The Federal Reserve increased interest rates again on May 3, 2023, by a quarter point, making it the Fed’s tenth rate hike since March 2022 in an ongoing battle to curb inflation. These interest rate increases have resonated in the economy, increasing the prospects of a recession in times of tightening concerns about the fragile state of the banks.
The interest rate hikes also put sustainability-oriented investing, better known as ESG investing, into disarray.
The trend toward ESG investing, which puts pressure on companies to meet environmental, social and governance benchmarks, has nearly redefined asset management over the past decade. ESG funds are a thing these days billion market.
The current high uncertainty surrounding interest rates, along with the prospects of a looming recession and a political reactionhas placed the future of ESG investors at a crossroads.
I specialized in sustainable financingand my recent work has the have an impact on those difficult economic times could have on the demand for ESG investing. Investments in American sustainable investment funds have done so visibly slowed down since 2022, with the worst net flows in five years. Here’s how three crucial factors could influence investors’ willingness to engage in socially conscious investing in the future.
Uncertainty about the interest rate
One of the main arguments that large institutional investors like BlackRock make for ESG investing is that this is the case creates long-term value for shareholders. It is believed that companies that pay careful attention to environmental, social and governance issues will be better prepared for risks in the distant future, including regulatory risks and physical risks from climate change.
However, increased uncertainty about interest rates poses a challenge today. That’s because higher interest rates can disproportionately impact the cash value investors place on long-term investment results. Let me explain.
Over the past year, the Federal Reserve has raised its key interest rate from near zero to a target range from 5% to 5.25% to fight inflation. In the financial markets, higher interest rates lead to higher discount rates. That means that future cash generated by long-term investments is considered significantly less valuable at today’s higher interest rates.
The further in the future the value of an asset is, the more heavily its value will be discounted when interest rates are high. Long-term investments are therefore – like most ESG investments – particularly sensitive to changes in interest rates.
This economic mechanism was also part of the backdrop to the recent decline in technology stocks and the series of bank failures that began with the collapse of Silicon Valley Bank.
An impending recession
Another factor that can impact ESG investing is the likelihood of an economic downturn.
If research showsinvestors do not necessarily make ESG investments for higher returns in the long term, but often for altruistic reasons or because of personal preferences to hold greener assets. For these ESG investors, a looming recession could change their view of this “luxury.”
In an early warning about this possibility a recent study In research with an economist from the Rotterdam School of Management, I found that retail investors showed signs of being reluctant to invest in sustainable investment funds during the early months of the COVID-19 shock in 2020. This was a period when many households were experiencing layoffs and furloughs , which likely prompted them to put aside luxuries and prioritize protecting the values of their 401(k)s, IRAs and other investment portfolios.
In other words, investors may be all for ESG, except in difficult times.
Prominent economists, such as former Treasury Secretary Larry Summers, have warned of one likely recession while inflation and the Fed’s battle against it continue. So does the International Monetary Fund lowered its outlook for global economic growth from 3.4% in 2022 to 2.8% in 2023.
Finally, recent political friction and anti-ESG policies in several states have begun to create headwinds for pension funds and large institutions that serve them.
For example, Florida And Kansas has passed laws in recent weeks and several other states included Texas And Kentucky have taken steps to limit the ability of public pension funds to invest in companies based on their ESG performance, citing concerns about fraudulent greenwashing and potential breaches of fiduciary duties, citing the obligation that institutional investors have to provide the highest to achieve returns at the lowest possible risk.
These restrictions could severely limit the capacity for ESG investing by institutional investors, who have played a key role in driving the growth of ESG investing.
a recent research from economists at Wharton and the Federal Reserve Bank of Chicago found that a Texas law enacted in 2021 that bars municipalities from contracting with banks with ESG policies had a distortive side effect on those municipalities’ borrowing costs. The policy ultimately increased the cost of public finances, meaning the law ultimately cost taxpayers.
Navigate the intersection
As companies hold their annual meetings in 2023, the discussions among company officials, investors and stakeholders will serve as an important barometer for the current state and future of ESG investing.
Due to the high interest rate uncertainty, the prospects of a recession and political unrest, ESG is under pressure. In recent years, stakeholders have been seen as a paradigm shift in how market mechanisms can address harm to society Taking a closer look at ESG investing with a critical eye on how strong it can endure and how much impact it can have.
The coming years will be the most important stress test yet.