is delivering windfall profits for fossil fuel companies in the short-term.

However, despite the high energy prices, we believe the driving forces behind the energy transition remain as strong as ever. In many ways, the war has enhanced these trends with a renewed sense of urgency to move away from coal, oil and gas, which could prove to be a turning point. This urgency was further made clear by the release of two IPCC reports in 2022, which warn that without deep and immediate emissions reductions across all sectors, limiting global warming to 1.5 degrees is beyond reach.

All this makes for a challenging time for investors who must navigate multiple crises at once.

There are those that believe that the key to investing is identifying the perfect time to buy and sell, but the truth is that no one knows with certainty when markets will rise or fall. History however tells us that geopolitical crises often have a sharp but relatively short-term impact on markets; and science tells us that fossil fuels have no role in a sustainable future.

Times of uncertainty can test investors’ fortitude. We believe these are the moments when active stock selection and thoughtful portfolio construction can provide a measure of solace and have a profound impact in the pursuit of long-term financial goals and a better world.

IPCC reports warn that without deep and immediate emissions reductions across all sectors, limiting global warming to 1.5 degrees is beyond reach.

Market commentary

The market continues to be volatile – Covid is still an evolving virus sparking widespread lockdowns as seen in China most recently; Russia’s invasion of Ukraine increases the probability of previously unfathomable tail risks such as nuclear war while the inflation and interest rate regime that has become entrenched over 30 years may be at a tipping point. We’ve seen the market measure of ‘fear’ - the VIX index – trade through a wide range this quarter with each headline. Starting the year at a relatively benign reading of 16, it peaked at 35 in early March when the hostilities in Ukraine began before receding back to a recent average of 20.

Given all the bad news and volatility, equity markets were relatively resilient through the quarter – the ASX delivered a small positive return over the quarter. However, the potential inflection in interest rates and inflation was clear in bond markets. As markets started to price a rapid series of rate rises by central banks to get ahead of the inflation cycle, Australian bond markets delivered their worst quarter on record, losing 5.9% (The Bloomberg AusBond Composite index was incepted in 1989). Long bond yields now significantly exceed pre-Covid levels, nearing the highs following the global financial crisis.

Inflation remains a significant threat to bond market returns, but a change in growth expectation is the bigger threat to equity valuations. Higher inflation has presented short term challenges to industrial-based equities and driven commodities sector outperformance.

We expect our equities portfolios to be resilient to any longer-term decline in growth expectations. This reflects our focus on quality and companies in less cyclical sectors and decarbonisation plays such as scrap metal and lithium. We also continue to engage with a range of commodity-related companies on improving their business practices, aligning with lower carbon emissions, and ultimately moving towards a more sustainable circular economy.

Covid is still an evolving virus sparking widespread lockdowns as seen in China most recently.