Essex Global Environmental Opportunities Strategy (GEOS) July 2022 Update
The first half market correction of 2022 can now be measured as the most extreme in over fifty years. The negative capital markets environment has been driven by the profound spike of inflation, the compound result of years of accommodative Federal Reserve policy coupled with the disruptions of the pandemic and the Ukrainian crisis. Since 2008, all facets of our economy have had access to cheap capital, from mortgages to commercial bank financing. Given the rapid rise in interest rates and resulting equity market correction, we are now, in the words of Warren Buffett, seeing who swims naked as the tide goes out. The pandemic has exacerbated inflation as nations compete for all inputs to economic growth, from labor to materials such as commodities and semiconductors. On shoring plans abound, the result of global supply chain disruption, trade tariff disputes, and commodity price pressures. For example, as automotive manufacturers move production to electric cars, all are forming joint ventures not only with battery manufacturers but are also linking collaborative efforts with each other to ensure access to materials and technology. At the end of the quarter, inflationary pressures and resultant Fed action did result in some declines in consumer sentiment and demand, as well as price declines for commodities from copper to wheat. Whether this signal points to full recession or temporary slowdown remains to be seen. We acknowledge that this is a cycle where above market growth will be had with differentiated business models such as we assess for our GEOS holdings.
In recent months, the SEC proposed a series of ESG-related rules that are relevant to GEOS. The first rule focuses on climate-related financial disclosures from public companies. The proposed rule aims to provide investors with standardized and comparable climate-related information to use in investment analysis and proxy voting decisions. Companies will be required to disclose information on topics such as climate governance, quantitative greenhouse gas emissions, actual and potential physical risks (physical climate impacts on company operations like flooding, drought, wildfires), transition risks (risks associated with low-carbon transition such as lost revenue, stranded assets, regulation), and climate-related business opportunities.
Essex submitted a comment letter to the SEC (link here) expressing our support for the rule, along with recommendations for improvement. Our most significant recommendation is to change the requirement pertaining to disclosure of scope 3 emissions, or emissions not directly controlled by a company in their value chain. Scope 3 emissions are less commonly disclosed by companies due to immature calculation methodologies, but they frequently constitute more than 80% of a company’s total emissions footprint. It is unclear whether the final rule will be expanded to mandate scope 3 disclosures, especially since the SEC has faced significant pushback from critics who question the SEC’s authority to mandate climate-related financial disclosures.
The SEC also proposed a rule that would require greater ESG disclosure requirements for registered funds. Currently, there is considerable confusion among investors as to how asset managers are utilizing ESG factors in their investment decisions. The proposed rule aims to reduce confusion and provide greater market transparency by mandating that asset managers provide certain disclosures about how ESG factors are used in the investment process. One key aspect of the rule is the SEC’s grouping of different ESG funds: ESG Integration, ESG Focused, and ESG Impact. Disclosure requirements vary based on how a fund is classified, with more strenuous requirements for ESG Impact funds versus ESG Integration funds.
Ultimately, we believe the proposed rule will help reduce market confusion about ESG investing and reduce the risk of greenwashing. There is currently a misconception among investors that all ESG funds follow the same approach to ESG, when in fact they may differ substantially (negative/positive screening, 3rd party ratings, integration, thematic, etc.). This misconception has partially fueled the recent backlash against ESG investing, with investors calling out ESG funds for holding oil and gas companies or investing in Russian companies prior to the invasion of Ukraine. By requiring asset managers to describe how ESG factors are used in the investment process, prospective investors will have a better understanding of how ESG factors impact portfolio management and security selection. We believe that GEOS is well differentiated amidst these headlines and proposed changes, given our long-standing focus on environmental solutions, and our consistently executed investment objective, philosophy and process.
We are amidst unprecedented times, and it is difficult to compare this period to any point in the past. The inflationary spike this year was more severe than the 1970s and was only matched by the World Wars. This may be apropos, given the pandemic and Ukrainian crisis. Both events have caused massive dislocation of resources – the very engines for economic growth and social stability. Energy and food supplies are completely disrupted, forcing adjustments across the globe to reconfigure systems on the fly. Aside from resource shocks, global economies are in flux given central bank responses to this inflation and the possibilities for resultant recessions. The degree of our Federal Reserve’s late and forceful response to inflation is also unprecedented and led to very sudden drops consumer sentiment and commodity prices at the end of the quarter. We are particularly taken with the degrees of volatility our markets are experiencing, from commodity prices to interest rates and near-term sentiment measures such as purchasing manager indices. The volatility is the result of the concurrent and varying economic signals, leading to waxing and waning sentiment on the degree the Fed’s action will have on our economy. As well, global economies are still resetting from the pandemic, and issues such as supply chain disruption and labor woes compound the complexities. All the while, climate change is exacerbating pressures on energy and food, with severe heat and drought limiting electricity and food output in every global region.
There is a strong probability that global central bank actions will slow inflation, suppressing economic growth. We believe capital will be scarcer, placing emphasis on differentiated business models and execution. Key considerations in our GEOS investment process are the business stability of a company, sources of growth capital and returns on investment. Our holdings are generally profitable or are on the path to profitability. Most importantly, our very investment objective addresses these global problems, from inflation to energy and food. Lately, we believe the equity markets wax and wane, solely focused on near-term data. This is an opportunistic time as there is a disconnect between stock prices and business fundamentals, the degree to which is unprecedented.
This commentary is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. The opinions and analyses expressed in this commentary are based on Essex Investment Management LLC’s (“Essex”) research and professional experience and are expressed as of the date of its release. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is intended to speak to any future periods. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties.
This does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product, nor does it constitute a recommendation to invest in any particular security. An investment in securities is speculative and involves a high degree of risk and could result in the loss of all or a substantial portion of the amount invested. There can be no assurance that the strategy described herein will meet its objectives generally or avoid losses. Essex makes no warranty or representation, expressed or implied; nor does Essex accept any liability, with respect to the information and data set forth herein, and Essex specifically disclaims any duty to update any of the information and data contained in the commentary. This information and data does not constitute legal, tax, account, investment or other professional advice. Essex being registered by the SEC does not imply a certain level of skill or training.
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