Commentary: Appreciation ESG Strategy

• Four of 11 sectors in the S&P 500 outperformed the overall index in the quarter — though only two produced meaningful outperformance — as the market was driven by a return to AI leadership.
• Tariffs remain the key risk to corporate profits in the second half of 2025, although there are positive catalysts supporting the outlook for 2026.
• Company engagements are a key pillar in ClearBridge’s climate strategy as we seek to understand and manage company-specific climate-related risks and opportunities.

The second quarter of 2025 took investors on quite a roller coaster ride. The quarter began with a post–Liberation Day dive that saw the S&P 500 Index decline 11% over the quarter’s first six trading days. Clearly, equity investors feared the economic impact from the largest potential tariff increase since the Smoot-Hawley Act of 1930. However, a decisive policy shift on April 9 — pausing tariffs for 90 days — quickly initiated a steep climb. The S&P 500 rose 24.5% in 56 trading days from the April 8 low into June 30 to finish the quarter with a 10% advance to a new all-time high. At this point it seems clear investors believe sweeping reciprocal tariffs are a negotiating tool, not a base case outcome.

Four of 11 sectors outperformed the index in the quarter — though only information technology (IT) and communication services produced meaningful outperformance — as the S&P 500 was driven by a return to AI leadership. IT stocks dominated the index, rising 23.7% and led by semiconductor and software stocks, which returned 43% and 29%, respectively (yes, in the second quarter alone). Thirteen of the 25 top-performing stocks in the S&P 500 were IT stocks, while five more were levered to powering the artificial intelligence boom. Communication services was the next best-performing sector, driven by rebounds in Netflix and Meta Platforms following the tariff pause. Finally, industrials and consumer discretionary sectors narrowly beat the market. Industrials stock performance was led by businesses levered to data center demand growth, while travel stocks — cruise lines specifically — led the advance for consumer discretionary.

All seven underperforming sectors lagged the index by over 5% (Exhibit 1), marking the first time seven sectors lagged the index by such margins in a quarter since the fourth quarter of 1999. Energy and health care stocks bore the brunt of underperformance, declining 8.6% and 7.2%, respectively. Energy sector performance was hindered by a 9% decline in the price of oil as traders bet the current Middle East conflict would spare energy assets and be short lived.

Exhibit 1: S&P 500 Driven by AI-Heavy IT Sector

"Despite our relatively cautious stance, the backdrop for risk assets remains decidedly positive." 

Health care malaise was broad-based as health care service providers, life sciences and tools, biotechnology and pharmaceuticals were four of the seven worst-performing industries in the quarter, declining in absolute terms and materially underperforming the index. Health care service providers were hit by continued turmoil at industry bellwether UnitedHealth Group in addition to industrywide concerns over the rising cost of care. Biotechnology and pharmaceutical stocks were hit as the Trump administration intensified U.S. drug pricing pressure and threatened potential pharmaceutical tariffs. The One Big Beautiful Bill signed on July 4 cut Medicaid funding. Reducing medical spending has been a political third rail and it has now for the first time been touched.

After two outsize positive performance years in 2023 and 2024 (+26% and +25%, respectively), U.S. equity markets are digesting a mixed bag of risks and opportunities in 2025. While the second quarter saw increased volatility from concerns over the impact of tariffs on economic growth and inflation, markets quickly dismissed those concerns, rallying back to all-time highs. In our view, the U.S. stock market currently stands near fair value, lacking material upside in the short-run and vulnerable to potential downside surprises in the second half of the year. We are more focused on the outlook in 2026 when multiple catalysts could drive an acceleration in corporate profits and many of the current risks are likely to dissipate.

