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Dan Alderson

"Judgement does not come suddenly. The proceedings gradually merge into the judgement.”

As we move towards the back end of the year, concerns about terminal interest rates and the prospect of a global recession are abating from the minds of investors, and the general public. Search term analysis of words like “inflation”, “CPI” and “hard landing” reveals the diminishing trend, but there are also fewer pundits raising these concepts as something we should worry about.

Despite my big reservations, it’s nice instead to have given more time than expected to the still-active CLO market. Please see examples of 9fin’s latest coverage here, here, here, here, and here.

But other issues are burgeoning. These do not yet receive the airtime they deserve — and will probably command in the very near future.

One newer theme certainly gaining some mention is China due to its faltering, deflationary economy and re-inflamed property sector problems. This column took a forward look at those a while back, and my colleague Chris Haffenden’s latest Friday Workout examines how things have played out.

Here’s predicting the next China twist. For all the economic uncertainty it presents, the country will become even more a political concern from next week when the BRICS meet at their 22 August summit — particularly if that brings big announcements on new members, trade/tech accords, replication of western supranational structures or progress towards a unified currency. Its neighbour Russia’s FX collapse to over 100 rubles to the US dollar should put that last topic near the top of the agenda.

In a way though, China (and Russia) as geopolitical disruptor is something to be expected, wielding an ever-present ebb and flow of exogenous impact on global investment trends.

In this edition of Macro Prophet let’s talk about something else that is immediately topical but will only present a bigger challenge over the next 15 months. It’s my contention that ESG is about to become disruptive not in the cool, start-up sense of the word, but as a source of downright pain and volatility.

In the US a bewildering, Kafkaesque narrative is emerging, showcasing the interplay between political ideologies, financial interests, and the quest for corporate responsibility. Swings to critical mass in this battle threaten the prospect of sharp withdrawals of capital either from funds that embrace ESG or those that are perceived to be backtracking on their commitments.

In the 1993 film version of Franz Kafka’s The Trial, the priest (in a riveting cameo by Anthony Hopkins) tries his best to bring protagonist Joseph K to his senses.

“Can’t you see what is going to happen to you! Can’t you see what is staring you in the face?!”

I don’t think it’s a stretch to say US politicians — and nerve-shredded investors — are capable of creating a debacle of bigger proportions than Liz Truss created for liability driven investment (LDI) strategies with last year’s UK ‘mini-budget’.

“Silly season” this year was heralded by the actions of three rating agencies. Fitch cut the US sovereign credit rating to AA+, Moody’s downgraded various US banks and put others on negative outlook, while S&P opted to drop ESG indicators from credit rating reports.

Some will argue these are distractions or nothing burgers. But they are all political fodder as the US election cycle cranks into its silliest gears. And the S&P decision highlights a battle that is heating up fast. Against a badly torn US political backdrop, the growing dissent against ESG could become a source of division like gun rights, LGBTQ+, abortion law, Black Lives Matter, and the southern border.

I’m not here (in this instance) to critique ESG or say whether it is weaponised finance, woke socialism, greenwashing, a means of affecting real change in the world, protecting the status quo, or merely cheap marketing. There is plenty of discourse elsewhere on whether or not it’s sensible to seek long term goals via short term financial incentives, whether the emphasis is goodness or risk, if higher management fees are justified by performance and a greenium, and even if the E, S, G have any business being lumped together.

But in the amphibious world of ESG, the temperature of this discourse is starting to cook some frogs. What I want to warn about is how the backlash could become much bigger and cause severe liquidity problems for fund investors and borrowers.

S&P’s retreat feels far from straightforward. It’s ostensible reasoning, investors had become confused by scoring, is understandable when cigs pusher Philip Morris commands a princely score of 84 while electric car manufacturer Tesla languishes at 37, bundled out of the S&P 500 ESG index last year only to make a recent chastised return. Elon Musk has shouldered all this with customary calm.

But it’s no wonder some suspect S&P is taking a rating outlook on the 2024 US presidential election. You’d be hard-pressed to find a Republican candidate who is not anti-ESG, with Donald Trump having past form in legislating against it and Florida governor Ron DeSantis very vocal on “slaying the administrative state”. S&P drew the ire of Republicans when it started publishing ESG report cards for US states on 31 March last year, and there has been mounting pushback at a state level since then.

Most industry commentary argues S&P decision will have little impact on ESG goals. But this needs further examination. Public equity might be well served by ESG ratings, but off the beaten track there are likely various nascent initiatives using S&P criteria in lieu of their own framework. One in credit I covered for my previous employer was the hope to make collateralised synthetic obligations a more transparent and compelling investment proposition by building bespoke ESG portfolios.

It’s also not clear how S&P can remain confident about other ESG business services it wishes to maintain. This could be a win for MSCI, which already has a pretty strong hold on ESG ratings and linked ETFs. That company’s CEO Henry Fernandez hardly fits the ‘communist’ label Trump likes to bestow on ESG proponents — in a more libertarian manner, Fernandez has said backing ESG is a way for him to stop government and socialism getting into the picture.

S&P’s disappearance trick is far from unique though. The last round of S&P 500 company earnings reports conjured this lamentable spectacle.

