Interview with fund manager Stefan Grünwald on Raiffeisen-EmergingMarkets-ESG-Transformation-Rent

Article from 4 December 2023 in Börse Express.

BÖRSE EXPRESS: The fund Raiffeisen-EmergingMarkets-Rent was launched on 3 November 2003 and renamed Raiffeisen-EmergingMarkets-ESG-Transformation-Rent on 18 October 2023. What were the main reasons for shifting to a stronger focus on sustainability and the role of the Emerging Markets in this regard? And how will this change be reflected in the portfolio?

Stefan Grünwald: Global sustainability goals, such as the struggle against climate change, cannot be achieved without the Emerging Markets, and sustainable changes and ESG potential can be identified in most countries. However, compared to the developed markets, the Emerging Markets often have weaker ESG ratings, due to the increasing production for export, exploration for commodities, and lower development standards as well as various political systems and distribution inequalities. Consequently, it is important to recognise positive movement towards greater sustainability and the sustainability potential, and to focus investment more strongly on these aspects. Not only do Emerging Markets with a positive transformation trend show higher resilience to environmental, social, and governance risks, they also offer opportunities due to the ESG transformation. By adjusting the fund’s focus, the investment concentrates on countries in this process of transformation, which exhibit a positive relationship of the ESG assessment to income and/or improvement. Countries with excessive ESG risks, up to and including default due to ESG aspects, are avoided. This results in an improvement in ESG ratings and rating quality, with the duration and yield maintained in comparison to the investment class.

In the past, investors were fairly cautious in relation to sustainable investments in the Emerging Markets. How do you think EM investors’ attitudes about ESG will change?

Assessing the Emerging Markets from an ESG perspective has become a necessity for investors nowadays. Global supply chains and commodity deliveries, the global division of labour in the economy, and calls for compliance with minimum standards mean that ESG assessments, ratings, and analyses are also a must for the Emerging Markets. Additionally, due to the stronger leveraging effects, the opportunities are increased by ESG-related developments and improvements all the way to more sustainability for countries with low ESG levels. The Emerging Markets have massive needs in terms of convergence and investments in energy production, the expansion of telecommunications, water supply and treatment, healthcare, and education. For instance, although China quite rightly makes it into the headlines in a negative sense for its use of coal, it is also the leading country in terms of expansion and investment volume in renewables and e-mobility and the related infrastructure. And on top of that, it accounts for over 50 per cent of total investment at the global level in this regard.

To some degree, Emerging Markets have an advantage in the sense that sustainable developments can be launched with a clean slate, i.e. without the need to overhaul existing infrastructure. This makes it possible to build infrastructure in a more sustainable fashion. This effect was seen in telecommunications in Africa: the difficult task of building fixed-line networks was simply skipped, as mobile telephony networks were successfully developed instead. So, it can be worthwhile to invest in the Emerging Markets, from an ESG perspective as well and not just in terms of returns and growth prospects.

US interest rate policy continues to be the most significant factor for the performance of the Emerging Markets (EM). What’s your view on the interest rate outlook in the USA and what will it mean for the EM bond markets? And what is your opinion about valuations for EM bonds?

The development of USD interest rates and the Fed’s interest rate policy have a direct impact on the performance of EM countries and thus these two factors are key considerations for the assessment of this investment class. It is likely that the cycle of interest rate increases in the USA has reached its peak for now, and that the Fed is finished with rate hikes. In light of this probable end to the rate hike cycle and the high premiums on EM USD-denominated bonds in a longer, historical comparison, long-term investment appears to be attractive. Furthermore, developments in global production have bottomed out, and growth dynamics in China have stabilised recently. Dynamics are expected to develop similarly next year in China, and the growth differential of the Emerging Markets compared to the developed markets should rise again. For countries with weaker debt profiles, rescheduling risk has mostly been reflected on the capital market. Nonetheless, USD interest rates will probably remain at higher levels for a longer period of time, and this means that careful country allocation up to and including complete exclusion due to default risks is still necessary.

In your opinion, which Emerging Markets have the biggest growth opportunities, play the biggest role in the global transition to more sustainability, and are thus increasingly the focus of your investments?

Viewed from the perspective of global objectives such as reducing CO2 emissions, the countries that are significant in terms of their economic and population size naturally play a major role, such as China and India, in particular. While China is pressing ahead with the development of renewables, India is lagging behind in this field. Changes motivated by environmental concerns generally lead to major investments, for instance in the field of infrastructure, along with a corresponding demand for commodities, as is the case with the energy transition. Countries in Africa and Latin America that have significant commodities will gradually profit from this, such as Namibia, South Africa, Chile, and Brazil, to name a few examples. Additionally, countries from Africa and the Middle East have the opportunity to use solar power or to produce and export green hydrogen over the long run. Countries such as the United Arab Emirates and Qatar are frontrunners in this regard. Countries which exhibit positive ESG ratings in relation to their income, such as the Dominican Republic, Guatemala, Jamaica, Ivory Coast, Costa Rica, Namibia or Indonesia are represented more and more in our portfolio, along with countries with potential for improvement, such as Oman, Qatar or Brazil.

At a press conference held by Raiffeisen Capital Management, you said the following: “The core objective of ESG approaches for the Emerging Markets must be to support sustainable development and sustainability potential. Viewed in this context, investing sustainably means accompanying this ESG transformation in a responsible way.” Very specifically, what do you mean by “accompanying this ESG transformation in a responsible way”? And what are the challenges that result from this?

