ESG Considerations for Capital Markets Forecasting

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of capital market expectations (CME) in the investment decision-making process and implications for ESG investing. Development of CME plays an important role in the investment management process. CME helps to inform strategic asset allocation and can be used to detect mispricing that is exploitable through tactical asset allocation. In either case, asset allocation should display cross-sectional and intertemporal consistency.

There are several steps to developing a framework for CME. First, the investment manager should determine the allowable asset classes and investment time horizon. Second, the assets historical performance and determinants of performance should be considered. The third and fourth steps involve identifying the valuation models and collecting the best possible data. Fifth, the investment manager should use their experience and judgement to interpret current investment considerations and sixth, formulate expectations for capital markets. Finally, the manager should monitor performance and refine the process.

Challenges in Developing Expectations

There are several challenges associated with developing CME. Often data needed for the evaluation process is published with a lag, is subject to revision, or is inconsistently defined. Data bias and errors can also exist as a result of transcription errors, survivorship bias, or smoothing used for appraised data estimates. Data bias can also occur due to regime change, nonstationary or asynchronous observations, and distributional issues. This makes it difficult for the investment manager to use historical data in their analysis.

Investment managers should also be aware that ex post risk could underestimate ex ante risk. In other words, it is difficult to predict risky events before they happen. Data mining and time-period bias pose an additional challenge for developing CME. The investment manager should condition their models for the likely state of the economy and recognize that correlation does not equal causation. In addition to uncertainty in models, parameters, and inputs, investment managers should not overlook the impact of psychological bias in the CME process. Anchoring, status quo bias, confirmation bias, overconfidence, prudence, and availability bias are all relevant for the investment manager that is seeking to develop CME.

Another challenge in developing CME is the possibility for exogenous shocks. Exogenous shocks are unanticipated events that can have positive or negative impact on the growth of an economy. The causes of exogenous shocks are numerous and include changes to policy, technology, or the discovery of natural resources. Natural disasters are an example of an event that can bring a negative exogenous shock to an economy. Financial or geopolitical crises can also bring sudden and unanticipated shocks that affect the economic growth trend of an economy.

Economic Trend Analysis and Economic Forecasting

Trend growth analysis is an important tool in the formulation of CME. Trend growth in a nation’s gross domestic production is the sum of the growth in labor inputs and the growth from the change in labor productivity. Growth in labor inputs is the change in employment resulting from population growth and growth in labor force participation. Growth in labor productivity is a result of changes to capital and technology inputs. The trend rate of growth provides an important anchor for estimating bond returns over long time horizons. Further, the level of nominal growth domestic product can be linked to the market value of equities if the share of the profits in the economy and the price to earnings ratio is known.

The investment manager will also need to consider approaches to economic forecasting when setting CME. There are three major approaches to economic forecasting. Econometric forecasting is the most formal and mathematical. It typically relies on structural and reduced form models. Economic indicators offer an alternative to econometric forecasting an involves the use of leading, lagging or coincidental indicators that can be used to predict turns in the economy. A diffusion index is a tool that measures how many economic indicators are up or down at any point in time. The third approach to economic forecasting is the checklist approach. A check list approach is time consuming because it requires the analyst to look at the widest possible range of data and may require subjective judgment.

Business Cycle Implications

Business cycles affect short-term and long-term expectations. However, making CME predictions based on the business cycle is complicated by the fact that business cycles can vary in their duration and intensity. Further, it may be difficult for the manager to determine the factors that affect trend rate growth and how the market may respond.

As a business cycle progresses through its various phases, there will be unique implications of inflation for cash, bonds, equity, and real estate returns. In the initial recovery phase, short-term interest rates and bond yields will be low and bond yields are likely to bottom out. Stock markets may rise strongly during an initial recovery with cyclical assets such as small stocks, high-yield bonds, and emerging market securities performing well. As the economy moves to the early expansion phase, short-term interest rates will rise, and longer-maturity bond yields will be stable or rise slightly. Stocks will trend higher during this early expansion phase. As the economy moves into late expansion, interest rates will rise, and the yield curve will flatten. The stock markets will often rise during this phase, but they may become volatile. It is common for cyclical assets to underperform and inflation hedges to outperform during late expansion.

