Strategist's Corner Episode 5 - Blue Suits and Greenflation: Exploring ESG Integration­

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  • 22 mins 19 secs
Rob Almeida, global investment strategist, and fixed income ESG analyst Mahesh Jayakumar discuss in this podcast episode how ESG is simply another input into our bottom-up fixed income process, as well as what greenflation is and its impact.
Channel: MFS Investment Management

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Rob Almeida:

Hello. Welcome to another edition of MFS Strategist Corner podcast. I'm your host, Rob Almeida.

Disclosure:
The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security, or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob Almeida:

In this episode, I'm joined by MFS's ESG fixed income analyst, Mahesh Jayakumar, to talk about ESG, integration and something called greenflation.

Rob Almeida:

All right, so thank you for joining us.

Mahesh Jayakumar:

My pleasure.

Rob Almeida :

Yep So give the audience context. When did you join MFS? Where did you come from? And maybe even go back. What got you interested in financial services?

Mahesh Jayakumar:

So I am very happy and proud to say that I've been part of the MFS family for three years now. I joined in Spring 2019. I was previously with the State Street Global Advisors for a decade. I used to run actually beta fixed income portfolios in both an ETF and commingled space global credit and government bonds.

Rob Almeida :

So all fixed income?

Mahesh Jayakumar:

All fixed income.

Rob Almeida:

Yep.

Mahesh Jayakumar:

And it's funny. I tell people with a lot of pride that I used to be ... I'm a computer scientist by training, right? So I used to write code for a living. I've written code in the airline industry. I've written code in the telecom industry.

Mahesh Jayakumar:

Went to business school and switched to finance and joined State Street at that time through their management training program. And so my tech friends always tease me about going to the dark side.

Mahesh Jayakumar :

"You ditched us and you moved to finance from the world of tech." But I find fixed income markets, macro, absolutely fascinating, right? I kick myself like 'how did I not get interested in the markets when I was firmly in the technology industry, when I was writing code for a living?' Because everybody should know about the markets. Everybody should understand what is happening with inflation. Why is-

Rob Almeida:

Well, how money works.

Mahesh Jayakumar:

Or how money works.

Rob Almeida :

Right.

Mahesh Jayakumar:

So it's amazing. So to me, the financial services industry ... And especially being in an investment manager and a research analyst, it's one of the most exciting roles because you are constantly learning, seeking, understanding. What better job than that, right?

Rob Almeida:

Right, right.

Mahesh Jayakumar:

And then I also spend some time at Oppenheimer Funds up in New York, in between State Street and MFS.

Rob Almeida:

So you're an ESG analyst for us in fixed income. So we understand the fixed income component. When did the ESG element come into your life?

Mahesh Jayakumar:

The ESG element came into my life at State Street because we in 2011, believe it or not, we launched one of the first green bond, smart beta systematic strategies. And the idea was to give dedicated green bond exposures, especially in an asset allocation context.

Mahesh Jayakumar:

If you can imagine, at that time green bonds were extremely high quality, super issuance, govi- issuance. And the idea was to replace part of a pure govi portfolio in asset allocation context with green, if you will, because the use of proceeds of green bonds after all are supposed to directly fund ESG projects and environmental projects.

Mahesh Jayakumar:

So that was my first taste of ESG. But at that time we also ran, just like we do at MFS today, we also ran a lot of ESG based exclusionary funds and strategies for clients. You can imagine religious investors, the churches of the world, have always had a bent towards excluding certain sectors in their portfolios-

Rob Almeida:

Faith based investors.

Mahesh Jayakumar:

Faith based investors, value based investors. So MFS, my previous employer, all - most managers I know, their ESG 101 if you will as an asset manager, was running this sort of exclusions based.

Rob Almeida:

Yeah. Customized solutions-

Mahesh Jayakumar:

Customized SMAs. Exactly.

Rob Almeida:

Got it.

Mahesh Jayakumar:

And there's nothing wrong with that approach because the idea is that, look, I'm expressing my values in my portfolio. I don't want to fund whatever - fossil fuels, tobacco-

Rob Almeida:

Well, if a client wants a blue suit, you give them a blue suit.

