United StatesRecognizing Systemic Risks in the “E” and “S” in ESG
The year 2020 will be bookmarked in history for many reasons. At the top of the list is the COVID-19 pandemic, whose impact on human lives and the economy has been extensive. It has driven unprecedented movements in financial markets, with equities plunging to bear market levels in less than a month and U.S. Treasury rates falling to historically low levels in a flight to quality. Subsequently, equities have soared more than 50% off lows.
While 2020 will be remembered for COVID-19, we believe it should also be remembered for bringing a new awareness about how environmental and social risks can have systemic impact on markets and are not just temporary financial disturbances. COVID-19 has shed light on the systemic risk of pandemics; we believe climate risk, biodiversity loss, and racial and gender discrimination and inequality also need to be viewed as systemic risks.
There is much common ground among these issues: All will be with us for the foreseeable future; all create widespread risks for financial markets; and all are challenging for investors to diversify and manage. The issues are more linked than you might expect at first glance.
Let’s consider the long-term systemic risks that these issues pose to the global economy along with near-term risks of high equity valuations driven by strong recent market performance.
Equity investors rewarded in the third quarter
Equity markets continued to soar for most of the third quarter before taking respite for a few weeks in September. Through August 31, the S&P 500 Index was up nearly 58% off March lows, more than retracing its losses during the early days of the COVID-19 crisis and stretching its valuation to historically high levels. Equities sold off in early September as investors became more wary of these valuations and lightened up on areas of the market (i.e. technology and growth stocks) that had outperformed, favoring long out-of-favor value stocks, instead, for this short period.
Nevertheless, the S&P 500 Index rallied near the end of September to cap off a second consecutive quarter of strong returns. For the quarter, the S&P 500 Index was up 8.9% and significantly outpaced the Russell 2000 Index return of 4.9%, which was still a very respectable return for small-cap companies. Non-U.S. equities, as represented by the MSCI EAFE Index, delivered a solid 4.8% return but once again lagged U.S. equities. Investment grade bonds delivered a modest return in the current low interest rate environment as the Bloomberg Barclays Aggregate Bond Index was up 0.62%.
Near-term risk: High absolute equity valuations
Equity market valuations are near all-time highs on an absolute basis. This has been driven by investors’ willingness to assume a return to normalized earnings in 2022. While improving economic data has buoyed investor optimism, there is concern that the economy remains considerably behind where it was at the start of 2020, and the market is likely not pricing in economic challenges that could potentially impede the pace of recovery.
In our view, these high valuations largely can be explained by Federal Reserve (Fed) policy that has been instrumental in helping the U.S. economy avoid at least some of the potential fallout of the pandemic but has launched what appears to be a new regime of historically low interest rates. With interest rates so low, the valuation of equities relative to bonds does not appear as expensive. Figure 1 below shows that the S&P 500 Index earnings yield (the inverse of the price-to-earnings ratio) has a considerable spread advantage relative to the yield on both corporate bonds and the 10 Year U.S. Treasury. This advantage, known as the equity risk premium, continues to attract money to the equity market. However, this premium is largely driven by historically low interest rates, which may be inducing investors to be more tolerant of risk as they stretch for returns.
Figure 1: S&P 500 Earnings Yield vs Corporate Yield vs Treasury Yield (7/15/2005 – 10/05/2020)
A key question remains: If we are in an extended period of low interest rates — as current Fed policy would imply — will investors be more tolerant of high equity valuations? In such an environment, equities will remain susceptible to significant volatility as particular risks come into focus. Among those risks are market reactions to the election outcome, continued impacts of COVID-19, trade tensions and an underachieving economic recovery.
Systemic risks from the “E” and “S” in ESG
The COVID-19 pandemic is a systemic risk that has wreaked havoc on our global economy: As of mid-July, despite a recovery off lows, industrial production was still down 18% in high income countries, 24% in middle income countries, and 22% in low income countries, according to the United Nations Industrial Development Organization. World economies are all struggling with high unemployment, and most of the world has experienced economic contraction.