Eventually the expansion will turn into a slowdown. During a slowdown, short-term interest rates will peak (or near a peak). At the same time, government bond yields will peak and may then decline sharply. The yield curve may invert – with longer-term interest rates dropping below short-term interest rates. Credit spreads will typically widen during the slowdown phase, especially for securities representing weaker credit. Stocks may fall, but interest-sensitive stocks and “quality” stocks will perform the best. As slowdown turns to contraction, interest rates and bond yields will drop. The yield curve will begin to steepen. The stock market drops initially at the onset of a slowdown but will usually start to rise well before the recovery emerges. Credit spreads will widen and remain elevated until clear signs of a cycle trough emerge.

To manage the economic impacts of the business cycle, politicians and central bankers will use fiscal and monetary policy respectively. Fiscal policy is an automatic stabilizer that mitigates cyclical fluctuations. For instance, when an economy moves into the slowdown phase the value of tax receipts to government will automatically decrease. Monetary policy is also a countercyclical force. The goal of monetary policy is to keep the growth rate at the long-term sustainable rate. In general, real rates are driven by fiscal policy and expected inflation is driven by monetary policy. The combination of real rates and expected inflation yield nominal rates. For example, if fiscal policy is tight and monetary policy is loose, the economy will experience low real rates and higher expected inflation. This will result in medium nominal rates.

The primary monetary tool that central bankers have at their disposal is the ability to set the target policy rate. To calculate the target policy rate, central bankers will consider the expected rate of inflation, the difference between the expect and target inflation rates, and the difference between the expected and trend gross domestic policy growth rate. These variables are linked through the Taylor Rule.

Macroeconomic, Interest Rate, and Exchange Rate Linkages

Identifying and interpreting macroeconomic, interest rate, and exchange rate linkages between economies is important for developing CME. Macroeconomic linkages suggest that there is correlation across countries as they are linked by capital flows and expressed through the current and capital accounts. In the short run, interest rates, exchange rates, and financial asset prices must adjust to keep a nation’s capital account (which is the net change of assets and liabilities during a certain period) in balance with the slowly evolving current account (which is the difference between a country's savings and investments). The current account, in conjunction with real output and the relative prices of goods and services, tends to reflect secular trends and the pace of the business cycle.

Interest rates reflect differences in economic growth, monetary policy, and fiscal policy. A country cannot simultaneously allow unrestricted capital flows, maintain a fixed exchange rate, and pursue independent monetary policy. These restrictions inform exchange rate linkages. When a country pegs their currency, the peg will decrease volatility and control inflation. The interest rate of the pegging country usually includes a risk premium which represents the risk the peg could be broken. With floating exchange rates, the link between interest rates and exchange rates is primarily expectational. High interest rates result in lower currency values. In other words, to equalize risk-adjusted expected returns across markets, interest rates must be higher (lower) in a currency that is expected to depreciate (appreciate). Interest rates are linked through the requirement that global savings must equal global investment. Therefore, they will tend to move together even though real interest rates around the world will not be equal.

Expectations for Fixed Income and Equity

When the investment manager considers methods of setting expectations for fixed-income returns, there are three general approaches. The first is the discounted cash flow method which assesses bond yield to maturities and Macaulay durations. The risk premium approach is a building block method which considers the risk-free rate and other risk premia including term, credit, and liquidity risk. Finally, equilibrium models like the Singer-Terhaar model can be used. For emerging market fixed-income securities, investment managers should recognize the distinct political, legal, and economic risks that could affect the government’s ability or willingness to pay.

