I was in Berlin last week for the annual conference of the Principles for Responsible Investment, the United Nations-supported organisation that aims to foster the employment of environmental, social and corporate governance standards (ESG) among global investors.
At the conference I moderated a panel discussion on making a sustainable financial system a reality and that topic seemed entirely apposite given the global capital markets backdrop.
This involves US equities hitting record highs and being as richly valued as they have been on most measures since just prior to the crash of 1929, while bond spreads have failed to back up even as the market discounts the withdrawal of quantitative easing and another rate hike from the Federal Reserve.
Meanwhile President Trump is aiming to slash the corporate tax rate to 20% from 35%, while in the UK, at last week’s Labour party conference, party leader Jeremy Corbyn railed against the failings of the global financial system to deliver social justice in the wake of the global financial crisis.
He then unveiled a series of policies which aim to redistribute wealth in the United Kingdom – with nationalisation and a hefty ramp-up of public spending at their core – on a scale not seen since the 1970s.
AT THE BERLIN conference I pondered exactly what it means to talk of a “new financial system”. After all, the fundamental elements whereby capital is raised and relevant price points are established appear constant.
So there are primary bond markets, whereby debt is priced at a spread over a relevant government benchmark, initial public offerings or block sell-downs by corporations in the equity markets, and syndicated, club or bilateral lending in the loan markets.
Where the disintermediation afforded by tapping institutional and retail funds via the capital markets falls short, the slack is taken up by the banks. And even in a world where banks in the US and Europe are paring risk in the face of more stringent regulation and rationalisation following the losses sustained during the global financial crisis, China’s banks are willing to keep global credit perky.
While there has been an explosion of issuance in the green finance market, the debt issued there remains valued and executed according to the “system” which has been in place for the best part of the last 50 years.
When the ESG lobby talks about moving to a sustainable financial system, the emphasis is not about the building blocks of that system, but on the practices of investors in relation to sustainability. In other words, investors must be mindful at all times of the impact of their allocation of capital, even if the available instruments for investment have been originated within the existing system.
That calls for a rebalancing of the perception of value, away from the short-term to a much longer tenor. When valuing a long-term project, the hope among ESG advocates is that considerations of the long-term impact of that project on society will allow a sustainable project with a lower NPV to outweigh a rival alternative with a quicker payback period.
AND THERE ARE other interesting aspects which involve a shake-up of the zeitgeist of conventional investment thinking. In Berlin we discussed so-called beta activism, wherein investors aim to impact the overall risk of the market – the beta, which has been regarded by portfolio theorists as an exogenous factor – rather than focusing only on the alpha generated by a skilful or well-informed fund manager.
A classic example of beta activism was the withdrawal of the mammoth California Public Employees’ Retirement System from the Philippines equity markets back in 2002 on the back of vocally expressed concerns about governance. That move pushed Philippine stocks down by 3.5% in what is a casebook example for beta activists. That group also advocates divestment away from equities which have low ESG scores.
The existing financial system might well morph into something entirely different, along the lines sought by ESG advocates, if financial technology has the impact it promises. So peer-to-peer lending and equity and debt issuance via blockchain technology might lead to an unprecedented disintermediation of capital away from conventional financial institutions such as commercial and investment banks.
And even within the confines of the existing system, the incorporation of ESG methodology into credit ratings and the enforcement of mandatory ESG reporting on corporations by government regulators herald a shift in corporate behaviour and asset pricing.
Of course, the counter argument is that the fiduciary duty of a money manager is to deliver a superior return versus a benchmark. But as it has been demonstrated that ESG-linked benchmarks deliver a superior rate of return versus conventional benchmarks, at least as far as the past five years-odd are concerned, those who call for a realignment of the zeitgeist in investment thinking appear to be winning the argument.