When we are talking about the Emerging Markets, ESG transformation means better ESG ratings compared to the level of development, in conjunction with possible positive development or positive ESG potential. These long-term ESG potentials and improvements must be recognised and supported with investments. However, quantifying sustainable improvements and potentials always involves a qualitative analysis and assessment. The potentials and the assessments also always have to be reviewed and adapted, as necessary. As the Emerging Markets are generally a difficult investment class in terms of sustainability criteria, it is necessary to proceed carefully and responsibly, taking into account the relevant context, when one is weighing up the various arguments, evaluating the potentials, and formulating a qualitative assessment of the countries. The same holds true in relation to avoiding excessively high risks from ESG topics all the way to defaults, as well as in relation to excessively low ratings, relative to the Emerging Markets as an investment class as well. In addition to the qualitative assessment, another major challenge we face is that recognising and logically explaining ESG potential is not yet reflected in the ESG indicators. Another aspect that is challenging at times is the thorough implementation of ESG topics across different EM countries. Furthermore, in an investment class as varied as the Emerging Markets, this selective approach can also lead to strong performance effects in terms of deviation from the general market trend.

Some experts say that countries with sustainability criteria which may appear less attractive from the perspective of the industrialised countries but which have a growing middle class are particularly interesting, because more can be achieved there than with an investment in industrialised countries. What do you think about this view and why?

As root causes, but also as providers of services for the global ESG transformation, the Emerging Markets play a key role on the way to a more sustainable world. We have the opinion that stronger ESG effects can be achieved with investments in countries that show improving ESG trends or ESG potentials, but still have low ESG ratings. So, investments in countries with lower starting levels, which are working to boost environmental standards, to prevent negative ecological impact, and to fight climate change, can generate more leverage than investments in countries which are more advanced in terms of sustainable criteria. ESG topics can implemented with a clean slate and very unsustainable processes can be replaced by more sustainable ones. In contrast to the developed countries, there tends to be more than just adaptation and improvement of existing aspects, and we see real, full-scale change. Such as with telecommunications infrastructure in Africa, like I mentioned earlier. We also see this kind of leverage for example, when renewables replace coal-fired power plants that are inefficient, compared to developed countries. Similar effects can be identified in social topics, such as income distribution, diversity, working conditions or participation, as well as in relation to political and governance aspects.

What role do E, S, and G factors play in the Emerging Markets and how do you proceed specifically with the selection of EM bonds when taking into account ESG criteria and what are the most important ESG criteria that you apply?

Fundamentally speaking, all three of these factors are taken into consideration in the assessment and selection of the countries. In particular, this applies with regard to avoiding countries for quantitative reasons, as all of the countries that are ranked in the 4th quartile in relation to all of the three factors are ruled out. All three of the factors are also included in the screening supporting the qualitative avoidance of countries and in the qualitative analysis. In line with the EU’s approach, we emphasise the environmental aspect in the first step, but we also take social and governance aspects into account as well. Along with the ESG assessments produced by MSCI and ISS (ratings and reports), the ESG-criteria that are incorporated into the analysis include, among others, the change in CO2 emissions, the share of and plans to expand renewables, coal consumption per capita or population density, life expectancy, the Gini coefficient, and values from political and corruption indices. The assessments are supported and supplemented by company-wide policies and the analyses of topics we identify as being critical for the future, such as energy, infrastructure, and commodities. The transformation countries, in which investment is mainly concentrated, are characterised by being signatories to the Paris Agreement, exhibit no quantitative or qualitative factors that would rule them out, and have a positive assessment in terms of their transformation. They are ranked as improving or high grade in terms of the Raiffeisen Capital Management ESG sovereign indicator, versus GDP per capita, or they have positive ESG potential. Along with economic and financial indicators, the allocation also incorporates the assessment by the Raiffeisen Capital Management ESG sovereign indicator, greenhouse gas emissions, and external ratings.

In light of the stronger focus on ESG topics in the selection and weighting of sovereign issuers, what are your medium- and long-term expectations for the performance of Raiffeisen-EmergingMarkets-ESG-Transformation-Rent?

Despite the stronger focus on ESG topics and a more selective approach, the Raiffeisen-EmergingMarkets-ESG-Transformation-Rent characteristics are similar to the investment class EM USD government bonds, in terms of duration, average rating, and return. Countries with higher ESG ratings should generally have a higher level of financial resilience, as well as better resilience against risks related to ESG topics. Additionally, they should have lower refinancing costs and lower repayment risk, and thus exhibit lower valuations versus comparable countries. Accordingly, taking a long-term view, we expect that their volatility will tend to be lower compared to the investment class. Furthermore, ESG topics may offer growth opportunities, which can be reflected in better performance by sustainable issuers versus their peers. Above and beyond this, countries with poor refinancing prospects, high ESG-related risks or little ESG potential are excluded by the ESG transformation investment process, and this reduces the risk of investment in countries with rescheduling risks that have not yet materialised.

I should invest in Raiffeisen-EmergingMarkets-ESG-Transformation-Rent today rather than tomorrow because…

... your investment supports sustainable development in Emerging Market countries, and the recent increases in absolute yields on EM USD government bonds can be exploited over the long run.