When setting expectations for equity investment markets, there are three return forecasting methods the investment manager should consider. The Grinold-Kroner Model is a discounted cash flow model where expected returns are the sum of the expected cash flow return (dividends and share buybacks), the expected nominal earnings growth return, and the expected repricing return. A second method is the risk premium approach, however, forecasting the equity premium directly is just as difficult as projecting the absolute level of equity returns. Finally, the Singer-Terhaar equilibrium model can be used to determine the equity risk premium. The equity risk premium is a function of the risk premium for the global market plus the risk premium for the segregated market, adjusted for the degree of integration. The risk premium with either market is the product of the Sharpe ratio of the market, the standard deviation of security returns, and the correlation between the security and the market. Like fixed income, equities in emerging markets are subject to political, legal, and economic risk. In addition, equity securities in emerging markets must also consider weaker standards of corporate governance, low accounting transparency, disclosure, regulatory uncertainty, and weaker property rights that could lead to seizure of property or nationalization.

Expectations for Real Estate, Exchanges Rates, and Volatility

Investment managers can assess the economic and competitive factors that may affect expectations for real estate markets. Real estate valuations are linked to business cycle movements and REIT values are closely correlated with equity valuations. In contrast, private real estate valuations are often smoothed and therefore have low correlations with equity. The expected reduction on real estate is the some of the cap rate and the net operating income growth rate less any growth in the cap rate. The expect return will include a premium for term, credit, equity, and liquidity.

Forecasting exchange rates requires the investment manager to consider goods/services, trade, and the current account. In particular, a focus on capital flows is warranted. As such, the investment manager should recognize that the current account and the capital account must always balance. The drivers of the current account tend to adjust only gradually. Most of the short-term and intermediate-term adjustment must occur in the capital account. Asset prices, interest rates, and exchange rates are all part of the equilibrating mechanism. The ability for the current account balance to influence the exchange rate will depend on whether the balance is likely to be persistent and sustained. The investment manager should also note that for capital flows, the mobility of capital principle suggests that capital will flow to the highest risk-adjusted rate of return. This can lead to hot money flows and currency inflation. According to the uncovered interest rate parity rule, this will dictate that exchange rates adjust in response to changes in the relative size and composition of the aggregate portfolio denominated in each currency.

Since volatility is an investable asset class, forecasting expectations is also an important consideration for the investment manager. Forecasting can be done using a variance-covariance matrix or a linear factor model. The sample variance-covariance matrix is correct on average and converges to the true matrix as the sample size gets arbitrarily large, but it cannot be used if there are many asset classes or if the number of assets exceed observations. Linear factor models have a benefit in that they can be used when the number of assets exceeds the number of observations. This can significantly reduce the number of unique parameters to be estimated and can reduce estimation error. However, unless structure is imposed by the factor model, it will not be correct on average. A shrinkage estimation (i.e. the weighted average of the two forecasting approaches) will increase the efficiency of the estimates.

Implications for ESG Investing

Having provided and overview of capital market expectations in the investment decision-making process, we now turn our attention to the implications for ESG-investing. ESG-investing is often conflated with the concept of socially responsible investing or SRI, but the two are not the same. SRI is typically focused on divestment while ESG is focused on engagement. Traditional fundamental analysis is increasingly integrating ESG factors and an ESG smart beta factor is gaining momentum in the investing world. ESG investing is also motivated by risk mitigation and management. For institutional investors, assessing whether a company is adequately managing risk is the top reason for incorporating ESG related information in their investment analyses ^[2].

ESG risk analysis integration has real-world implications. For example, Volkswagen’s emissions testing scandal is not only an environmental and regulatory non-compliance issue, it is also a financial and litigation risk for shareholders ^[3]. An ESG scoring system can be used to inform expectations of not only companies, but also the macroeconomic performance of sovereign nations ^[4]. Using ESG factors can help to forecast emerging megatrends like climate change, that shape the economy and business environment in the coming decades. In other words, ESG is a forward-looking concept that should be factored into capital market expectations. ESG considerations may not have been previously factored into the investment manager’s analysis, but we live in a time of disruption, and understanding ESG implications are important for developing capital market expectations.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://www.researchgate.net/publication/327821711_Capital_Market_Expectations_of_Risk_Materiality_and_the_Credibility_of_Managers'_Risk_Disclosure_Decisions
3. https://www.mendocinocounty.org/home/showdocument?id=18523
4. https://hub.ipe.com/download?ac=88988

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