About Machiavelli, Double Edged Swords and Virtuous Cycles


Michael Hasenstab, CIO, Templeton Global Macro

Many investors believe that ESG is only relevant in the analysis of corporations. Templeton Global Macro, who manage Templeton Global Bond Fund*, think differently. ESG, believes Michael Hasenstab, Portfolio Manager and CIO, can have tremendous effects on macroeconomic performance, and therefore should influence his team’s investment decision when selecting sovereign bonds. “ESG speaks to an economy’s potential as an investment destination and the sustainability of that investment. Not only does industry research support the effectiveness of incorporating ESG analysis, but we have also found it to be a critical prong of our research process,” he states in a recent white paper (Global Macro Shifts: Environmental, Social and Governance Factors in Global Macro Investing).
Economists and historians have for a long time recognised and debated the importance of environmental factors and social and political institutions for the long-term economic development of countries. Some of the early theories – going back all the way to Machiavelli in the sixteenth century – assigned great importance to the role of the environment, stressing that geography and climate determined the success of agriculture, the prevalence of diseases, and other determinants of economic growth. The purpose of environmental factors has been explored more recently by Jared Diamond in his 1997 best-seller Guns, Germs and Steel, and by Jeffrey Sachs in a 2001 paper (Tropical underdevelopment, National Bureau of Economic Research).

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Figure 1: TGM-ESG Score
As of February 2018 (Source: TGM)

In short, robust governance at the sovereign level contributes to the quality, stability and predictability of the policy environment and is likely to lead to stronger growth and greater resilience. Social conditions influence the stability of a country as well as the ability of the government to enforce policies and affect national competitiveness and efficiency. Environmental factors may have a more long-term effect on the economy at the global level, but droughts and floods in emerging and frontier markets, for example, may have devastating human and economic costs.

“In the sovereign space, ESG analysis drives our evaluations of government institutions, policymaking and social cohesion – all of these are major factors in determining the quality of a country’s macroeconomic environment. Fiscal policy and monetary policy can be run responsibly or they can run unsustainably – that difference can have a tremendous effect on the exchange rate, risk premiums, interest rates and inflation levels. We have seen those factors becoming even more critical in emerging and frontier markets where there’s greater sensitivity to policy missteps, and greater potential impact to the macro environment. We’ve often seen those types of ESG factors directly influence asset prices and the exchange rate, so it’s critical to get those assessments right in your research.”

Labour and Demographics: Double Edged Swords

In the recent ranking of the current scores for the 44 countries analysed by the Templeton Global Macro team (Figure 1), Denmark and Switzerland appear to have the highest score at 9.2 and Venezuela, the lowest at only 2.2. One of the reasons no country received a perfect score is that labour and demographics can penalise highly developed countries. “Demographics can be double-edged; a growing population can both aid in growth potential as well as create challenges for governments to generate enough jobs or create risks to social instability. Demographics also affect a country’s tendency to consume or save, which has effects on growth,” the team explains. “Labour and wages are connected to complicated issues like competitiveness and productivity. Wage flexibility increases resilience to external shocks and protects export competitiveness, while rigid labour laws push labour into the informal market and reduce tax collection.”

Virtuous Cycles

The idea of virtuous ESG cycle emphasises the importance of the TGM-ESGI score evolution. As shown in Figure 2, Switzerland and Denmark, the best ranking countries in absolute ESG score, are not expected to change in the next three years (the medium term, for the Templeton Global Macro team). This is good news of course from an ESG point of view, but it may not provide investors with opportunities to generate above-average risk-adjusted returns by investing in these countries’ sovereign debt. Conversely, countries who show the highest expected rating change represent a great opportunity.
“The most important distinction in our approach is that we take a forward-looking view. A lot of the ESG work out there takes a backward looking view, assessing just where a country stands today and where it’s been, but not necessarily where it’s headed. If you look at the traditional ESG indices they often align with a country’s GDP, so the wealthy countries look good and the emerging and less rich countries look worse by comparison. But those types of measurements don’t usually paint the full picture from an investment perspective.

