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Investment Office Insights Q2 2022 – ESG performance and should we be concerned about a recession

8 min read 5 Dec 22

The Investment Office Insights article is a quarterly thought leadership piece which covers 2-3 topical items that the Investment Office think are worthy of comment and analysis. Each quarter, you will get a chance to hear from various teams within the Investment Office, depending on what is topical at the time.

In this quarter’s Investment Office Insights we hear from two different teams within the Investment Office. The Multi Asset Portfolio Management team provides an insight into the factors affecting ESG performance, and the Long Term Investment Strategy team investigate the possibility of another recession.

Around $600bn was invested into sustainable mutual funds and ESG exchange-traded products in 2021globally, with European investors leading the charge. It is clearly the right thing to do - allocating capital to help move the planet towards a sustainable future - but clients will also, understandably, be wondering how this style of investing could impact their returns and chances of achieving their investment goals. Performance dispersion has been larger than usual this year, so analysing what has driven these moves may help to provide some reassurance.

Source: Bloomberg, MSCI and M&G Investment Office, as at 31.03.2022

Past performance is not a reliable indicator of future performance.

Source: MSCI and M&G Investment Office, as at 31.03.2022

There are many different approaches to ESG investing. Some look for best-in-class companies and exclude entire industries, while at the other end of the spectrum we have funds that moderately tilt away from traditional index weights, rewarding companies with higher ESG scores and those making greater efforts to transition.

Taking UK equities as an example, the stocks held across various ESG funds can differ materially.

However, one thing that most of these products have in common is a lower allocation to the Energy and Materials sectors.

There has been significant dispersion in equity sector performance in 2022. The spread between the best and worst performing UK sectors has been the largest since 2009, and the standard deviation of quarterly sector returns is double the 10-year average.

With supply constraints and strong demand, due to the reopening of economies after COVID-19 lockdowns, the Energy sector started the year well. Russia’s invasion of Ukraine supported a further ascent in commodity prices, boosting the performance of many of the stocks that operate in these industries.

Source: BlackRock Aladdin, MSCI and M&G Investment Office, as at 31.03.2022

The huge outperformance of Energy and Materials has played a large part in the underperformance of many ESG strategies this quarter. For the MSCI UK ESG Leaders Index, sector exposure differences explain about 60% of the recent lag (vs MSCI UK), and for the MSCI UK ESG Universal Index, which seeks to minimize exclusions, as much as 80% of its underperformance can be explained by sector weights.

As with most investments, ESG building blocks are likely to form part of a longer-term strategy. There will undoubtedly be periods of outperformance and underperformance, when sector dispersion is high, but we must remember that investing is a marathon and not a sprint. Sustainable investing will help us deliver better outcomes for future generations and should not be detrimental to longer-term returns. Innovators and companies with strong governance should reap the rewards over time and many that fail to transition will pay a heavy price.

The last recession, triggered by the coronavirus pandemic, was one of deepest but also the shortest US recession in history(1). With the springboard recovery in the first half of last year, at times, 2021 felt much more time-compressed compared to recent economic cycles. Unsurprisingly, we are already facing higher inflation and expectations of slowing growth(2). It coincides with a time when policy supports are being withdrawn. This raises the question: is it time to worry about a recession? To help us answer this, we assess various indicators to gauge where we are in the business cycle.

1 NBER, business cycle dating committee announcement, July 2021

2 Consensus Economics

Understanding the business cycle

Contractions and expansions are two phases of a business cycle. Expansions can be further divided into early-, mid- and  late-cycle phases. To differentiate between these phases, it is common to look at the difference between the current and the potential level of output. This is known as the output gap. For our purpose potential output is the level of output sustainable in the long run. Sustainability refers to a lack of inflationary pressure. Using this concept, we can define the phases:


Output gap

Financial conditions


Early-cycle or recovery

Negative but converging to potential


Below target

Mid-cycle or expansion

Neutral, but turning positive


Rising, getting close to target

Late-cycle or overheating



Above target

Slowdown or recession

Easing, close to or below potential output


Slowing, falling close to or below target

In practice the business cycle is not as neat as this. Although the cycles are recurrent, their phases do not always follow sequentially. Noisy data can also send contradictory signals. However, we can still use a wide range of indicators to assess where we are in the business cycle. These indicators would naturally interact with growth. In particular, we look at leading economic indicators (LEI). These indicators correspond to near-term movement in economic activity. Examples include Purchasing Manager Indexes (PMIs), yield curve measures and consumer expectations. A composite index of these indicators can help signal turning points in a cycle.

Both T&IO's in-house and external(3) leading economic indicators are currently pointing to positive but slowing growth. Recent inflation prints have also come out significantly above target. For that reason, growth and inflation are two key components requiring our attention.