We believe that tariffs are the key risk to corporate profits in the second half of 2025 and are less concerned about geopolitical events or the outlook for fiscal and monetary policy. While it seems likely the tariff deal deadline extended beyond July 8, there has been slow progress beyond a few broad deal “frameworks.” Tariffs on our biggest trading partners in the EU and China are likely to stay high and take longer to resolve, while tariffs on secondary trading partners will remain in place for an extended period. To date, the impact to both growth and inflation has been muted by existing inventory and a fear of backlash for raising prices; however, our conversations with corporate management teams suggest that, while they are willing to absorb some cost, prices are likely to rise this fall as pre-tariff inventory is absorbed. We estimate that the average effective tariff rate will ultimately settle in the 14%–15% range from approximately 2.5% in the prior year. Given imports at 14% of U.S. GDP, that would increase inflation by 2% minus whatever portion of the cost is borne by foreign exporters.

While the overall economy can absorb that impact without a recession, we believe that current profit estimates are too high and are likely to weaken. Housing, autos (Exhibits 2 and 3) and investment spending excluding AI are all starting to weaken and should become more pronounced in the months ahead. Fortunately, inflation expectations continue to be well anchored, and although higher tariffs are likely to lead to higher goods inflation, lower oil prices and a slowing housing market should help to offset those pressures. We expect long-dated rates to remain higher for longer as deficit concerns are real and worrisome.

Exhibit 2: Housing Growth Weakening

Exhibit 3: Auto Sales Also Under Pressure

Despite our relatively cautious stance, the backdrop for risk assets remains decidedly positive, suggesting that pullbacks remain buyable. Credit spreads have again tightened to all-time lows (Exhibit 4), market breadth remains positive with nearly 75% of S&P 500 stocks above their 50-day moving average (Exhibit 5), the yield curve remains positively sloped with well-anchored short rates, and capital markets activity appears to be accelerating.

Exhibit 4: Low Credit Spreads Suggest Investor Confidence

Exhibit 5: Market Breadth Has Improved

Our economic and market outlook has improved since the administration softened its stance on Liberation Day tariffs. Although we believe the market is fully valued, policy remains favorable to economic growth in the near term while capital markets conditions suggest risky assets — such as stocks — can continue to perform well. As such, we have leaned incrementally into more cyclical areas of the market while lightening our exposure to traditionally defensive sectors. That said, we are long-term investors focused on outperforming through a market cycle via downside protection. We remain focused on looking out two to three years to make investment decisions based upon our assessment of a company’s longer-term sustainable earnings growth rate versus what is implied in today’s share price while being mindful of how near-term earnings trends or government policy outcomes could impact the road ahead.

The ClearBridge Appreciation ESG Strategy underperformed the benchmark S&P 500 Index in the second quarter. On an absolute basis, the Strategy had gains in eight of 11 sectors. The IT, communication services and industrials sectors were the main positive contributors to performance, while the health care sector was the main detractor.

In relative terms, overall stock selection contributed positively but was offset by negative sector allocation. Stock selection in the IT, communication services, materials and energy sectors and health care and energy underweights added the most, while stock selection in the health care and financials sectors, an IT underweight and materials and consumer staples overweights detracted.

On an individual stock basis, the biggest contributors to relative performance during the quarter were Apple, Netflix, Eaton, Broadcom and Emerson Electric. The biggest detractors were Nvidia, Berkshire Hathaway, Costco, UnitedHealth Group and WEC Energy.

During the quarter, we initiated new positions in Texas Instruments and Palo Alto Networks in the IT sector and Old Dominion Freight Line in the industrials sector. We exited positions in Workday and Arista Networks in the IT sector, U.S. Bancorp in the financials sector, Merck and UnitedHealth Group in the health care sector and PepsiCo in the consumer staples sector.

For almost 40 years ClearBridge has been incorporating climate risks and opportunities into our fundamental investment strategy. As climate has become more and more relevant in our portfolios, we have taken steps to enhance our process and ensure material climate metrics are appropriately captured.

Company engagements are a key pillar in ClearBridge’s climate strategy as we seek to understand and manage company-specific climate-related risks and opportunities. ClearBridge engagements on environmental, social and governance (ESG) topics generally have two overlapping objectives:

1. Research: Gaining a better understanding of ESG issues that could impact our investment thesis.

2. Impact: Encouraging specific changes at the company to better align its operations with sustainability best practices.

Across these two objectives, our engagements span many different climate-related topics (Exhibit 6), with engagements primarily focused on higher-emitting sectors.