Climate risk is also a systemic risk. Perhaps the first major encounter that financial markets had with climate risk came in 2005, when the Kyoto Protocol entered into force and the imposition of a cap-and-trade system in many markets resulted in a reevaluation and price adjustments to many utility companies and stocks of other large emitters. Back then, investors largely regarded climate risks as regulatory in nature, and diversifiable. The picture is different now. Climate risk is increasingly seen as systemic — which means it’s something that investors cannot manage simply through diversification.
Recently, the Commodity Futures Trading Commission (CFTC) issued a new report about the impact of climate change on the U.S. financial system, calling it a systemic risk. Work done by the Federal Reserve last year also pointed to the fact that climate change could pose systemic risks for the U.S. economy and financial markets. The mounting risks of climate change are undeniable; as this is being written, we have broken all records for wildfire extent in the West, while the Gulf Coast has been inundated by several hurricanes and tropical storms — with more on the way. All these events have economic impacts on the communities, states, countries and, indeed, the globe; the more they happen, the less isolated they are, and the more businesses will be affected by them.
This year we’ve also absorbed the terrible news that the world is experiencing biodiversity losses on an unprecedented scale, and we stand to send more than a million species into extinction this century if we are unable to halt the losses. According to the Organization for Economic Cooperation and Development (OECD), the world lost an estimated $4-20 trillion per year from ecosystem services losses, and an additional $6-11 trillion per year from land degradation. Further losses could be crippling, and, like climate change and the pandemic, present systemic risks.
In isolation, none of these perfectly signal the new normal in terms of systemic risk. But they’re linked: Climate change is implicated in both this pandemic and likely future ones, as is biodiversity loss — the more we squish all the rest of Earth’s inhabitants into smaller scraps of habitat, the more likely it is that we will experience future epidemics and pandemics as new viruses jump from animal hosts to humans with no immunity.
The people most vulnerable to the economic losses we will face if we do not successfully mitigate climate change and reverse biodiversity losses are poor people, and they, in turn, are disproportionately Blacks and other people of color. We’ve already seen how vulnerability to COVID-19 has more profoundly affected minorities due to a long legacy of inequality and its tentacles — poor housing, exposure to pollutants and contaminated air and water, and racial profiling that affects everything from law enforcement encounters to credit ratings to employment. If we cannot solve the increasing inequality among races and genders, we face a future of increasing strife and conflict — the same future that comes with climate change.
All these issues have quickly spread around the globe, and all of them have and will continue to affect the economy and financial markets. The good news is that it is possible to beat them through commitment, capital and collaboration.
Manage risk, find value drivers and take action
Near-term risks to the equity market at current valuations as well as systemic threats to economic and financial markets are being viewed through a new lens.
Historically low interest rates have created a challenging environment for allocating between equity and fixed income. In this environment it’s prudent for investors to be especially mindful of individual risk tolerance. Increasing equity allocations to stretch for return could raise overall portfolio risk beyond an acceptable level.
To combat long-term systemic threats within individual equity and fixed income portfolios, we remain focused on the risks and opportunities from the transition to a more sustainable economy. This approach can help portfolios better weather these storms and benefit from companies that are best positioned to thrive in the long run.
We can also act on these threats through advocacy, such as urging regulators to make markets more aware of these systemic factors. This year, we petitioned the SEC to oblige companies to make the precise locations of their key facilities publicly available so investors could better assess the companies’ physical risks in the face of climate change. We also revised an earlier petition to the SEC about gender pay reporting, asking the agency to require companies to disclose pay gaps for all demographic groups — gender, ethnic and racial.
The actions we must take to address climate change, biodiversity loss and inequality all are related to creating a more sustainable economy, and it’s in these areas that we look for value.
Definitions
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).
The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.
Equity risk premium is a term that refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing.
Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. It is a type of yield that is referenced when a bond has provisions that would allow the issuer to close it out before it matures.
Index Definitions
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index, representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net,” which includes dividend reinvestments after deduction of foreign withholding tax.
The Bloomberg Barclays US Aggregate Bond Index is a broad base index maintained by Bloomberg L.P. that is often used to represent investment grade bonds being traded in United States.
One cannot invest directly in an index.
The statements and opinions expressed in this commentary are of the authors and as of the date of publication. All performance data quoted represent past performance, which does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. See Pax World Funds’ performance for most recent month-end performance information. Holdings for the funds are subject to change. Please see the Pax World Funds’ holdings for current holdings information.
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