Mahesh Jayakumar:

Blue suit. Exactly. And that's what many managers are still doing by the way. And it's okay. It's values based investing it's ESG 101. Now I would argue that there's better ways to do ESG investing.

Rob Almeida:

Right.

Mahesh Jayakumar:

And of course the market has picked up on that. MFS is firmly a believer of ... ESG has to be a holistic means of incorporating into an investment process, and not a blunt tool where you just exclude sectors and that's it. You don't care about the sustainability profile. You can't do that.

Rob Almeida:

Well, let's unpack that and I'll play for the sake of the audience devil's advocate. So I think the way the industry talks about ESG today is it's an output and I'd offer it's an input, just like any other fundamental input.

Rob Almeida:

When I think about investing, oftentimes the things that can really blow you up, go awry, it's things that you can't count, that you couldn't wrap your arms and maybe not the E but certainly that the S and the G in ESG.

Rob Almeida:

So talk a little bit about maybe some of the problems you see in the state of ESG investing today and what you think the right approach is.

Mahesh Jayakumar:

I love that analogy, Rob. It's not an output, but it's an input. That's exactly how MFS thinks about it. So if you are an active investor and you think about how we invest in fixed income, you think about business strategy. What are the sources of revenues and uses of cash?

Mahesh Jayakumar:

You think about the issuer's credit profile and what is the chance for a downgrade or an upgrade? You think about liquidity of a bond, right? If I buy this bond from this issuer, can I trade it in the future?

Mahesh Jayakumar:

You also think about relative value. Is this particular issuer's bonds trading rich or cheap? Now, as I mention all those factors, ESG is one of the other factors that you would consider in this multi-pronged equation of how you look at an issuer.

Mahesh Jayakumar:

And the reason ESG is important is because it's a non-financial factors. Think about what ES and G are. Right?

Rob Almeida:

I like that.

Mahesh Jayakumar:

These are non-financial factors.

Rob Almeida:

Yep.

Mahesh Jayakumar:

And the idea with non-financial factors and the reason you look at them is number one, they are a risk mitigation tool, right? So if in fixed income, if you think about the fact that we're going to get par back at the end of the maturity of our holding, you are managing for downside risk, right?

Mahesh Jayakumar:

Not to say that you can't take advantage of opportunities that might keep the bond stronger, but in general in fixed income as a practitioner you're thinking about downside risk and avoiding downside risk.

Mahesh Jayakumar:

The idea of looking at ESG as non-financial factors is precisely to avoid downside risk because if an ESG risk manifests itself, just like you said, in a controversy, in a blow up, what happens? That causes bonds to widen and then draw down. So the idea is-

Rob Almeida:

It creates financial materiality.

Mahesh Jayakumar:

Exactly. It creates financial materiality. And the idea then is this non-financial factor risk somehow going to play into financial materiality via the transmission mechanisms that you can think of?

Mahesh Jayakumar:

Is it a hit to revenues? Is it going to increase your expenses? is it going to be balance sheet liability in the future? So this is why understanding ESG factors is extremely important. It should be part of your holistic investment thesis if you will. And that's exactly how we do it.

Rob Almeida:

So then let's take a step back. Give us a day in the life. So obviously I know the answer to this question because we've worked together now for over three years and I watch you inside the fixed income department, but how are you trying to help MFS investors contextualize and incorporate that into their models?

Mahesh Jayakumar:

So the most exciting part of my day job is to work hand in hand with the credit analysts in multiple ways. Number one, guide our credit analysts, who are the ones actually doing the work, but guide them on exactly what you said, financial materiality.

Mahesh Jayakumar:

So understand what ESG factors are material from an impact on the finance of a particular issue or a company. So as you can imagine, for example, in the oil and gas industry, the E pillar, the environment pillar, is extremely material because of transition risk, climate transition risk.

Mahesh Jayakumar:

So if there is going to be a tax on carbon in the future. If there is going to be decreasing demand for fossil fuels, what does that mean for the future of these companies? So the environmental pillar is extremely important for oil and gas companies.

Mahesh Jayakumar:

Vice versa. Think about banks and financial institutions and service companies. What's the most important pillar for them? It's the S pillar, right? Human capital, customers, product quality and safety. These are some of the most important risk for services firms.

