By Morgan Slebos, Senior Policy Analyst, PRI and Craig MacKenzie, Head of Strategic Asset Allocation Research, Aberdeen Asset Management
Long-term social issues – the ‘S’ in ESG – matter for investors. They are key factors determining both long-term GDP growth and the level of equilibrium of interest rates. The reality is that social factors are among the most material long-term drivers of returns.
Investors have rightly focused on identifying and addressing the impacts of social issues in the market through investor-company engagements. But this work needs to be coupled with investor attention to the underlying drivers that influence economic growth and ultimately social outcomes – labour productivity, workforce participation and demographic change.
A failure to address these underlying drivers is important for investors for two reasons:
- Slow growth and ultra-low interest rates are a recipe for low investment returns in the years ahead – particularly as equity and bond prices are at stretched levels. This will make it yet more challenging for investors to service their liabilities in the long term.
- Slow growth is also a threat to political stability. Stagnant median incomes and high levels of inequality fuel the rise of populist parties who may pursue incoherent economic policies that make a bad economic situation worse – particularly policies that restrict the global trade, capital and migration flows.
The good news is that, while these social trends are deep-seated, they are not set in stone. They may be shifted by effective action by governments and other actors. The PRI’s work on a sustainable financial system is starting to look at the ways investors can support proactive policies to mitigate these risks to investment returns, financial system resilience and social outcomes.
Economic growth: stuck in neutral?
In the long run, returns from equites and many other risk assets are driven by economic growth. Growth in corporate revenues and earnings are key drivers of equity returns. For equity markets as a whole, this is ultimately driven by growth in the economy.
Alongside equities, many investors also depend on returns from government and corporate bonds. Weak growth and the global savings glut mean that government bond yields today are near all-time historical lows. Low government bond returns have forced investors to search for yield elsewhere, compressing credit spreads are resulting in low expected returns from credit too.
Low expected returns in the world’s largest equity and bonds will be a major challenge for long-term investors. Pension funds may struggle to achieve their funding ratios. Insurance company solvency is put at risk, and more generally investors will struggle to meet their objectives.
Economic inequality is influenced by many factors. If technology means many middle-income jobs are automated, there could be even stronger divides in the labour market, with more income inequality. Technology is also turning more low-skilled jobs into self-employment with fewer protections for workers. Similarly, if the economy creates more winner-takes-all business models with high barriers to entry, then we may see the spoils concentrated in the hands of the lucky few.
But inequality is also a public policy choice. It results from taxation policy, public education policy and levels of investment in urban development. The kind of frustration that motivates some supporters of Brexit and President Trump could result in a realignment of policy priorities and a reversal of current trends. The economic policies prescribed by populists will not necessarily increase incomes. Policies such as drastically reducing immigration or walking away from free trade agreements may end up reducing growth in incomes even further.
Changing structure of society
One of the most important factors underlying the sluggish growth outlook is the fact that much of the world is in the early stages of a major demographic transition. Ageing populations, an emerging middle class, falling fertility rates and a shift in working age are all contributing to a major demographic shift which could create slow economic growth.
Shifts in working-age population growth in East Asian, several major European countries, the UK and US are likely to either shrink the labour force or reduce growth more slowly than in the past. This will significantly reduce the rate of potential GDP growth.
Demographics are also a factor underlying today’s ultra-low interest rates. Interest rates have been falling since the 1990s – well before the financial crisis and the era of unconventional monetary policy. Central banks believe that the cause of the long-run decline in interest rates is a global ‘savings glut’ that stems from demographic change and a growing imbalance resulting from an increase in savings by baby boomers and emerging middle classes, and a decreasing propensity to invest by companies and governments due to low growth expectations. The imbalance between savings and investment pulls down real interest rates.Eventually, the savings glut will reverse, leading to higher interest rates. But this is not expected to occur for some time. This has led some commentators to posit that the world could be entering an era of secular stagnation – where the ‘zero lower bound’ for interest rates makes it difficult for central banks to stimulate the economy in a down-turn resulting in sluggish recoveries and increasing financial instability.
Demographic trends aren’t destiny, but they are hard to change
There are some ways that countries can compensate for the economic impacts of demographic change – by allowing more immigration, increasing labour force participation and encouraging older people to remain in work.
Immigration is an important factor and a major reason why working age populations are forecast to continue to grow in the developed economies. However, tolerance for immigration can change. The recent electoral success of populist anti-immigration movements suggests that tolerance appears to be declining in many places and reducing the impact of immigration on labour force growth.
But younger people seem much more tolerant of immigration, so perhaps this opposition will not be permanent. As population pressures build in Africa and the effects of climate change start to be felt, there will be a pressing need to manage immigration more creatively.
Governments can also take steps to encourage higher rates of labour force participation – for example, by raising the age at which state benefits and pensions are paid. This can delay the effects of demographic change, though it is not always popular and political leaders are increasingly reluctant to alter the pension age due to fear of an electoral backlash. Governments can implement policies that support parents in the workplace – for example, by subsidising nursery places for the less well-off, more flexible parental leave and job-sharing schemes.
Productivity and innovation
The other major factor in driving slower growth is the very low levels of productivity growth in many developed economies. Productivity growth is currently running at less than 1% per year, vs over 2% in the decade before the financial crisis.
