During our daily scan of the financial news recently we noticed the clever (or coincidental) juxtaposition of two stories: one profiled an endowment that has recently decided to exclude fossil fuels from its portfolio and the other, which could be considered to lie in opposition, highlighted the increasing risks associated with reflation. 
The latter story suggested that traditional energy companies were one of the more effective ways to guard against rising inflation expectations. In the current climate, reflation is a very real scenario yet, running in parallel to this challenge, ESG risks are as prominent in our minds as they have ever been.
How should we deal with this quandary?
Background
The economic linkages between inflation and natural resources such as oil and metals/mining are complex. In the 1970s, after the collapse of Bretton Woods and the ensuing stock market crash, easy money and high oil prices sent inflation spiralling.
One might have surmised a clear cause and effect relationship between oil and inflation, but it has been variable since. Traditional energy companies now comprise a smaller proportion of equity market capitalisation and technology has become increasingly dominant in countries like the US and the UK. Furthermore, while there may be evidence that some long-term secular forces (e.g. ageing populations) are plateauing, they are still undoubtedly relevant.
Nonetheless, it is possible that the gigantic monetary and fiscal stimulus deployed over the past 12 months, coupled with booming economic activity resulting from ‘the reopening’ will result in significantly tighter economic conditions in the form of goods and labour. Simply put, the stimulus packages may overwhelm long-term disinflationary secular forces and lead to a world with a very different economic setting.
This may have already begun to materialise. Traditional energy companies have recently seen sharp rises in their stock prices (albeit from low levels) as markets have recognised the potential for greater inflationary forces. Assuming a world with supply constraints on natural resources, tighter labour conditions and improving economic demand, intuitively, this could well continue.
The below table shows a simplified assessment of the inflation linkage and what we consider four key factors for a collection of different asset classes. We highlight natural resource equities given their ‘high’ expected return and ‘high’ ESG risks. This has caused much deliberation in our team as it is a relatively unusual situation for a strategy with “high” ESG Risks to score well overall, relative to other possible investments.
At first sight, it might appear that there are myriad options for those seeking to guard against inflation risks, but on closer inspection, we find that:
• Commodity futures come with high ESG risks and lower expected returns than natural resource equities
• Inflation-linked bonds might be a useful defence mechanism, though may not give you much ‘bang for your buck’ in a growth portfolio
• Floating rate credit may be part of a solution, though it doesn’t tick all the boxes as the inflation linkage is only moderate and credit spreads have tightened significantly
• Direct timber/agriculture, renewables and PPI all require use of the illiquidity budget, which may or may not be available
Natural resource equities, such as traditional energy and the metals/mining companies, are easy to implement, remain depressed in price terms (despite the recent upsurge) and have modest associated fees. Yet, the category includes some of the highest carbon emitting companies, with elevated ESG risks more generally (particularly climate transition risk).
Some arguments suggest that certain natural resource investments are essential in the transition to a cleaner world. For example, certain base metals are a requirement in the switch to electric vehicles. On balance it is hard to argue that these sectors are at the more controversial end of the ESG spectrum.
To help frame the scale of the challenge, let’s consider a simple ‘stress test’ for the reflationary scenario. Natural resource equities represent 5-10 per cent of the global equity market. With a five-year horizon, it’s possible these stocks could double or even triple in price, bringing them into line with traditional valuations in other sectors.
Large swathes of the rest of the equity market are more vulnerable to an increasing discount rate (which is reasonably likely in a reflationary scenario as nominal bond yields are forced higher), including the big tech companies. If we assume the rest of the market remains flat, then we would be looking at 1-2 per cent per annum underperformance for an equity portfolio that excludes natural resources. This could be significantly higher if we see a general market sell-off.
Is divestment the answer?
Fulcrum has examined several possible reasons as to why an investor may elect to divest natural resource equities:
• To lower the carbon footprint. This is unlikely to result in lower absolute carbon emissions overall. The carbon is still being emitted but reflected in other portfolios.
• All facets of engagement have been exhausted and there is no evidence of, or commitment to, change from the underlying companies. We are sympathetic to this position, but we find that new engagement methods are developing rapidly.
• Fossil fuels are going to become redundant anyway. This may be true over the long term, though we don’t see it as a justification for divestment; it is an investment view.
• To increase the cost of capital for the underlying companies. In some sense, divestment can be viewed as the ultimate method of engagement. If there is divestment ‘en masse’, there may well be an impact on the cost of capital, which could prompt further company action or have broader impact (such as political stigma). However, the ultimate effectiveness of this approach is not guaranteed given the prevalence of marginal buyers. For example, the tobacco sector, which is often excluded from portfolios (including ours) remains profitable and has an investor base with critical mass.
We respect the difficult divestment decision. Climate goals have to be a team game. By ‘team’, we mean our entire industry. You may be thinking ‘if the status quo persists then we aren’t going to meet climate goals!’ This is almost certainly correct and so how can innovation help?
Three solutions
A bit of elbow grease will go a long way. As you consider whether natural resource equities should be a part of a portfolio, we have three suggestions that might aid the discussion:
1. Engage, engage, engage
Methods of engagement will vary from one investor to another. One example is engaging with traditional energy companies on the transition to clean energy, where we have seen early indicators of success in the way companies report and the setting of long-term goals. Another is to discuss the Science Based Targets initiative in external manager meetings. This discussion promotes consideration of the temperature-based methodology, Implied Temperature Rise, which helps us assess alignment with long-term climate goals.
Importantly, we recognise there are data issues faced by investors wishing to be better informed on ESG. For example, temperature-based metrics are prone to certain assumptions. However, data is unlikely to improve if users don’t request it, interrogate it and engage. None of this is easy but the more asset managers engaging thoughtfully, the better.
2. Selectivity
Given the well documented ESG risks associated with traditional energy, one approach could be to filter the universe to focus on the most forward-thinking (and acting) companies. Several major fossil fuel companies are playing a substantial role in the clean energy transition and we have seen very concrete action from companies in terms of future carbon emission commitments.
As a live example, we have developed a theme in our portfolios entitled ‘Energy Transition’, distinct from our ‘clean energy’ theme (which is more of a pure play). We feel these companies are likely to be rewarded for their innovation over the long-term relative to others. We also feel that taking this stance will encourage laggards to up their game. The important nuance here is that we are not saying ‘we will never own you’; we are saying, ‘up your game, and the responsible investment case might improve to the point that we can own you’.
3. Originality
Whether you choose to divest or not, other asset classes that might not ordinarily be part of the discourse when it comes to inflation, could provide hard-to-find diversifying return streams, such as Asian convertible bonds. Separately, there may be more esoteric investments with a clearer relationship to inflation that are worthy of consideration, such as emissions futures.
And finally…
The likelihood of a reflationary scenario has increased along with the hard-to-ignore chance that natural resource equities perform very strongly. Responding to climate change will not be easy, but we believe being innovative through engagement, selectivity and originality will help us all along the way.
Matthew Roberts is head of alternative solutions at Fulcrum Asset Management. The views expressed above are his own and should not be taken as investment advice.