For example, countries like Norway usually score high and are already wealthy, but lending to the Norwegian government is not going to provide a lot of yield. However, lending to countries that need capital and that are trying to move up the income path by implementing the right policies may often provide far greater opportunity for higher income and capital appreciation. Our participation in those markets often helps the countries get the capital they need while also providing our investors with a compelling return – those are the types of mutually beneficial opportunities that we look to identify in our ESG efforts.

Figure 2: TGM-ESG Score Differential: Projected (next three years) – Current
As of February 2018

A Tale of Two Countries

An interesting example from the Templeton Global Macro teams research is a comparison of how social factors has affected the development in Greece and Ireland.
The global financial crisis dealt a heavy blow to several eurozone countries. The sudden spike in unemployment and the need to implement austerity measures tested social cohesion and political consensus to an unprecedented degree. The strength of social factors became a crucial determinant of resilience and success. Greece and Ireland are arguably the two clearest, diametrically opposed examples, as illustrated by the graph in Figure 4.
Since its first bailout in 2010, Greece had to adopt a number of strict measures, including fiscal austerity and structural reforms. The fiscal adjustment was frontloaded and based more on permanent expenditure cuts than tax increases, and in total amounted to a staggering 20% of GDP between 2010 and 2014. Shortfalls in revenue collection and problems with spending control, however, were tensions that came in the way of budget implementation. Furthermore, the Greek population saw the program as an unfair diktat imposed by Europe and the IMF; the measures had little if any popular support. Eventually, the New Democracy party (ND) was voted out and replaced by the more radical left-wing Syriza party, which opposed the bailout terms and led to the suspension of the Troika program. Lack of social and political cohesion proved to be an insurmountable obstacle to the effective adoption of the severe changes needed to get the economy back on its feet. Economic performance remained weak, and debt sustainability at risk.

At the height of the same crisis, the Irish government announced the National Recovery Plan (2011–2014), which aimed to lower the deficit below 3% by 2014 and return to sustainable growth. The plan envisioned a total of €15 billion budget adjustment between 2011 and 2014. The adjustment was frontloaded, with €6 billion (or 40% of the total) implemented in 2011. Ireland’s population understood the need for fiscal adjustment and supported the harsh and painful measures, allowing successive governments to keep the plan on track with the IMF and EC conditions. Ireland’s economic fundamentals improved more quickly as a result, which also put the country in a stronger bargaining position; it was able to resist repeated calls by its EU partners to increase Ireland’s corporate tax rate, a cornerstone of its pro-business stance and international competitiveness. Ireland’s economy took off relatively quickly, enjoying one of the most robust recoveries in the EU.
Press reports over the last several years have often highlighted the hardship suffered by Greek citizens, so one might wonder if Greece faltered because it faced harsher conditions than Ireland. That, however, does not seem to be the case: a 2011 study comparing austerity measures across the UK, Spain, Portugal, Greece, Estonia and Ireland showed that the size of the adjustment undertaken by Ireland was substantially higher than that of any of the other countries. Ireland was one of the few European countries that experienced a decline in GDP per capita, in contrast to Greece where income grew between 2007 and 2010.

Figure 3: TGM’s E, S and G Scores for Greece and Ireland,
As of February 2018

Among other factors, there could be two ESG-related reasons why the Irish public was willing to endure the painful austerity measures while the Greek population was not. For one, a study shows that the distributional impact of the policy changes in Ireland was among the most progressive, meaning the wealthy suffered disproportionately to the poor. This appears in Ireland’s superior Gini index coefficient compared to Greece’s—the more equitable distribution of the adjustment might have helped underpin social stability and cohesion within the former. A second potential factor was the perception of corruption. In a survey dated 2012 and published by the European Commission, 99% of respondents in Greece agreed to the statement, “corruption is a major problem in our country,” versus 86% in Ireland.

“These differences in social factors can have long-lived economic consequences: at the end of its economic adjustment program, Ireland needed a modest 1.5% of GDP primary surplus to ensure debt sustainability, in contrast to Greece, which still needs a 6% primary surplus,” concludes Hasenstab.

Read this article and about 5 other Sustainable Fixed Income strategies, and more in this NordSIP Handbook.

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