Growth slows but expected to remain positive

A strong recovery in 2021 has meant that most of the major economies have now reached their pre-pandemic level GDP (except Japan). Econometric models and observations of long-term growth rates indicate that economies are also converging towards their potential output levels. The United States is leading in this respect. It is on track to close its output gap this year(4). Latest forecast also show collective downward revisions to this year’s growth expectations. These revisions have come from various institutes including the government, central banks, and market participants.

Figure: Annual GDP Growth and Median Consensus Forecast

Source: DataStream, Consensus Economics (Mar 2022 estimate)

Forecasts are not a reliable indicator of future performance.

There are several reasons underlying the slowdown. First, it is inevitable that the rate of growth will naturally slow from the high pace of 2021, and we note that last year’s growth reflected a rebound in activity from the lockdowns of 2020 (base effects). And secondly, whilst activity has rebounded, the pandemic is yet to go away. We are still faced with supply bottlenecks and rising prices, although with signs that global supply chain pressures may have peaked(5).

Next, high energy prices were expected to moderate in the coming months. However, the energy market is once again being disrupted by an exogenous shock coming from the war in Ukraine. Consumers, accounting for 60-70% of economic activity, may become anxious yet again. A higher cost of living has already been a consistent source of concern reported by consumers(6). Whilst nominal wage growth has been strong in most parts of the developed world, real wages are lagging. Consumer sentiment is also deteriorating from last year’s peak across developed market economies. Therefore, a lack of growth in real wages and declining sentiments may contribute to slow spending.

These uncertainties come at a time when policy support is being withdrawn. A tightening monetary landscape, by design, is expected to increase debt servicing burden on the economy, moderating growth. However, we observe that the tightening cycle starts from a highly accommodative policy stance. A steady deleveraging in both the household and corporate sector over the past decade means that their starting positions are also shielded against higher rates. Therefore, whilst each of these presents potential to slow growth, it is difficult to pinpoint how much growth will slow by and exactly when. This ultimately means we could have a slower and more uneven recovery.

Inflation remains elevated

Whilst the picture for growth is complex, medium-term inflation outlook is much clear. High inflation remains a pressing concern for most parts of the world. Temporary drivers of inflation have been lingering around for longer than anticipated. This includes supply chain disruptions and volatile energy prices. Energy accounts for roughly 10% of an inflation basket for advanced economies. Even before the Russian war, crude oil and natural gas prices were elevated. This was a by-product of the pandemic. As economies reopened, global energy demand were outpacing supply. There is now an added uncertainty coming from the war. Russia is responsible for 12.5% of world output of crude oil. They also supply around 20% of the world’s natural gas production. Both Russia and Ukraine are also key producers for world agricultural commodities. Together they account for 30% of global wheat exports.

Excluding these volatile food and energy prices, some of the alternative measures of inflation are also signalling that inflation pressures are broad-based. This further adds to risk coming from second-round effects. Put differently, a prolonged period of higher inflation may result in a second wave of price increases. A strong labour market is another factor which could lead higher wage growth being passed through to consumer prices. A combination of high level of job openings and low unemployment rate gives more bargaining power to the workers to push up wages.

Together, these factors points to positive inflation surprises and we have seen material upward shifts in consensus inflation projections for 2022 (chart below).

Figure: 2022 Inflation Forecast vs 10y average inflation* (%)

Source: DataStream, Consensus Economics. *10 year average from 2010 to 2020.

Recent projections by central banks also show significant uplift to inflation expectation. Policymakers have moved away from characterising high inflation readings as “transitory”. In the UK, annual inflation is now expected to peak around 8.0% this year. This is more than 2 percentage points higher than expected in November. The Federal Reserve also increased their forecast for this year’s Personal Consumption Expenditure(7) (PCE) from 2.7% in December 2021 to 4.3% in March. To help tame these rising prices, the Bank of England became the first major central bank to start hiking rates in December last year. The Federal Reserve also initiated raising the Fed Funds Target rate at its March meeting.

We note that base interest rates have begun to increase, albeit from a highly accommodative starting position. In addition, other measures of financial conditions, such as supply and demand of credit, still points to an expansionary phase of the business cycle. For instance, results from the Senior Loan Manager Survey and the Bank of England’s Credit Conditions Survey reveal that criteria for credit  lending remains easy. This is favourable for the household and the corporate sector where credit demand is still strong.

3 OECD, Conference Board, New York Fed - April 2022

Oxford economics - April 2022

5 NY Fed Global Supply Chain Pressure Index - April 2022

University of Michigan Consumer Survey and The GfK Consumer Confidence Index - April 2022

Federal Reserve’s preferred measure of consumer price inflation - April 2022


The combination of closing output gap, above target inflation, are mitigated by still-loose financial conditions and solid private sector balance sheets. Weighing these considerations, we expect that any slowing of growth momentum will likely be reflective of a mid-cycle slowdown rather than an outright recession. Having said that, central banks will need to walk a treacherous path between maintaining growth and containing inflation.

The value of any investment (and any income taken from it) can go down as well as up so your customer might not get back the amount they put in. The views expressed in this document should not be taken as advice or a recommendation.