02 July 2020
Rahul Mathur of GAM Investments discusses the importance of integrating ESG framework into investment strategies from their inception.
From micro to macro
Sustainable investing is synonymous with allocating capital to companies aligned with sustainable business principles. A whole industry has grown to evaluate companies according to environmental, social and governance (ESG) criteria, as well as to provide quantitative ratings. We believe this singular micro (or firm-level) focus has crowded out any meaningful discussion around the potential for macro (or economy-wide) opportunities for sustainable investment. This is in spite of the facts that (1) the foundations of the ESG guidelines adopted by firms, in addition to the existence and functioning of capital markets, are shaped by economic systems and macroeconomic policies and, (2) the sustainability of overall economic growth and the net impact of externalities are driven by the cumulative actions of individual firms operating within policy regimes.
This article seeks to introduce a global macro perspective to sustainable investing and illustrates how it is possible to differentiate between economies using an investment strategy which naturally incorporates assessment of economic sustainability.
The ESG minefield
In the fourth quarter of 2019, NatWest Markets conducted a survey among 50+ investors with assets under management of more than USD 16 trillion to gauge their approach to ESG investment1. Among their findings, almost 60% of respondents indicated their organisation’s ESG strategy is not consistently applied across investments and the lack of reliable ESG data is seen as a meaningful impediment to investing sustainably. The implication of these findings is that investors are regularly faced with asset managers attempting to overlay a veneer of ESG methodologies upon existing investment processes. In addition, where fund managers are becoming overly reliant on third party rating agencies, not only is an essential element of due diligence effectively being outsourced but also, the ability to generate alpha is diminished as fund managers passively congregate around popular buy lists.
Rather than paying lip service to the cause of sustainable investment, a credible approach to ESG investing will have incorporated sustainability within an existing investment framework from the very outset. Where ESG methodologies, consultants or teams appear to have been bolted on overnight, allocators may be right to question why those investment processes have changed and the extent to which external, third parties may be relied upon.
Fundamental analysis has always been an intrinsic part of our investment process. We rely on original economic research using publicly available data and publications to evaluate economies. Among data, leading indicators are used to help determine the likely direction of an economy. Central bank reports and economic publications provide insight into monetary and fiscal policies. To the extent that ESG factors tend to be consistent with sustainable growth and productivity, ESG factors are implicitly taken into consideration, along with a host of other macro variables, as part of a pragmatic approach to assessing the drivers of medium-term economic growth and inflation.
The factors and examples of their application
Sustainable economic growth is quantitatively defined as the upward trend in environmentally adjusted net domestic product. Qualitatively, this relates to the rate of economic growth that can be maintained without creating negative environmental externalities. For example, rapid growth today may exhaust natural resources and create environmental and economic costs for current and future generations. Such costs include pollution, the depletion of oil and fish stocks and global warming. For an economy to achieve sustainable growth, it likely needs to increase its productive potential.
We have always sought to differentiate between economies where policymakers actively pursue sustainable economic growth and those that do not. Environmental factors play a role in this assessment. As an example, we are constructive on the medium-term outlook for the Swedish economy for a number of reasons. Sweden is often ranked as the most environmentally sustainable country in the world. It has earned this ranking for its use of renewable energy resources and low carbon dioxide emissions, as well as social and governance practices. In 1995, Sweden became one of the first countries in the world to initiate a carbon tax, which has heavily reduced Sweden’s dependency on fossil fuels. The benefits of this policy approach have become increasingly evident in recent years, especially in comparison to economies employing less stringent standards. For example, economies such as China, where less rigorous environmental measures have been adopted, have been periodically forced to shut down factories in order to combat pollution. Factory shutdowns in China (Q4 2017) had a significant impact on both output and employment.
At the microeconomic or firm level, social factors include customer satisfaction, gender and diversity, data protection and privacy, community relations and employee engagement. At the macroeconomic level, however, social factors take into consideration human rights and labour standards. Both qualitative and empirical research indicates that there is a significant causal relationship from human rights to economic growth2. Economies with greater democratic freedoms and participation rights tend to exhibit sustainably higher levels of growth and, inter-relatedly, political stability. From the macro perspective, a growing number of bilateral and multilateral free trade agreements, as well as regional economic integration arrangements, contain social and labour provisions related to workers’ rights. Taken together, we believe labour standards play an important role in the functioning of labour markets, worker productivity, output, and international trade.
The Mexican economy has been at the forefront of developments in labour standards in recent years. Effective 1 July 2020, trade between the US, Mexico and Canada is governed by the USMCA free trade agreement. The USMCA outlines extensive labour provisions, including the prohibition of imports of goods made by forced labour and (relative to its predecessor, “NAFTA”) adds new commitments related to violence against workers, migrant worker protections and workplace discrimination. The updated labour provisions under the USMCA directly improve the welfare and productivity of Mexican workers, while at the same time ensuring access to a large export market in the US (accounting for 73% of Mexico’s total exports). We remain constructive on the outlook for the Mexican economy, where progress on social factors, among other considerations, has enhanced the medium-term outlook for growth and productivity.
Corporate governance factors cover the rights and responsibilities of the management of a company. Although governance issues are not always relevant to investors from a microeconomic perspective, good governance is often the outcome of government policy and is one of the cornerstones of functioning capital markets. Policies which promote corporate accountability, political stability, government effectiveness, regulatory quality, rule of law and the control of corruption collectively enhance corporate governance. Economies which score poorly along governance criteria tend to exhibit less mature and less liquid markets. These economies may be excluded entirely from some ESG-focused portfolios or, where included, views expressed could be sized accordingly. There can also be the possibility of expressing a negative view, through short positions, on an economy where policies to promote good governance might appear to be at risk.
Policies promoting sound corporate governance are often a prerequisite for both domestic and international corporate investors. Governments that proactively pursue these aims tend to be rewarded with foreign direct investment and capital inflows. For example, Mexico’s previous president, Enrique Peña-Nieto, oversaw the historic reform of the energy sector in 2013, which ended state-run monopolies and opened energy markets to investment and competition from both foreign and private companies. In the following years, Mexico awarded more than 100 contracts to foreign companies, both for oil exploration and solar and wind farms. The opening up of this sector required enhanced corporate governance and transparency in order to attract foreign participation.
A practical approach
As investors increasingly focus on ESG investing, it is important to remember that the opportunity set is considerably wider than the dominant discussion around corporate securities. How companies operate is shaped by the prevailing policy, legal and regulatory environment, which in turn influences the sustainability of overall economic growth. We feel it is essential for active investment managers to be pragmatic and inherently recognise the importance of ESG factors to sustainable economic growth.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.