Mahesh Jayakumar:

I'm glad you mentioned the governance pillar earlier because the governance pillar is something the data analysts have always thought about even before you formalized it under the E- S and G -

Rob Almeida:

It's not new. We just-

Mahesh Jayakumar:

Exactly.

Rob Almeida:

Right.

Mahesh Jayakumar:

Exactly. So the idea there is to guide and make sure that our credit analysts are thinking about the most material ESG factors. The second aspect of working with them, especially in fixed income unlike equities, is we're not infinite shareholders, right?

Mahesh Jayakumar:

Our time horizon, unlike an equity shareholder, is not infinite. You own a short bond or an intermediate bond or a long bond. So you have to understand, yes, a particular ESG issue might play out. But is it going to play out in the time horizon as the owner of the bond that I'm concerned about-

Rob Almeida:

You've got a three year bond, but this is a risk factor in-

Mahesh Jayakumar:

10 years.

Rob Almeida:

Right.

Mahesh Jayakumar:

Is it going to affect the valuation or is there a chance for a risk happening? No. So understanding materiality, understanding time horizons, is one of the most important aspects of working with our credit analysts.

Mahesh Jayakumar:

The other thing that I talk about is this concept of themes and emerging themes. So the idea with ESG themes is they can cut across multiple sectors. So if you think about climate, climate can cut across any sector.

Mahesh Jayakumar:

And so the impact of climate risk is particular to that particular sector. So if you think about autos, right? Look at what the auto companies are doing. They're trying to move away from internal combustion engine. "ICE" vehicles as a product to EVs.

Mahesh Jayakumar:

And the idea there is, look, if we need to decarbonize our economy, transportation is one of the biggest contributors to carbon emissions. So the auto companies are basically saying our part as part of the decarbonization journey. And remember they are also going to get affected by taxes on tailpipe emissions.

Rob Almeida:

Right? Yes.

Mahesh Jayakumar:

Right? It's not only the oil and gas industry. It's also the transportation industry. So in their case, they're like climate risk and decarbonization to the auto industry is all about transitioning their portfolio from ICE to EVs.

Mahesh Jayakumar:

In the oil and gas industry, the transition might be from reducing fossil fuels a product to renewables. Right? One of the things energy companies are very good at, they understand project development. They understand deployment of large capital, managing capital risk to undertake a large energy project.

Mahesh Jayakumar:

It's the same knowhow that they can apply to renewable energy projects that they've historically done for fossil fuel projects. So you are seeing some oil and gas companies basically increase their portfolio of renewables and plan to slowly transition away from fossil fuel production while others are focusing on, "Look, we're not going to stop producing fossil fuels, but we're going to try to make our fossil fuel production better, cleaner."

Mahesh Jayakumar:

For example, the biggest things that oil and gas companies are doing today is methane abatement because methane gas is a byproduct of oil and well production. And so the idea is to make sure that methane doesn't leak.

Mahesh Jayakumar:

And you can imagine methane is four times as potent at greenhouse as carbon dioxide. And therefore these companies, to them to certain oil and gas companies, decarbonization means reducing the overall GHG footprint, the carbon footprint.

Mahesh Jayakumar:

And that means focusing on avoidable leaks, for example. So each sector will have its own implementation of what it means from a climate and a decarbonization perspective. But that's an example of a large theme like climate affecting multiple sectors.

Rob Almeida:

Right. So about a month ago in the stairwell we were talking about inflation and we're just coming off of May's CPI 40 year high, but you said something to me that really stuck out and you called it greenflation. Talk a little bit about that.

Mahesh Jayakumar:

So let's turn by the clock. 60's, 70's you had really rapid industrialization globally, including the U.S. And companies were not necessarily thinking about their environmental footprint or how they behaved. What are the consequences of polluting the water and the-

Rob Almeida:

Just maximize profitability.

Mahesh Jayakumar:

You know, it's just maximized profitability at any cost, including, unfortunately, the environment.

Rob Almeida:

Yep.

Mahesh Jayakumar :

Fast forward, forget the ESG movement for a minute.

Rob Almeida:

Right, right.

