BY BLAKE S. PONTIUS, William Blair Investment Management

The January 2019 collapse of a Brazilian mine tailings dam—which released 11.7 million cubic meters of toxic mud, killed at least 150 people, and led to a corruption probe—underscores the critical but underappreciated value of environmental, social, and governance (ESG) considerations in emerging markets.

ESG: More Important in Emerging Markets?

The majority of ESG-aware asset managers surveyed by Citi Research in October 2018 expressed the view that ESG factors are more important in emerging markets than developed markets, particularly from a corporate governance risk perspective.

Generally, weaker corporate governance practices in emerging markets relative to developed markets have played a role in shaping this opinion. More seasoned, quality-focused investors have long appreciated the need to be sharp on governance considerations when investing in frontier countries such as Kenya and Argentina, as well as the more mainstream countries such as China, India, and Brazil.

We’ve seen a variety of environmental and social issues become increasingly relevant to investors.

Emerging markets have more state-owned enterprises, necessitating a higher level of scrutiny of governance practices by prospective investors. While varying across different countries, there is generally a greater prevalence of family founders with majority stakes within emerging markets. Lower rates of board director independence and weaker corporate transparency are other realities contributing to the elevated governance risk profile.

Beyond these more obvious considerations related to governance and business culture, we’ve seen a variety of environmental and social issues become increasingly relevant to investors. From an environmental perspective, combating air, soil, and water pollution is becoming a more significant focus of government policy in China and India. And from a social perspective, investors are increasingly scrutinizing how companies are managing broader stakeholder relationships that can materially impact financial performance.

Back to the Brazilian Dam Disaster

The latter point takes us back to the Brazilian dam disaster.

The resource-intensive energy and materials sectors continue to play an important role in the socioeconomic welfare of many emerging and frontier economies, with concomitant ESG risk factors that can have severe consequences beyond share price performance.

For example, mining companies that operate in environmentally sensitive areas where indigenous populations live have to be thoughtful about how they develop resources. They must also ensure the safety of their employees through ongoing capital investments and training.

Brazil’s Vale SA, which owns the dam that collapsed in Brumadinho, knows that all too well. The company has since announced that it will close all 10 of its dams in the country with a similar design. 

Ratings Reflect Greater Risks, but also Opportunities

These risks can be seen in the ESG ratings distributions of emerging versus developed markets. Conventional ratings distributions, such as the one shown below from MSCI, reflect a negative skew in emerging markets relative to developed markets. (Applying MSCI’s ratings methodology, CCC is the lowest ESG rating assigned to companies on an industry-relative basis and AAA is the best.)

Click graph to enlarge.

This negative skew in ESG ratings reflects some of the risks I discussed above, with a consistent overhang being weaker governance structures for companies across different sectors within emerging markets. Companies lacking a majority independent board, for example, are systematically penalized. The existence of a combined chairman and CEO or dual share classes with unequal voting rights are also detrimental to the rating.

Over time, we expect ESG ratings for emerging market companies to broadly improve as more capital flows into ESG-focused equity and fixed-income strategies, and as more asset managers integrate ESG considerations in traditional strategies.

Emerging market ESG funds now account for nearly 10% of global emerging markets funds, up from just 2% a decade ago, as illustrated below.

Growth of ESG Assets in Emerging Markets

We’ve already seen tremendous growth in ESG-focused emerging markets fund assets, from less than $1 billion in 2008 to $20 billion in 2018, as measured by EPFR and Citi Research. Emerging market ESG funds now account for nearly 10% of global emerging markets funds, up from just 2% a decade ago, as illustrated below.

Asia ex-Japan represents a significant percentage of ESG-focused assets in emerging markets based on data collected by the Global Sustainable Investment Alliance (GSIA), with the largest markets for sustainable investing being Malaysia (30% of total professionally managed assets), Hong Kong (26%), South Korea (14%), and China (14%).

Malaysia’s prominence may come as a surprise considering the high-profile scandal involving its state-owned investment fund, 1MDB. Similarly, China’s inclusion on the list of prominent ESG markets contradicts the conventional perception of weaker governance given the role of state-owned enterprises (SOEs) and environmental mismanagement (ambient air pollution kills hundreds of thousands of citizens every year, according to the Chinese Ministry of Health).

But, perhaps surprisingly, according to a recent biannual review of corporate governance practices in Asia by research firm CLSA, Malaysia was the “biggest mover in 2018,” climbing to 4th place in Asia’s corporate governance market ranking.

And China was the fastest-growing market for sustainable investing from 2014 to 2016, according to the GSIA. Sustainable assets there were up 105%, followed closely by India (up 104%).

Much of that growth was driven by investment opportunities arising from public policy initiatives to clean up the environment, including China’s efforts to improve air quality by working to transition away from coal toward natural gas and renewables.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of William Blair Investment Management nor TEXPERS, and are subject to revision over time.