This clearly has inverse relation to what is happening at a political level. As S&P itself has noted, at least 165 bills and resolutions against ESG investment criteria were introduced in 37 states between January and June 2023, “despite legislative analyses that pointed to billions of dollars in potential losses”. Conversely, Democrats continue to rally behind sustainability-focused legislation.

Politicians like West Virginia Treasurer Riley Moore and Kentucky Representative Andy Barr have made a virtue of being in the pocket of fossil fuel. Last year Moore wrote a letter to six financial institutions — BlackRock, Goldman Sachs, JP Morgan, Morgan Stanley, US Bancorp and Wells Fargo — saying they would no longer be able to do business in his state due to their advocacy against the industry.

But this year’s Republican state legislation is ramping up the pressure. Thanks to DeSantis, from 1 July Florida put a sweeping anti-ESG law into effect requiring investment managers to certify their investments are based only on financial factors. Florida state treasurers had already pulled $2bn from BlackRock funds in December over the matter. This and other state withdrawals prompted other firms to try to show they were less ESG-orientated. Another giant, Vanguard, withdrew from the Net Zero Asset Managers (NZAM) initiative, claiming it wanted to improve clarity for its investors (in language strikingly similar to what S&P just said).

The pressure is working. BlackRock CEO Larry Fink has scrapped use of ‘ESG’ from the firm’s US communications, claiming it has been weaponised by the left and the right. The firm continues to promote the term in European discussions, however.

It’s surely no coincidence that Republicans began waging the assault on ESG ahead of the US election cycle, causing damage to the movement that will become ever harder to redress in the whirl of rolling news and countless other electorally emotive policy debates. But it also drew strength from a period last year when sectors like tech that had traditionally supported ESG outperformance were trailing less ESG-driven sectors like energy. This allowed easy arguments that ESG criteria ran counter to funds’ fiduciary responsibility to investors.

In August 2023, that argument is harder to back up, with the S&P 500 ESG index up 18%, having outperformed even the surprising 16.5% gains of the traditional S&P 500.

But in credit, another lamentable picture is painted by not just a fall in green, social and sustainable bond issuance (something that has to be taken in context of a general primary lapse). The advantage such bonds have enjoyed against traditional counterparts has also ebbed. Of course, more exacting ESG investors might argue this stems from greenwashing having impacted the overall performance of ESG while the unbridled energy sector has been on a tear.

In the highly charged political sphere, no analysis of such performance data sets is likely to make a huge difference, however. Not when legislative manoeuvres have already advanced so far and anti-ESG rhetoric has become a lightning rod for many voters as well as investors and companies — with Republican talking heads encouraging the American public to boycott companies that cow to ESG. Further incentivisation has come from scare claims that ESG scores will follow for individuals.

This provides enough context for last week’s reports that McDonald’s had removed reference to ESG from its website. Although, what the term was doing in conjuncture with a company that produces more CO2 emissions than Portugal is probably a bigger mystery.

Globally, there is more reason for optimism on ESG. As ING points out in a recent note, sustainable finance product issuance totalled $717bn in the first half of 2023. Although this was down 7% year-on-year, it was more than the second half of 2022. As such the whole year volume for 2023 could still exceed 2022.

Green bonds have been a driving force in this.

“The cautious optimism is caused by multiple factors,” said ING. “A higher ESG data disclosure outlook can create a more easily workable environment for issuance, clean energy policies such as the US Inflation Reduction Act can continue to spur sustainability efforts, increasingly extreme weather events could motivate issuers to finance long-term climate mitigation, and sustained government efforts can increase the issuance of sovereign ESG debt.”

The US IRA Act could shake up clean energy with $370bn planned on energy security and climate change.

But regional differences in volume are stark. Europe, Middle East, and Africa (EMEA) issuance in H1 2023 recovered from a H2 dip in 2022, to a level comparable with H1 2022 and H2 2021. This goes hand in hand with European sustainable finance policy that continues to gain traction.

“The Americas, in contrast, experienced a 21% decrease in issuance in the first half of 2023 compared to the second half of 2022, an extension of consecutive half-year drops since the second half of 2021. While likely not a determinative factor, the backdrop of anti-ESG voices has introduced disruption, uncertainty, and risks for both investors and issuers. There has in consequence been, understandably, an extra layer of questioning when it comes to issuing sustainable finance products.”

Even in the US though, ESG investor optimism is still warranted given the scale of what big firms continue to amass. As 9fin reported Monday, Blackstone’s latest energy transition vehicle, Green Private Credit Fund III, has pulled in more than $7bn. The BGREEN III fund, which was first launched at the beginning of 2022 but didn’t fully close until this month, outstripped its initial fundraising goal of $6bn.

Let’s hope Republican legislation on the matter is done for 2023 and political discourse in 2024 finds other topics more worthy of focus.

“Justice,” as Kafka would have it, “is like a train that is nearly always late” — which doesn’t sound very ESG at all. I still wager that anyone trying to unpack the multi(ne)farious debates around ESG investment will feel a little like being Joseph K — a protagonist ensnared in a labyrinthine legal system without clear explanations or tangible outcomes. “It receives you when you come and dismisses you when you go.”

As Albert Camus said of the novel itself, “It is the fate and perhaps the greatness of this work that it offers everything and confirms nothing.”

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