Mahesh Jayakumar:

Stakeholders. And when I say stakeholders, governments, consumers, employees are all realizing we need to do our part in minimizing damage to the environment and to our surroundings. We need to treat our employees better. We need to treat our communities in which we're doing business better, et cetera.

Mahesh Jayakumar:

And you can call it ESG or any other name. But the idea is that there is now going to be a cost to corporations globally to become better citizens, to become behave better.

Rob Almeida:

Yeah. More sustainable.

Mahesh Jayakumar:

And more sustainable. And so that's obviously going to bleed through, into extra costs.

Rob Almeida:

Someone has to pay for it.

Mahesh Jayakumar:

Somebody has to pay for it. The companies themselves have to pay for it or they can pass it on right to the consumers. Now I'd argue in some cases, in a premium product, the consumer might be willing to pay more for a product that has been produced sustainably by the company versus an unsustainable-

Rob Almeida:

Particularly if they're in an oligarchical industry or-

Mahesh Jayakumar:

Absolutely. But I would also say in some cases it's going to be TINA, There Is No Alternative, right?

Rob Almeida:

Right.

Mahesh Jayakumar:

You know, we love the use of TINA, right? But not in this context, but I'll put use into this context, which is what happens if you don't change your sustainability behavior? You are likely going to be out of business.

Rob Almeida:

Compliance is expensive and non-compliance is even more expensive.

Mahesh Jayakumar:

More expensive. Right? You're going to be probably out of business because your competitors are going to use sustainability as an advantage to show consumers how they can produce something better cheaper, greener.

Mahesh Jayakumar:

So this idea of greenflation is that, yes, you're going to have to spend to become a better sustainable firm. But greenflation is not only that. Think about the fact that we talked about EVs just a few minutes ago.

Mahesh Jayakumar:

So the production of electric vehicles requires heavy use of nickel, cadmium, copper, et cetera. So the race to source these precious metals and other base metals in order to produce car batteries, in order to produce EV batteries, is going to drive soaring demand for metals.

Rob Almeida:

And you're seeing it in your prices, yeah.

Mahesh Jayakumar:

You're already seeing it today. So that is going to continue. That's another part of greenflation is this - is the increase in metal prices into the future because of demand for them, not only for EVs, but storage, battery storage of power, more advanced digital electronics that requires these sorts of metals.

Mahesh Jayakumar:

Any sort of digitization, battery technology, automation is going to drive up metal prices. And that's another part of greenflation. The third part of green inflation is you are already seeing physical risk, physical climate risk, wreck havoc on the climate, right?

Mahesh Jayakumar:

You're seeing floods when you have not seen ... People talked about the once in a 100 year flood or once in a 500 year flood. And now the idea is those once in a 100 year floods are occurring every five years.

Rob Almeida:

Yeah. It's not 100 years.

Mahesh Jayakumar:

It's every decade.

Rob Almeida:

Right.

Mahesh Jayakumar:

So you can imagine what that sort of physical risk does to agriculture and agriculture crop producing land. So if crop producing land is going to experience more weather shocks, the productivity of that land is going to go down.

Mahesh Jayakumar:

And so that's going to hike up food prices. You're already seeing that at play-

Rob Almeida:

More stress on the supply. Oh, you're already seeing it right. Through

Mahesh Jayakumar:

... through the Russia Ukraine war as we know it. There it wasn't a climate shock. It was a manmade war shock. But nevertheless, this is what happens when grains cannot reach half of Africa and the developing world.

Mahesh Jayakumar:

So even if you don't have a war, if you have climate-related weather risk on crops that's going to drive up the price of food. And finally, deglobalization. You and me have talked about deglobalization. What does it mean for onshoring supply chains?

Mahesh Jayakumar:

That's extra costs. And you could argue what is the connection between deglobalization and ESG you ask, Rob? Well, maybe you are reshoring production to friendlier regimes as opposed to hostile countries. And therefore you are basically managing governance risk for lack of a better word by reshoring production to friendlier regimes.

Mahesh Jayakumar:

So all in all, the more I think about this very carefully I don't see how we're going to escape greenflation. Now, I'm not passing judgment on whether it's good or bad. I'm just stating the facts that these are the conditions that will lead to higher prices, higher production costs and higher expenses.