About the Author:

BY NIKOLAJ SCHMIDT, T. Rowe Price

Volatility returned to markets in mid‑May after trade talks between the U.S. and China appeared to stall. If the current dispute between the two biggest contributors to global gross domestic product becomes a full‑scale trade war, it will adversely impact not just the U.S. and China, but the entire world economy. Trade wars do not produce any winners in the long term.

Tariffs directly affect economies in two main ways: first, because they function as simple taxes on goods and, second, because they cause uncertainty, which impacts household and corporate decision‑making. Let’s look at each of these in turn.

Tariffs as Taxes

Although taxes on goods increase the tax revenues of governments, they also lead to a misallocation of resources, which drives the overall economy into an inefficient equilibrium. In economics jargon, this is known as the “deadweight loss” of taxation. Because tariffs raise the price of consumption, the purchasing power of households is reduced and fewer goods are bought. At the same time, households and companies try to substitute away from the tariffed goods, thereby ending up consuming a basket of goods that has been distorted by the tax. This new basket of goods represents an inferior choice to the consumer.

When President Donald Trump tweets that the U.S. will win the tariff war, he assumes that U.S. households and companies will substitute toward a domestically produced basket of goods and that this will indirectly create new American jobs. I’m skeptical. 

Although taxes on goods increase tax revenues, they also lead to a misallocation of resources.

In my view, it is more likely that U.S. households and companies will shift their consumption to goods produced in Vietnam or Mexico rather than back to American‑produced goods and that U.S. jobs which have been outsourced to China will not be repatriated before the production process has become entirely automated. American‑produced goods would be a viable alternative if either the U.S. was the most cost‑efficient producer after China (which it is not) or if the U.S. harbored the production facilities required to produce electronic gizmos it currently imports from China. In an unsettled trade regime, U.S. companies are unlikely to build onshore production facilities to cater to this potential demand.

Tariff Uncertainty

The second way that tariffs reduce consumption is by creating uncertainty, which causes households to postpone consumption and companies to defer capital expenditures. The impact of uncertainty on an economy is akin to monetary tightening (which is clearly not part of President Trump’s agenda). As the U.S. and China are the two biggest economies in the world, any uncertainty created by a prolonged trade war between the two will affect the global economy. The few countries that might benefit are those, such as Vietnam and Mexico, that can deliver substitutes for tariffed Chinese goods in a cost‑efficient manner.

The impact of uncertainty on an economy is akin to monetary tightening.

Trade wars do not just hit consumption, they also impact inflation, central bank policies, and exchange rates. As tariffs function largely like consumption tax hikes they are likely to cause headline inflation to rise initially, but just like any other form of fiscal tightening, they will eventually cause growth to slow. This will lead to an increase in output gaps, which reduce core inflationary pressures. As U.S. households and consumers substitute away from goods produced in China, China is likely to respond by trying to export its excess capacity to the rest of the non‑U.S. world. This is how the disinflationary shock of tariffs is transmitted across the globe.

The impact of tariffs on central bank policies will differ by region. For a developed economy central bank, the monetary policy implications of tariffs are straightforward: Tariffs lead to slower growth and lower core inflation pressures, so the appropriate monetary policy response is dovish. In emerging markets, however, rising uncertainty is more likely to trigger capital outflows, putting downward pressure on growth and upward pressure on inflation. To keep capital onshore, emerging market central banks may be forced to respond with monetary tightening.

How tariffs affect exchange rates is a complex function of demand elasticities. Usually, the country whose output gap is most adversely affected by tariffs is likely to see its currency depreciate the most. In the current environment, this would mean that emerging market currencies would depreciate versus the U.S. dollar and the U.S. dollar would lose ground against other major currencies.

Given the negative overall impacts of tariffs, it is tempting to conclude that sanity will prevail and that the U.S. and China will step back from the brink and walk away from a situation that will only serve to harm the economies of both countries. However, President Trump seeks to be reelected next year and may decide that the political gains from an outright fight with China outweigh the political cost of slower economic growth. Indeed, support for populist parties across the world continues to grow on the back of rising inequality and concerns about the impact of globalization. Tariffs may not be a good idea economically, but it is politics, not economics, that wins elections. Consequently, we are unlikely to see the back of tariffs anytime soon.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of T. Rowe Price nor TEXPERS, and are subject to revision over time.

About the Author:

Although some pension-related laws were passed, legislators had their focus on other issues

As expected of the 86th legislative session, public pensions were a part of the discussion. However, legislators did not scrutinize the policy area as they did during the reform efforts of Houston's and Dallas' retirement systems in 2017.

Rep. Dennis Bonnen

When the 86th Texas Legislature convened on Jan. 8, Gov. Greg Abbott and Lt. Gov. Dan Patrick returned to their respective posts. However, the House found itself needing to elect a new speaker as a result of Joe Straus’ retirement the leadership position. The House members elected Rep.Dennis Bonnen, R-Angleton, to preside over the 86th Legislative session. Speaker Bonnen exhibited his reputation as an astute and tactical House member whose experience includes critical chairmanships and as speaker pro tem under Straus.

