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BlackRock Commentary: Net-zero transition reprices assets

Alex Brazier, Deputy Head at the BlackRock Investment Institute together with Wei Li, Global Chief Investment Strategist, Vivek Paul, Senior Portfolio Strategist and Chris Weber, Head of Climate Research all forming part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.

The transition to decarbonize the world is happening and investors can no longer ignore it. Increasing investor preferences for sustainable assets are leading to a great repricing that has a lot of room to run, in our view. This doesn’t preclude browner assets such as traditional energy stocks from staging rallies at times. This is a feature of transition, we believe, as they can benefit from mismatches in supply and demand as the economy is being rewired to reach net-zero carbon emissions.

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Past performance is no guarantee of current or future results. Forward looking estimates may not come to pass.
Sources: BlackRock Investment Institute, with data from the Center for Research on Security Prices, Feb. 1, 2022. Notes: To estimate climate-driven repricing, we attribute historic returns to two drivers: cashflow news and discount rate (DR) news. We then identify the DR news associated with climate change using carbon emission intensity (CEI)  as a proxy. To isolate the DR component of returns, we apply the standard decomposition formula of Campbell (1991) using a standard factor model of expected returns (which embed well-known predictors such as value, momentum, and quality). Attribution to climate scores is then given by forecasting regressions of DR news on a measure of CEI. Sector returns are MSCI US Sector index- weighted averages of stock-level returns. Green represents the technology sector, the most “green” in our work, whereas the utilities sector is the most “brown” in the repricing. The 2016-2019 bars represent the total repricing over this period; and the 2021-2025 expectation is the cumulative repricing we expect over that period. The estimate is highly uncertain and is based on factors including risk premia effects in other long-run transitions such as demographic trends, market pricing of green bonds, and investor survey data on how much return they would be willing to give up to for more sustainable assets. See Sustainability: the tectonic shift transforming investing of February 2020 for details.

 

How do we know the repricing is happening? Our method strips out common drivers of returns, such as news on earnings, or the impact of factors such as momentum and growth. This allows us to isolate the cost of capital and measure how it’s being affected by changing investor preferences for sustainable assets. We proxy the exposure of a company to the transition by measuring its carbon-emission intensity, or direct CO2 emissions as a share of enterprise value. What do we find? Relatively green sectors such as tech repriced positively (left chart) in 2020 whereas browner ones such as utilities showed the mirror image (right).

We posited in 2020 there was a tectonic shift toward sustainable assets underway as investors would increasingly embrace sustainability. Capital and investments would start to flow to more sustainable assets and away from less sustainable ones. We argued that this would cause a repricing over time as we believed markets would get ahead of the actual transition to a greener world. Our new analysis shows the repricing effect is real and growing, as it was negligible in the period 2016-2019 (the left bars in the charts). We believe the repricing has much more room to run, based on factors such as investor preferences for greener assets and historical changes in risk premia for similar long-run transitions such as demographics (the right shaded bars).

If that’s right, why have browner assets such as fossil fuel companies staged such a rally in the past year? Context is key. First, our repricing analysis controls for factors not directly tied to the long-run transition, such as surging demand amid the unique restart of economic activity last year. This exposed an underlying fragility in energy markets: a mix of geopolitical factors and weather-related supply disruptions hit just as European inventories were low. The result: spiking prices of fossil fuels and their producers. Second, the performance of traditional energy stocks tells you something about how the economy is currently wired. But it doesn’t say anything about where it’s going.

The rewiring will involve a massive re-allocation of resources, in our view, and transform the macro environment. There will be periods when traditional energy can benefit from mismatches in supply and demand. The root cause is that transition of the energy sector has so far been lopsided, we believe, with extra investment in renewables failing to keep pace with reduced capex in fossil fuels. The higher fossil fuel prices rise, the more competitive renewables become. The outlook for renewables is bright, and we also see lower-carbon fossil fuels playing a key role in ensuring continuity of affordable energy during the transition. The world will need to pass through shades of brown and green to reach net-zero by 2050, we believe.

Our bottom line: We see the transition driving a relative return advantage for greener sectors such as tech and healthcare over browner sectors such as energy for years to come, all else equal. There will be periods when browner assets outperform, and we see investment opportunities in low-cost oil and gas producers leading decarbonization within their sectors. Withholding capital or indiscriminately divesting from these industries is counterproductive to the transition and investor portfolios, in our view.

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Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of February 9, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point this year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.

Market backdrop

U.S. inflation hit 40-year highs in January, stoking expectations of a hawkish policy response. Two-year U.S. Treasury yields posted the biggest one-day jump since 2009. We don’t think the CPI data was a big surprise relative to those seen during powerful economic restart. Central banks are not cutting through confusion, letting markets equate near-term inflation surprises with more rate hikes. But yields fell from their highs on geopolitical jitters, and equities finished lower for the week.

Week Ahead

  • Feb. 15  – UK unemployment data
  • Feb. 16 – U.S. retail sales, IP; China PPI and CPI; UK CPI
  • Feb. 17 – U.S. Philly Fed Business Index

UK CPI and unemployment data for January could give an indication of how fast and how much the Bank of England (BoE) will further tighten its policy. We think markets are currently pricing in too many hikes; something that could persist until the BoE clarifies its approach. In China, inflation data could give clues about whether the country will stick to policy easing. U.S. retail sales will give a read on the restart’s momentum, and industrial production figures on status of supply bottlenecks.


BlackRock’s Key risks & Disclaimers:

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 14th, 2022 and may change. The information and opinions are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ’forward looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. 

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.


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