Some institutional investors might dismiss ‘inclusive capitalism’ as merely a warm and fuzzy political slogan. Brexit, which many in the establishment incorrectly predicted, has highlighted fissures between perceived winners and losers from globalized markets. This is not just in the U.K., but potentially throughout Europe and the U.S., where populist and nationalist sentiments are increasingly evident at the ballot box. Some benefits of open borders and the free flow of people, know-how and trade accrue to some more than to others. Many see their wages stagnate and prospects appear to narrow amid an influx of people from elsewhere that alters not just the economic landscape but also their neighborhoods, their schools and their cultural identities. Younger and more urban demographics might embrace such phenomena as the world they’ve always known; others might perceive a threat to their way of life.
Though the aftermath of the vote may leave investors scrambling to make sense of gyrations in markets, the undercurrents of this schism have unfolded over the long term and could continue to impact portfolios in a range of ways. For many long-term investors, integrating environmental, social and governance (ESG) analysis into their investment process is aimed not only at identifying poor corporate behavior or gauging management quality; it also increasingly reflects the importance of understanding a fuller set of portfolio-related risks that include large-scale social and environmental trends playing out over longer horizons.
Inequality – the ‘haves versus have-nots’ – has gained relevance for some investors as these tensions continue to cohere in the political arena. Few companies (and arguably few investors) anticipated the swiftness with which regulators have closed loopholes in tax laws, raised minimum wages, or required disclosure of disparity between the pay of CEOs and workers. Analysis by MSCI ESG Research also indicates that the real estate sector’s emphasis on serving the high-end market creates a crisis of affordability for households in the middle. This is perhaps a market opportunity for individual companies, but collectively risks courting further political backlash down the road by exacerbating a shortage of affordable housing in the world’s capitals.
These undercurrents can result in risks to asset prices across multiple asset classes over the longer term.Our analysis of ESG risks facing government bonds points to an upswing in vulnerable employment and possible dislocations in labor markets in many developed countries arising from rapid economic, social and technological change. The risks of Brexit may extend beyond immediate consequences for trade and investment, including impacts on human capital, social stability and demographic risk. This week, MSCI ESG Research downgraded the outlook for the U.K.‘s ‘A’ ESG Rating (requires ESG Manager Login) from “Neutral” to “Negative”.
While it is difficult to predict extreme political and social events, it is possible to build models to test a portfolio against potential shocks. Some investors have indicated to us the importance of considering the consequences of inequality and popular discontent into their view of risk. Their next logical step could be to incorporate those views into a structured program of scenario testing.
Many of the policies espoused by politicians across the political spectrum share characteristics of populism, including opposition to trade agreements, support for government spending, and isolationist foreign policy. In coming weeks, MSCI is planning to incorporate ESG research on the underlying drivers of populist sentiment into our macroeconomic modeling capabilities to provide tools to help examine the potential outcomes of these scenarios. For example, what effects might such policies have on portfolios over the long term? And what lessons can be learned from historical precedents and current proposals to help analyze the potential impacts on institutional portfolios under various populist scenarios.
Linda-Eling Lee is Global Head of MSCI ESG Research.