For the 86th legislative session, the governor, lieutenant governor and speaker established public school finance and property tax reform as priorities that were not new issues to the legislature but showed the need for coordination of resources as the House and Senate collaborated on solutions. Other items also given critical focus were school safety and teacher pay.

Before the midterm elections in 2018 and the start of the 86th legislative session this year, William "Bill" Miller, co-founder of lobbying firm HillCo Partners, said he was not certain how many Democrats would win competitive House elections.

"The net result for pensions is less pressure from the conservative Republican wing to change the status quo," said Miller, whose firm represents TEXPERS.

BEGINNINGS

Sen. Joan Huffman

Rep. Jim Murphy

At the start of the session, the House combined its Committee on Pensions with its Committee on Investments and Financial Services. Chaired by Rep. Jim Murphy, R-Houston, it heard pension-related legislation as well as legislation related to financial institutions and services. The Senate State Affairs committee, chaired by Sen. Joan Huffman, R-Houston, was the Senate committee with jurisdiction over pensions.

TEXPERS' Legislative Committee frequently met to discuss and analyze proposed legislation that could impact local public retirement systems. TEXPERSsupported legislation urging the U.S. Congress to eliminate government pensionoffset and the windfall elimination provision of the Social Security Act. TEXPERS officials also continued to be vocal on opposed legislation and stayed involved in discussions regarding legislation that could be impactful to all its system members. 

NEW LAWS 

Two pieces of legislation passed that impact retirement systems, Senate Bill 322 and SB 2224. Representatives Huffman and Murphy co-authored both bills, which the state legislature passed. The governor signed them into law.

SB322 requires retirement systems in Texas to submit a report on investment practices to the Texas Pension Review Board, which oversees all state and local public retirement systems in Texas for actuarial soundness and compliance with state law. Huffman filed similar legislation during the 85th legislative session in 2017. Pension systems that already are currently required by law to submit such a report, as well as systems that have a book value of $30 million or less, are exempt from the bill.

During the deliberation of this legislation, TEXPERS legislative committee members worked diligently to present concerns and options to address them with the bill's authors. As a result, SB 322 was amended with language to mitigate cost, redundancy, and to allow for more accurate reporting of the information.

SB 2224 requires a retirement system in Texas to adopt a written funding policy, a measure that some local plans are already doing. The bill was discussed by TEXPERS' Legislative Committee as well as with Pension Review Board officials and found that the report was ultimately workable to systems.

Legislators proposed legislation detrimental to local defined benefit pension plans. However, bills that proposed switching defined-benefit pension plans to 401(k)-like defined-contribution plans did not move.

Also, legislators filed specific measures intended to address issues the Pension Review Board encountered during the interim. Proposals included the reporting of investment fees that were designed to address areas such as contracting of certain investment services. Other measures included adjusting the current 40-year trigger in the state's Funding Soundness Restoration Plan statute to 30 years to coincide with the Pension Review Board's funding guidelines as well as legislation requiring a report from systems on fees and commissions charged by specific consultants.

TEXPERS officials engaged legislative staff and brought to their attention various aspects of their proposed laws to help make language more workable, and many of the revisions were approved. Ultimately, these bills were left pending in committee.

In addition, legislators introduced a measure to amend the Texas Constitution to ensure that the state is not responsible for local pension liabilities. The bill passed the Senate but did not move in the House.

At the state level and as anticipated, the Texas Teachers Retirement System received funding to make the system sound and to provide a 13th check to retirees. However, the Texas Employees Retirement System was funded at status quo and remained at infinite in its funding level. The Texas Municipal Retirement System also introduced a technical clean-up bill that was approved by the legislature.

BEHIND THE SCENES

This session, the governor also reappointed Keith Brainard and Marcia Dush to the Pension Review Board. The appointments of Dush and Brainard, along with Stephanie Leibe and Rossie Fariña-Strauss, were all confirmed by the Texas Senate. The governor also named Leibe chair the board.

During the interim, TEXPERS and HillCo will monitor and remain involved with the Pension Review Board as it continues discussions with local plans in an intensive review of a process that requires local plans to work with respective sponsoring entities given specific amortization triggers. The Pension Review Board also will implement recently passed legislation.

About the Author:

Eddie Solis is a legislative consultant with HillCo Partners, a lobbying firm based in Austin. The firm represents TEXPERS.

San Antonio retirement fund elects James Smith as chairman

James Smith

James "Jim" Smith is the newly elected chairman of the San Antonio Fire and Police Pension Fund. 

The public employee retirement system held elections during a fund board meeting May 29. Smith, an active police trustee of the fund, previously served as vice chairman. 

He was first elected as a trustee to the retirement system in 2010. He has served on the fund's Investment Committee, Personnel/Audit Committee, and Legislative Committee. 

A sergeant with the San Antonio Police Department, Smith also is a member of the Texas Association of Public Employee Retirement Systems and serves as first vice president on the nonprofit's board of directors.