Rob Almeida:

Well, and let me skip to the punchline. So you mentioned thinking back to the 50's and 60's, if you look at any chart and you see the growth of the Dow or the S&P and you juxtapose that against GDP looks like a massive alligator mouth, particularly the last 10 to 12, 13 years.

Rob Almeida :

There's a reason for that. So you had profit maximization that came at the expense of stakeholders. It might have came at the expense of to the labor base. It might have came at expense of the environment, pollution, et cetera, et cetera.

Rob Almeida:

And these things are reversing. So it's not just the cost of capital, but it's onshoring, it's now having to shift from single use plastic to recycled plastic and someone has to pay for it.

Rob Almeida:

Now, the rebuttal I often get from clients is, "Well, the consumer will pay for it through higher inflation." Well, what always happens is the consumer substitutes. Technology, which is greater than ever before, allows for that substitution.

Rob Almeida:

So it not only gives us a window into how a company operates where maybe they could operate in the shadows a bit more. They can't operate in the shadows anymore, and they can substitute for a company that is operating in a more sustainable way.

Rob Almeida:

So it just seems to me the answer's so simple, the outcome, which is a much narrower gap between average S&P or benchmark operating margins and GDP. The reverse of the last 10 to 12 years.

Mahesh Jayakumar:

And by the way you're seeing it already. And I was reading an article. This is not a - in the U.S., for example, a blue east coast or coast versus a red interior phenomenon. I was reading articles about the fact that the arrival of the F-150 EV truck, by the way, the demand for those EV trucks in the Heartland is more than ever, right?

Mahesh Jayakumar:

Because folks have realized when you have a sticker shock at the pump with $6 diesel and $5 gas, an EV truck looks very appealing. And if what we are discussing plays out, which is inflation in commodities. Inflation in even oil, for example, because of the fact that as oil and gas companies look at the horizon and say, "Uh-oh. There's going to be decrease in demand for our products." They have basically cut CapEx for the past decade, Rob, as you know.

Mahesh Jayakumar:

So the oil and gas complex has also cut investments in new oil fields, in new exploration, which means that the potential for gas prices can be very high is going to continue for a while. Right? That supply shock is going to continue. That's going to make EVs look even more appealing to-

Rob Almeida:

Yeah. The break even rates are so much lower now. Right. Right.

Mahesh Jayakumar:

So you are absolutely right. I mean, the one good thing about mankind and markets is we always know how to adapt. We have historically adapted. And I think we will adapt to this new regime if you will, Rob, of higher prices, deglobalization and higher and supply demand gaps and constraints.

Mahesh Jayakumar:

We will adjust. But the adjustment, as you have already pointed out in prior podcasts, it's not going to be free. Somebody has to pay for it. And we'll see. In some cases it'll be consumers. In some cases, it'll be the companies themselves taking hit to margin.

Rob Almeida:

And to put a bow on this, that's where integration, ESG integration, as an input matters so much and discerning between: what's ESG factor? Is it financial immaterial? And is it in the asset price? Because ultimately that's our job. That's what we're trying to solve for. And that's why you're here.

Mahesh Jayakumar:

Thank you. No, exactly. Our credit analysts ... Think about what a fixed income credit analyst is thinking about. Free cash flow, EBITDA. Free cash flow, EBITDA.

Mahesh Jayakumar:

And to your point, how is this extra cost affecting revenues and indirectly EBITDA and free cash flows? Or how is it going to decrease demand for their product permanently? Right.

Rob Almeida:

Yeah. EBITDA for the audience, define that.

Mahesh Jayakumar:

It's the ultimate measure of understanding if a company is going to be solvent. How are they spending their ... How are they raising and how are they spending, right? Which is earnings before interest taxes, depreciation, and amortization.

Mahesh Jayakumar:

It backs out all the accounting expenses if you will, and looks at tangible expenses and tells you the revenues minus the actual tangible expenses. What does that look like for a company?

Rob Almeida:

Thank you. Thank you for joining us.

Mahesh Jayakumar:

My pleasure, Rob. Thank you.

Rob Almeida:

Appreciate it very much.

Mahesh Jayakumar:

Thank you.

 

 

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