Exhibit 6: Top Environmental Factors Engaged Upon in 2024

ClearBridge’s model for ESG integration, which includes ESG discussions as part of fundamental company research led by our investment teams, allows climate-related engagements to be thoughtful and well-rounded discussions on climate topics. As the following examples show, our analysts and portfolio managers cover very different topics in discussions with companies in very different sectors while still focusing both on companies’ climate strategies and the connection of these strategies to the companies’ business case.

Amazon.com: A Fully Integrated Approach to Climate

In September 2024, ClearBridge joined Amazon for a group discussion with the company’s ESG and Energy Sustainability teams as part of Climate Week to discuss Amazon’s environmental strategy. Amazon went into the many components of its company-wide initiative to achieve net zero by 2040. Each business unit — grocery, studios, AWS — has dedicated sustainability leads, with a team led by Head of Energy and Sustainable Operations Chris Roe ensuring carbon goals are embedded in annual plans and reviewed by leadership. In setting its strategy, Amazon focuses on metrics specific to different business units like carbon per dollar of gross merchandise value (GMV) in retail and per unit of compute in AWS. Amazon has also launched a $2 billion fund to accelerate decarbonization technologies into commercial products.

Cost and carbon are highly correlated in Amazon’s climate strategy as retail operations get more efficient. Major challenges include reducing Scope 1 emissions from middle-mile logistics, where diesel trucks remain a bottleneck. However, progress is evident in last-mile delivery: 680 million packages were delivered by EVs in the previous year. Efficiency gains in packaging have also led to a 40% reduction in packaging waste over nine years.

Internally, Amazon uses climate risk models to anticipate energy usage and drive real estate design. Factors in the models include generative AI’s future energy needs, growth of Amazon’s fleet, locations of logistics facilities and water availability for different sites.

While ClearBridge encourages emissions reduction targets aligned with the Science-Based Targets initiative (SBTi), Amazon appears to have a responsible approach of setting internal science-based targets per business unit, although these are not formally verified by the SBTi. Amazon does, however, work with both SBTi and academics to align with International Energy Agency pathways. The company avoids offsets for interim targets, reserving removals like direct air capture for residual emissions — which are expected to be mostly Scope 3 by 2040.

This discussion provided us with a better understanding of Amazon’s climate strategy and we remain positive about its climate efforts. Our biggest takeaway was how well resourced and data driven Amazon’s climate efforts are from an organizational standpoint, driving down the cost/carbon impact per dollar of value with the value metrics being defined at a segment level: e.g., carbon footprint per unit of compute for AWS or per dollar of GMV in Retail.

Microsoft: Powering AI Responsibly

In November 2024, ClearBridge held a call with Microsoft’s sustainability investor liaison to discuss shareholder concerns on energy efficiency, as with the huge growth of AI has come a massive demand in energy as well. We discussed Microsoft’s AI energy needs and its goals to become carbon negative. Microsoft reconfirmed its commitment to achieving its climate goals with its recently announced power purchase agreement for nuclear power with Constellation Energy, which involves restarting Three Mile Island. Microsoft clarified it won’t own or operate this facility, but will be a customer of Constellation, with which Microsoft has maintained strong supplier conduct statements. When asked about safety concerns, Microsoft explained the reactor slated to be restarted was functioning safely and effectively for decades before being turned off for economic reasons in 2018. This represents a significant part of Microsoft’s commitment to nuclear power. The company sees this agreement as part of achieving its 2030 and 2050 carbon emissions targets (for net negative emissions).

As it relates to renewables, Microsoft continues to encounter the issue of intermittency (as do peers). It is conducting research on power battery storage and other mechanisms to solve this issue and includes deals for wind and solar in its portfolio approach to its power generation needs.

We were encouraged to hear Microsoft is still committed to bringing carbon emissions back down as energy needs increase. Since this engagement, Microsoft has also announced many agreements to purchase offsets, as the energy efficiency of AI, particularly in data centers, is still a challenge. We continue to see Microsoft’s climate strategy as leading among peers and will continue to engage with the company on this topic.