Sticking with ESG in a bear market

As we creep further into bear market territory, sustainability-minded investors want to know how recent economic developments have impacted ESG investing’s long-term outlook. Let’s take a closer look.

The United States bear market, coupled with the possibility of a prolonged recession, is understandably making investors a bit skittish. Environmental, social, and governance-focused (ESG) investors might be worried that these troubling financial times mean they can no longer afford to invest with an eye toward supporting sustainability. But what do recent economic developments mean for the future of ESG investing? Here’s what you need to know.

2022’s bear market

The ESG sector arguably entered the mainstream in the years since the 2008/2009 financial crisis—a period which has enjoyed a prolonged bull run—and the sector has since blossomed into a $35 trillion industry.¹ However, the broader economic market suffered in 2022, and ESG funds weren’t immune to its volatility.

One of the biggest reasons for this is that the technology industry has been one of the hardest-hit sectors this year. The Nasdaq Composite Index, dominated by technology equities, is down 30% from its record peak in November 2021.² Many ESG funds maintain high exposure in tech, and, as a result, ESG-focused investors feel it when the tech industry takes a hit during an economic downturn.

In comparison, more traditional benchmark energy indices experienced growth this year. A closer look at the first quarter (Q1) in 2022 reveals only 13 of the 66 Morningstar ESG indices performed better than their non-ESG counterparts—a steep 30% drop from the same period in 2021 when 31 of the 66 Morningstar ESG indices generated superior returns relative to their corresponding non-ESG benchmark.³

Overall, the S&P 500 Energy Index is up 68.93% year-to-date, while the S&P 500 Index is down 19.83%.⁴ As ESG performance lags, traditional energy markets thrived amid the economic volatility and energy crisis in Europe.

During market downturns and periods of sustained economic volatility, many investors turn all their intention to risk management. The current period of high inflation, in part brought on by the Ukraine crisis, has challenged liquidity across Wall Street.⁵ Many institutional investors have already rebalanced portfolios by moving capital into the traditional energy sector and increasing their allocations in risk-off assets and commodities like gold, which are often seen as a hedge against inflation. 

How the market has affected ESG-focused investing

Predictably, inflows into sustainable funds and ESG investments have slowed, with more capital trickling into defensive equities and risk-off assets.

In Q1 2022, sustainable funds brought in 35% less in new capital compared to the previous quarter. Sustainable debt issuance has also declined faster than the general bond market in Q1 2022, with a 19% year-on-year drop versus 5% in 2021.⁶

Sustainability-linked debt instruments are a notable exception, which remain attractive to investors because of their flexible design. The proceeds are not limited in use with sustainability-linked debt—unlike with green bonds—so it’s no surprise that the sector has enjoyed more than 100% year-on-year growth through 2022.⁷  By linking sustainability performance to interest rates, sustainability-lined debt instruments incentivize companies to prioritize ESG-related issues at the boardroom level.

The ESG venture capital market has also gained steam this year. A rush of deal activity in January 2022 saw $6.4 billion in new investments trickle into climate tech funds.⁸ So, it’s not all doom and gloom! The ESG sector has been more of a mixed bag in 2022 relative to the overall market downturn. Although ESG has suffered from slower capital inflows this year, the drop in inflows is less than the drop we’ve seen across the broader market.⁹ There’s no sugar-coating the short-term performance of many ESG equities, but the long-term performance and outlook for ESG indices remain strong relative to non-ESG comps.

ESG investing in tough financial times

Against this backdrop, many investors are wondering if it’s time to double down on ESG-related investments or pull out of the sector altogether. Many long-term investors smell potential “buy-low” opportunities. This current period of market volatility reinforces the fundamental investing principles, structural forces, and economic rationales driving ESG’s bright long-term outlook.

For example, publicly traded renewable power portfolios generated significantly higher returns and experienced lower volatility during this past decade compared to fossil fuel-led portfolios. While renewable energy tech costs have fallen sharply during recent decades as per “Wright’s Law,” fossil fuel costs have held steady for more than a century¹⁰ . Evidence like this suggests techno-economics continue to make greater inroads into the clean economy and are better positioned to capitalize on the world’s ongoing energy transition.

Even with ESG’s structural advantages in place, that doesn’t mean this bear market hasn’t sparked valid concerns among sustainability investors. To produce low-carbon goods that hold economic value, in addition to precious metals and minerals, companies need supply chains and global workforces to fire on all cylinders. The current inflationary climate tightens margins, increases costs, and brings new financial risks for many operating within the ESG sector.

On the other hand, increasing regulatory and societal pressures are finally shining the spotlight on corporations’ ESG records. Of the more than 750 global policy tools that currently measure sustainable finance, 40% are centered on ESG.¹¹

Moving forward, the push to meet net-zero targets outlined in the Paris Agreement and the ongoing proliferation of ESG regulations should only fuel investor demand and sustain ESG’s strong long-term growth outlook.

Navigate the bear market with confidence

Following an unprecedented growth period spanning more than 12 years, the ESG market is now encountering its first bout of sustained volatility. As one of the largest asset managers in the world, AXA IM is no stranger to managing risk in bear markets—and guiding our clients through difficult market conditions.

If you look at historical markets, investors tend to lean towards the fundamentals the further we drift into bear territory. The ESG sector will likely go through a contraction phase as we ride out the volatility. But remember that the streamlining and restructuring we expect to observe across the ESG sector is a natural response to any sustained era of growth, and it’s a sign of a healthy, competitive industry.

Also, many ESG equity funds have underperformed in the broader market due to their structural underweight in traditional energy stocks. Companies in the oil and gas sector have benefitted from super-normal profits because of high global oil and gas prices, which has translated into strong share price performance. However, as the global energy transition gains momentum and renewables generate a larger share of power, global oil and gas prices could come under pressure, hurting the sector performance of traditional energy securities.

Moving forward, we believe greater regulatory scrutiny, improved investor awareness, and evolving ESG metrics will help the strongest ESG performers thrive.¹² Companies with proven ESG performance should hold up well under fundamental analysis, demonstrating their ability to potentially drive sustainable stakeholder value and operate in the clean economy.¹³