Insights
The Search for Better Outcomes
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Insight Article
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January 18, 2022
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The Search for Better Outcomes
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January 18, 2022
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The Search for Better Outcomes
The Search for Better Outcomes |
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2021 ended with the re-introduction of restrictions to deal with the new Omicron variant of COVID-19 and it is not clear whether 2022 will see companies muddling through or rising to the challenge of delivering better outcomes. Read more Hear more from the International Equity Team’s Head of Sustainable Outcomes, Marte Borhaug.
What is a better outcome? As long-term investors we seek to deliver better outcomes for our clients through producing attractive returns. In order to do that we must invest with a conscious eye on whether companies can deliver better outcomes not just today but 5, 10 and even 20 years from now. We back companies that have the characteristics needed to lead in the long run, like recurring revenue, pricing power and strong management, and importantly also have the awareness to invest in managing and improving their ESG impact.
This logic is consistent with how humans have evolved. If we are to believe the latest neuroscience,1 humans inherently seek ‘better outcomes’ and, perhaps contrary to common belief, it is not the achievement that gives us satisfaction but the journey itself. We do this because a ‘seeking system’ gives us a feeling of reward and pleasure when we explore our surroundings and seek new information for survival. Similarly, companies seeking to deliver better outcomes and faced with a changing world must explore their surroundings and seek new information for survival.
Looking back on 2021, they had plenty of change to manoeuvre. Instead of a pure ‘return to normal’, 2021 has been a year of continued headwinds. Although we saw signs of a bounce back as COVID-19 lockdown measures lifted in the spring plus sharp earnings growth, a number of economic challenges have lingered: from supply chain disruption and labour shortages to intensified China-US trade and political tensions.
Despite these issues, equity markets continued to boom, buoyed by positive vaccine rollout news, with growth stocks and more cyclical value stocks taking turns to drive the market forward, seemingly unphased by peak earnings and peak margins or persistent inflation taking hold. The dangers of earnings and multiple correction grew larger, but seemed always just beyond the horizon. Investors started the year leaning into the cyclical rally but ended the year looking for more defensive positioning, which may bode well for quality investors.
We also saw ESG momentum continue to build in 2021, with USD $139.2 billion2 of flows globally going into ESG funds. In Europe, the most mature sustainable investment market, this shift to ESG funds has been via active management. This is not a surprise. It’s hard to remain passive in the face of challenges like climate change; if you believe the world is going to change significantly as sustainability externalities start to be ‘priced in’, there will be winners and losers creating investment risks and opportunities. Being on the right side of that change is key.
Source: Morningstar, 31 December 2021
Source: Morningstar, 31 December 2021
Source: Morningstar, 31 December 2021
Source: Morningstar, 31 December 2021
Underlying the shift towards ESG is evidence that more and more countries are taking steps to create a more sustainable society and economy. Most of the actions in 2021 were linked to COP26 (the 26th United Nations Climate Change Conference) that took place in Glasgow in November. The pressing urgency of the climate challenge brought a series of new commitments to tighten carbon targets, phase ‘down’ coal, removal of fossil fuel subsidies, tackle methane emissions and stop deforestation. Countries representing 70% of global emissions and GDP have now committed to reaching net zero by 2050 or 2060, with massive implications for many corporates— Display 2. Regulators acted too—and some have come a long way. In Europe new sustainable investments3 that aim to give clients more transparency around sustainable investment came into force and the European Central Bank presented an action plan to include climate change considerations in its monetary policy strategy.4 In the US the SEC has moved from throwing out investor proposals pushing companies like Exxon on climate change in 2019, to forcing companies to hold investor votes on emission targets in 2021.5 Whether one believes the pace of change is too fast or too slow, the direction of change is clear.
For the year ahead, the environment remains uncertain, whether one looks at it through the lens of economics, health, politics, or sustainability, but we believe there are three trends that will shape outcomes for companies, economies and societies.
