Matching Market Opportunities with ESG Investing

Chief Investment Strategist

Too many investors view environmental, social, and governance (ESG) investing as an either/or decision. Either investors embrace a broad ESG strategy designed to mitigate risk and deliver long-term value or they invest more tactically in market opportunities they perceive will be more profitable.

But why not choose both — a disciplined ESG approach and a compelling market opportunity? The increasing number of ESG ETFs means investors can do just that.

It’s time to break down existing ESG silos and use thoughtful, well-constructed ESG solutions to target market opportunities, like those available today in international developed markets, small-cap stocks, and municipal bonds:

  • International developed market stocks have attractive relative valuations and resilient fundamentals, and a softening dollar might finally spark outperformance
  • Small-cap stocks have outperformed large caps over the past three months and historically lead the market in the early stages of a rebound1
  • Municipal bonds offer attractive tax equivalent yields as duration risk shifts to credit risk in an evolving fixed income landscape

International Developed Market Stocks: Peaked Dollar May Be a Catalyst

Compared to US stocks, international developed market stocks have had a relative value advantage for some time now. For example, the Bloomberg SASB Developed Markets ex US Large & Mid Cap ESG Ex-Controversies Select Index has a 12-month forward price-to-earnings (P/E) multiple of 11.8 versus the S&P 500 Index figure of 18.2.2 What may be less widely known by investors is that international developed market stocks have delivered higher revenue growth than US stocks during the second quarter earnings season.3 But, despite being considerably less expensive and generating comparable earnings outcomes, they have continued to struggle to outperform their US counterparts.

However, a new catalyst may be emerging to propel international developed market stocks higher. The US dollar has climbed more than 11% year-to-date,4 creating a headwind for international developed market stocks. Consistent with previous Federal Reserve (Fed) monetary policy tightening cycles, the dollar advanced in anticipation of higher interest rates and during the early stages of the tightening cycle. But as the cycle matures, the dollar often begins to weaken. That could be the catalyst international developed market stocks need to improve their performance.

Potential Relief for International Stocks as Tightening Cycle Matures

Potential Relief for International Stocks as Tightening Cycle Matures

For investors considering whether to swap their international developed market equity allocation to an ESG solution, the SPDR® Bloomberg SASB Developed Markets ex US ESG Select ETF (RDMX) is an ESG alternative to standard international developed markets benchmarks such as the MSCI EAFE Index. RDMX seeks to track an index that is designed to include companies with favorable ESG traits based on the SASB materiality framework while looking to avoid those that could be more prone to ESG controversies.

Small-Cap Stocks: Starting to Shine, Ready to Lead Recovery

For much of the first half of the year, investors attempted to recession-proof their portfolios. Tightening monetary policy, fading fiscal stimulus, surging inflation, the continued aftershocks from the pandemic, China’s zero-COVID strategy, and the Russia-Ukraine War conspired to produce at least a cyclical economic slowdown, if not a full blown recession. As a result, investors flocked to Treasurys, gold, and defensive sectors like utilities, consumer staples, and healthcare.

But, one of the enduring investment lessons from the pandemic is that the economy is not the market. For example, risk assets rallied strongly at the peak of the pandemic misery. Soon — and before the economic and earnings data bottom — investors will likely begin to price in a recovery. Historically, when that happens, small-cap stocks tend to lead the market in the early stages of an economic rebound.5

In fact, the S&P SmallCap 600 Index has surged 11.6% over the past month. And entering August, small- cap stocks are on a three-month winning streak against large caps.6 If that momentum continues, an array of small-cap ETFs will likely benefit, including those that incorporate ESG factors.

The S&P SmallCap 600 ESG Index is designed to measure the performance of securities meeting certain sustainability criteria, while maintaining similar overall industry group weights as the S&P SmallCap 600 Index. Compared to the S&P 500 Index, the S&P SmallCap 600 ESG Index has higher expected EPS growth (17.2% vs. 12.6%) and a lower 12-month forward P/E multiple (12.3 vs. 18.6),7 making it an attractive opportunity for investors.

Small-cap Fundamentals Remain Sound with Added ESG Analysis

Small-cap Fundamentals Remain Sound with Added ESG Analysis

Moreover, thanks to S&P’s profitability screen when constructing the parent Index, the S&P SmallCap 600 ESG Index typically has fewer constituents with negative earnings, higher return-on-equity (ROE), better profit margins, lower financial leverage, and more attractive P/E multiples compared to similar small-cap indexes. These high quality and value-stocks may benefit investors, especially in today’s volatile market. The SPDR® SmallCap 600 ESG ETF (ESIX) is designed to capture these top-ranked companies based on their ESG score in their respective industry group.