Some argue that low productivity is here to stay. In this view, rapid growth in productivity seen in the 20th century was exceptional, driven by dramatic improvement in educational attainment in the workforce, and radical technological advances. Many of these changes could only happen once; subsequent changes are likely to be incremental resulting in lower productivity growth.
This might be too pessimistic: we may be on the cusp of a Second Machine Age or Fourth Industrial Revolution. Some commentators argue that machines can do almost anything human beings can. In their view, automation makes the world better and this era will be better for the simple reason that, thanks to digital technologies, we’ll be able to produce more: more healthcare, more education, more entertainment, and more of all the other material goods and services we value.
Poor productivity also seems to result from several other factors. The IMF and OECD have identified the large gap between the most productive companies and the least as a particular area to address. This long tail of poor productivity can be explained by companies having failed to invest sufficiently in long-term competitiveness.
Perhaps more damning is the argument that companies have become too short-termist, with executives focusing too much on hitting the near-term targets that trigger their share option packages, rather than working for longer-term success. There may be other reasons for the troubling lack of dynamism in large parts of the corporate sector, a lack of competition in a ‘winner takes all’ economy; the persistence of highly indebted ‘zombie’ companies kept alive by very low interest rates; and the old and inadequate public infrastructure in many advanced economies.
Dealing with poor producitivity
Faster productivity is likely to be the best hope of offsetting the economic growth implications of demographic changes. If we are unable to improve on today’s dismal productivity growth, we will see very low levels of GDP growth, with negative consequences for incomes and investment returns, and political stability.
Technological progress is alive and well and we can expect periods of more rapid productivity growth across a range of business sectors in the future. When those benefits will appear at scale is an open question.
Robots cannot cure our productivity ills without steps being taken to resolve the other sources of our productivity malaise. There is much work to be done addressing the other causes of weak productivity growth – by addressing short-termism, encouraging corporate capital investment; addressing the weak diffusion of innovation across the economy; improving competitiveness; and investing more in public infrastructure.
Emerging policy agenda
Addressing these issues is not an easy task, but there are a number of possible policy interventions that have already been suggested by bodies such as the IMF, OECD, World Bank and central banks.
These recommendations focus on current barriers to productivity growth and supporting workers disproportionately affected by economic disruption. Productivity growth is an essential policy lever because it is the most important source of higher income and rising living standards over the long term – it also should have direct benefits for equity investors in the form of higher corporate earnings.
In encouraging higher productivity growth, it will be important to minimise the impact of disruption on workers displaced by new technologies – for example, by ensuring there are effective retraining programmes. This will help ensure the stability of social, political, economic and financial systems.
Recommendations put forward to sustain productivity growth include:
- policies to foster diffusion of technology and reinforce trade openness and the international mobility of skilled workers;
- policy signals to encourage private investment and risk taking, particularly high-quality public investments in education and training, basic R&D, and infrastructure;
- removing unnecessary barriers to competition and providing tax incentives for R&D;
- reforms to policies that restrict worker mobility and amplify skills mismatch and funding for lifelong learning to combat slowing growth and rising inequality;
- retool income policies and tax systems to support lower skilled workers who suffer disproportionally from disruptive economic transition.
Investors can help this emerging policy agenda gain traction.
Investors need to get in the driver’s seat
There isn’t a trade-off between addressing the big social issues and investor interests. In fact, the opposite is true; there are few things more beneficial to long-term investor returns than mitigating the risks arising from these long-term social trends.
In January, the PRI explored inequality and how investors might address this issue. We profiled some of the tools that investors may use to inform investment decisions and determine shareholder engagement, such as economically-targeted investment products, microfinance, bottom of the pyramid strategies and blended finance. This is one useful step.
The most important step investors can take is to move away from the tendency to be passive on large scale social issues. Long-term investors like pension funds and insurance companies have a huge stake in the long-term future of the economy. CEOs and politicians are here today, gone tomorrow, but long-term institutional investors, and the beneficiaries who depend on them, have to live with the consequences of poor economic policy for decades to come.
We have an interest and a responsibility to use our influence to tackle the underlying barriers to more dynamic and sustainable long-term economic growth. This means addressing the social trends in demographics, productivity and inequality that put this growth at risk.
Investors can and already do play a role directly in fostering growth through the allocation of capital in support of long-term investment. But there are other important roles to play.
- PRI signatories represent US$29.5 trillion global equity ownership and can influence corporates through their active ownership. To reverse the effects of poor productivity growth, they engage with companies on poor corporate management structures and incentives, as well as the way in which the business is investing in its future development.
- Investors can work with policy makers to develop economic policies which drive faster, more sustainable growth, and mitigate the impact of the savings glut. This includes policies to improve productivity, reduce the extremes of inequality, and minimise the disruptive effects of necessary economic transformation. Ambitious new policies, such as those put forward by the OECD and the IMF, will need to be supported by investors.
- Infrastructure investment will be an important avenue to boost growth, reduce the savings glut and offer returns for investors. Public investment in infrastructure – in important source of productivity growth – has been on a long-term downward trend in developed economies for decades. Many economic policy makers have suggested the world embarks on a large-scale infrastructure investment to boost demand, capital investment and productivity – while also addressing issues such as climate change. Given that sensible infrastructure investment pays for itself, this should be a high priority.
As part of the PRI’s work on a sustainable financial system, we are convening a group of investors to develop research on these policy issues and to explore ways that investors, companies and policy makers can address the structural social trends that undermine growth and long-term investment returns.