Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Inflation concerns over ESG
They are two hot topics of analyses in the investment world. What is not so well known is that the coming round of inflation will likely be exacerbated by ESG strategies.
The obvious element to cause a spike in prices in many areas comes from the fight against climate change. But it is not only the ‘E’, which needs consideration with inflation. The ‘S’ and ‘G’ are also involved.
Charlene Malik is a portfolio manager at TwentyFour Asset Management, one of the fixed income boutiques at Vontobel Asset Management. She says in a recent (July 12) blog, ‘ESG is Inflationary‘, that ESG is a new source of inflation which was not present to the same extent in the previous cycle.
She says the impact of ESG cannot be overlooked when forming a view on the current cycle’s inflation outlook. “As companies and individuals adopt sustainable practices, we believe the potential exists for inflationary consequences in the short and medium term,” she says.
With the environment, the transition to a net zero by 2050 landscape, while providing a positive outcome, is “guaranteed to engender higher prices”, Malik says. There may well be lower costs over the long term from renewable energy, but not in the short-medium term.
With social, there are concerns already about the switch to net zero exacerbating the divide between the haves and the have-nots, which may have to be compensated or have other costs such as political unrest.
The trend to greater inclusion among corporates adds to recruitment costs, skills training and retention policies. The trend to focus on supply chains for harmful practices, while ultimately a good thing for society, will cost money in higher wages and greater oversight.
With governance, companies need to dedicate greater resources for reporting to stakeholders and governments. The likelihood of additional regulation could have a productivity cost.
Malik says that while there is little hard data on the social and governance consequences of the ESG trend, earnings calls for investors by big companies in the March quarter, various companies indicated their intent to pass onto consumers price increases generated by their supply chains.
“That said, there is every possibility that inflation from ESG proves transitory in the long term (ultimately everything is transitory!),” she adds.
“Lower running costs of electric vehicles, increased productivity from having a diverse workforce and stable energy prices bestowed by renewable energy sources are all plausible beneficial effects created by companies adopting a more sustainable posture. However, we believe that organisations adopting better ESG behaviours will, on balance, create inflationary pressures in the short and medium term.”