  • Over the past few years, investor portfolios have become increasingly overweight to US large cap stocks. In anticipation of an economic rebound, where small caps tend to lead, consider the SPDR® S&P SmallCap 600 ESG ETF (ESIX).

Municipal Bonds: Offering Attractive Tax-Equivalent Yields

As a result of the Fed’s four rate hikes so far this year, rapidly rising interest rates — especially short-term rates — have left bond investors few places to hide. And with stubbornly high inflation data expected to keep the Fed in tightening mode until at least early 2023, fixed income risks likely will remain skewed to the downside in the short term. While poor conditions for fixed income investments could improve over the final four months of the year, investor caution is still warranted.

Recent data suggest that inflation may have peaked and that it’s finally beginning to decelerate. The Consumer Price Index was unchanged in July after rising 1.3% in June.8 And the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Index excluding food and energy, has fallen each month from a peak of 5.3% in February to 4.8%.9 In addition, monetary policy tightening is slowing demand and raising concerns about future economic growth. With inflation expectations falling and recession fears rising , long-term yields have declined, a positive for bond prices. For example, the US 10-year Treasury yield has fallen from a peak of 3.48% in mid-June to 2.78% in mid-August,10 raising investors’ hopes that the Fed’s tightening cycle is approaching its end. As risks within fixed income allocations shift from duration risk to credit risk, municipal bonds may be an appealing option for taxable bond investors.

Tax-equivalent yields are elevated in a fixed income landscape largely defined by historically low yields. The increasing probability of a recession has spooked fixed income credit investors, but issuers of municipal bonds remain in solid financial condition. States’ unemployment rates are at or near historic lows. Meanwhile, states’ tax receipts across multiple dimensions (e.g., income, property, etc.) are at all-time highs. And, most states received federal money through fiscal spending programs designed to combat the negative impacts from the pandemic.

So as bond investors abandon riskier credit investments, municipal bonds may offer attractive tax-equivalent yields with acceptable credit risks.

On an After-tax Basis, Municipals Still Attractive

On an After-tax Basis, Municipals Still Attractive

Because municipal bonds can target ESG goals, from improving water supplies and mass transit to energy efficiency and economic development, many investors are interested in strategies that apply ESG considerations. In fact, the municipal bond market experienced a record year for sustainable bond issuance in 2021, and total projected annual share of issuance could increase to about 13% this year. That’s up from just 5.5% in 2020.11

To meet increasing demand from investors, more ESG fixed income strategies are coming to market, including in the municipal bond ETF category. Launched earlier this year, the actively managed SPDR® Nuveen Municipal Bond ESG ETF (MBNE) is designed to invest in municipal bonds whose issuers are either leaders within their sectors in delivering ESG outcomes or whose proceeds are used toward positive environmental or social projects. Nuveen utilizes a value-oriented strategy designed to identify higher-yielding and undervalued municipal bonds meeting certain ESG characteristics.

  • To seek attractive tax-equivalent yield with acceptable duration and credit risks and favorable ESG characteristics, active municipal bond investors may want to consider the SPDR® Nuveen Municipal Bond ESG ETF (MBNE).

ETFs Make ESG Investing Simple

According to VettaFi (formerly ETF Trends), ESG investors increasingly favor simple approaches12  — and ETFs’ transparency and easy-to-understand indexes deliver.

As the number of ESG ETFs continues to grow, it will become even easier for investors to apply a disciplined ESG approach to current market opportunities. It’s also worth noting that the market downturn offers investors an opportunity to harvest portfolio losses in core portfolio positions and rebuild them with ESG funds.

And, Morningstar’s flow data on sustainable funds suggests that investors in new ESG positions may be more likely to stay the course in a market downturn. Over the first half of this year, sustainable funds grew by 2.5%, while US funds overall shrunk by 0.4%.13 Also, sustainable funds had net inflows in April and June compared to $90 billion in outflows from funds overall.14

ESG doesn’t have to be an either/or proposition. The increased availability of ESG ETFs, together with the prospect of ESG assets being stickier over the long term, make it increasingly likely that investors can position their portfolios to benefit from short-term market dynamics without giving up on the risk mitigation and long-term value potential of a broader ESG strategy.

More on ESG