One of the core challenges facing investors in emerging markets in general — and frontier markets in particular — is quantifying risk levels in countries lacking the political stability and transparency that define developed markets. But we have found growing evidence that examining these markets through the lens of environmental, social and governance factors can provide investors with possible early warnings of growing economic and financial risks, and potentially enhance investment returns.
In the past year, for example, a close analysis of the ESG scores of Turkey and Lebanon clearly flashed signs of trouble, prompting some investors to avoid their bonds before subsequent trouble. Further, ESG scores today could be providing valuable clues about how individual emerging market countries will be affected by the COVID-19 pandemic and its consequences.
In the seven years ended July 31, the J-ESG Emerging Market Bond index — which takes ESG factors into account when gauging performance — has outpaced the standard J.P. Morgan Emerging Market Bond Global Diversified index benchmark by a cumulative 4.7 percentage points. This suggests that overall ESG ratings of sovereign bond issuers can indeed enhance returns. However, a deeper dive into underlying ESG factors could provide an even bigger benefit.
Experience suggests that opportunities and risks are most clearly discerned in movements within the individual components of a country's ESG score. Governance, for example, is especially important — mainly in the case of sovereigns — because it can impact the other two components of the ESG equation, such as a government's ability to reach environmental goals and achieve positive social outcomes. As such, the "G" pillar should make up 50% of a country's overall ESG score, we believe.
Turkey's ESG scores have steadily deteriorated over many years, particularly its governance factors. An erosion of the independence of such key institutions as the Ministry of Treasury and Finance as well as the central bank has resulted in a significant deterioration in policymaking. This foreshadowed material economic and financial market underperformance for much of the last year even as environmental and social scores remained high. Similarly, in Lebanon while governance factors have deteriorated for many years, worsening social scores can be traced as the catalyst for widespread protests in 2019. Given years of economic mismanagement driven by poor governance, Lebanon's descent into economic collapse led ultimately to default on its $30 billion eurobond debt in March.
Today, COVID-19 is testing whether ESG's positive effect on investment performance can hold up during a public health crisis. Early signs are positive: As of July 31, despite the unprecedented market sell-off in March, the J-ESG Emerging Market Bond index had outperformed the J.P. Morgan EMBI year-to-date by 1.4 percentage points.
In fact, ESG research might be particularly effective due to the specific nature of the crisis. In a global pandemic, countries with the strongest ESG scores (particularly the S and G pillars) are likely best prepared to respond to serious strains on, for example, health systems and social safety nets. Conversely, countries scoring poorly on these measures typically lack the capacity to respond effectively.
Many of these factors would fall into the "S" pillar of ESG, to which we assign a 30% weight, with environment making up the remaining 20%. Not only do social measures shine a light on health issues that are critical to understanding national well-being (such as life expectancy and mortality rates), they also track such things as rising economic inequality, which can reveal cracks within a societal structure. We've seen the impact of weak social factors before: The Arab Spring and, last year, protests in Ecuador and Chile could all be partly traced to public issues, such as large income inequality and relatively young populations.
Our experience suggests that investors that integrate these and other ESG metrics into their portfolio decisions have the potential to avoid pitfalls and improve potential investment returns — not only during the crisis, but through the recovery and beyond.
Richard House is chief investment officer for emerging markets and Giulia Pellegrini is a senior portfolio manager for emerging markets, both at Allianz Global Investors, London. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.