Source: International Energy Agency (2021), Net Zero by 2050, IEA, Paris
Source: International Energy Agency (2021), Net Zero by 2050, IEA, Paris
First, after a pandemic that has so far seen 230 million cases and nearly 5 million deaths, we expect a stronger push on social challenges, from diversity to inequality, as economies get back on their feet. COVID-19 has not only hit companies and economies but has put the world back two decades in the fight against poverty, as vulnerable countries and groups of people have shouldered the brunt of the burden.6 The pressure on companies to play their part in tackling inequality is likely to continue, from eliminating race and gender inequities to protecting the human rights of workers in the supply chain. This year we already saw the introduction of Nasdaq’s new rules7 requiring firms to disclose board-level diversity statistics and have, or explain why they do not have, at least two diverse directors. Similar diversity measures were also announced by the Hong Kong stock exchange, making it clear that ‘a single gender board is not considered to be a diverse board’ and calling on companies to appoint a director of a different gender.
We are also seeing increased action from policy-makers and investors. On human rights, the EU is considering rules to make human rights due diligence mandatory while the global responsible investor organisation the UNPRI has announced a new global collaborative platform to support investors in taking action on social issues.8 Together these pressures are likely to lead to greater action on the S in ESG.
Second, work will turn from climate commitments to policy reality—and so watch out for more laws, fiscal incentives, investor pressure as well a continuation of rising climate litigations as the transition to low carbon continues. This will not only impact the fossil fuel industry. For example, the car industry—whether it’s proposals to effectively ban new fossil fuel cars from as early as 2035 like the EU or suggesting new incentives for electric vehicles like the US, the economic rules of the game are changing. Every sector will need to change and companies who want to stay ahead will need to adapt now or risk ending up in the company graveyard.
Third, next year could prove to be the year of ‘nature’ as countries meet for the much less talked about COP15 (the 15th United Nation conference on biodiversity) to address the depletion of planetary resources.9 Targets will be set in Kunming in China for the next decade and commitments from both governments and the private sector have already emerged. A coalition of more than 50 countries has committed to protect almost a third of the planet by 2030.10 We’re also seeing the emergence of voluntary disclosure frameworks for companies (Taskforce on Nature-related Financial Disclosures – TNFD) and investors promising to eliminate agricultural commodity-driven deforestation risks across their investment portfolios and invest in nature-based solutions. Although new targets are unlikely to lead to an immediate price on free resources such as water, air, forests, and the ocean, it should speed up government action, business decisions and investment allocations. Companies looking to future proof their business will need to understand how dependent they are on planetary resources and how they are impacting nature through their products and services to take action to manage the risks and explore opportunities.
Whatever the pace of change in 2022, efforts to create a sustainable future is a game that’s played out in decades, not months. Just like any journey, there will be bumps in the road but as the transition takes place, we believe companies with a strong ‘seeking system’ that helps them be alert to the world around them will help them stay on top of their game and deliver long-term returns for clients. As bottom-up stock pickers, and with my role as Head of Sustainable Outcomes for the International Equity team, we’re determined to keep seeking better outcomes, to learn and improve our offering to you and to keep pressing for progress from the world’s best companies.
https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.pr210708_1~f104919225.en.html
https://www.ft.com/content/50b52600-dd43-427c-88a6-149cf790cb70
https://news.un.org/en/story/2021/12/1107752
https://listingcenter.nasdaq.com/assets/Board%20Diversity%20Disclosure%20Five%20Things.pdf
https://www.stockholmresilience.org/research/planetary-boundaries.html
Risk Considerations
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small- and mid-capitalisation companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. ESG strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.
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Head of Sustainable Outcomes
International Equity Team
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Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus for the Morgan Stanley funds please download one at morganstanley.com/im or call 1-800-548-7786 for the Eaton Vance and Calvert Funds please download one at https://funds.eatonvance.com/open-end-mutual-fund-documents.php or contact your financial professional. Please read the prospectus carefully before investing.