On the back burner, but certain to return as time goes on, is whether and how to re-frame pension policies regarding Russia’s allies, its petroleum purchasers and, beyond that, businesses that produce or market in other authoritarian and totalitarian nations. ESG investing has taken on a new wrinkle, if the world is now heading toward deglobalization with Western economies pulling away from dictatorships. Call it ESG+G, for environmental, social and governance plus geopolitical investing principles.
When President Nixon opened the door to Chinese trade and Mao Zedong’s successor Deng Xiaoping pivoted toward a market economy, a half-century trend toward cross-border trade and economic globalization ensued. Although labor-market advantages were hardly the exclusive province of China, all it takes is a trip to Walmart to see vivid proof of how pervasively our offshoring of production to the Red Dragon has reshaped the U.S. consumer market.
Economists blessed this expansion of international trade as beneficial to all, the logical result of “comparative advantage” whereby each nation produces what it does best at lowest cost and consumers benefit from a cornucopia of affordable goods and services. (The latter category includes call centers in India and the Philippines, for example.) Capital thereupon flows to low-cost countries, bootstrapping their economies and bringing prosperity to those fortunate enough to join the global trade regime.
On the other end of the capitalist food chain, Western multinationals including U.S.-based Apple, Nike and Tesla have not only moved production offshore but are also gleaning billions in revenues from consumer sales in countries run by autocrats. Last year, about 20 percent of Apple’s and Nike’s sales were in China and Russia. Other U.S. companies with heavy sales in China, ranging from 27 percent to 50 percent, include Intel, Qualcomm and Texas Instruments.
The obvious question to anybody who plays chess and not just checkers is what happens if such profitable arrangements falter. Europeans are re-thinking their trade relations with China because of its acquiescence in Russia’s belligerence. What if Western sanctions start extending to commercial activity inside the nation-state enablers of Russia’s atrocities? And what if Third World trading partners are forced to choose between U.S. and Chinese markets, interests and technology? Suppose China decides that Taiwan, or for that matter the entire South China Sea, is now fair game for a Donbas-style “liberation.” And then there are the Middle East despots and companies entrenched there. Will multinational companies with large footprints in the wrong places suffer economic losses that result in American pension portfolio underperformance? Note that British Petroleum took a $25 billion write-down upon its exit from Russia. These are issues that few investors are taking seriously enough yet, but which I expect to become a discomforting discussion topic as time goes on.
A Line in the Sand?
Leading up to the current geopolitical turmoil, much of the ESG movement has been value laden, rather than algorithmically numbers-driven. The 2022 surge in oil prices has brought out catcalls of negative press for ESG investing. Because there are multiple factors to consider, it’s hard to construct a pension fund portfolio formulaically around ESG principles, although various plans do reference ESG concepts in their investment policies. It’s easier to favor portfolio managers that include ESG criteria in their decision-making process, and in some cases there are ESG scores, checklists, indexes and funds that form the foundations of portfolio construction.
But nobody has seriously confronted the issue of geopolitical sustainability in a systematic manner that draws a line in the sand and accepts potentially lower short-term investment results in trade for longer-term risk avoidance. It’s far easier to find investment strategies and policies that avoid fossil fuels than to identify any that shun totalitarian polities.
It’s also far too early in the global geopolitical shift to know what the best strategy for public pension funds will be. But one tool that should be considered by trustees, consultants and investment officers is what I’ll dub “seismic portfolio risk analysis.” The idea is to model the potential impact on a fund’s overall portfolio if the geopolitical and economic world divides abruptly into separate, independent spheres, with liberal market economies in one camp and state-centric autocratic major powers isolated in another.
In this scenario, public multinational companies will be faced with pressures to relocate their low-cost offshore production now based in the hostile economic regimes, and would also likely suffer a loss of profitable markets for consumers in those regimes who will thereafter shun their products by edict or nationalist fervor. The value of those companies’ future earnings cannot possibly withstand those disruptive pressures on profit margins, absent a completely new, adaptive business model. It’s potentially the mercantile equivalent of the Big One along the San Andreas Fault.
In the case of China, some pension trustees already have been scratching their heads about the wisdom of holding shares of mainland, Hong Kong and Taiwanese companies that could be de-listed over accounting issues or impaired by Beijing’s edicts and interventions. Companies like Alibaba, Baidu, JD.com and Tencent have already seen their U.S.-listed offshore proxy stock prices drop over such concerns, which could be a harbinger of deglobalization’s impact on capital markets pricing and inferior returns from “emerging markets” as an investment asset class.
Pricing in Risks to Profitability and Growth
Nobody expects a dramatic shift in the world economic order to occur overnight, so this risk analysis exercise is longer term in its focus. And markets eventually discount the risks of lower future sales, usually faster than pension risk advisers do, so one must always ask the devil’s advocate question of whether belated application of an ESG+G screen for autocracy exposure would actually result in better investment performance for pension funds in the long term. Conversely, it’s fair to doubt whether Big Money has now fairly priced in the risks to profitability and growth that may lie ahead for the likes of Apple, Starbucks, Nike, Tesla, Qualcomm and Taiwan’s chip and device manufacturers, if either China or Western powers someday take a hard line. If not, then what’s the right strategy?
Arguably, trustees and investment teams need a serious conversation with portfolio managers who are overweight in companies and countries that could foreseeably lose favor and stock exchange value. To ground that dialog, some form of risk analysis is required. One protocol could be as primitive as routinely identifying which major corporate equity and debt holdings in a system’s portfolio have cost and revenue exposure of more than 10 or 15 percent in such potentially at-risk regimes, and prodding managers to trim down those geopolitically vulnerable positions unless there is a clearly compelling undervaluation thesis. Another sensible approach would be to require underweighting of major companies relative to a benchmark index, based on their percentages of autocrat-nation revenues.
Ultimately at a fiduciary level, if a pension fund’s total worst-case exposure to all earnings and income derived from autocratic nations is an insignificant fraction of its total portfolio, the composite risk is probably not worth losing sleep over, on purely financial grounds. But politics could still enter the theater stage for pension boards that ignore this issue.
Pension consultants and risk advisers have a new role to play in this dialog. ESG investing is now under fire, so a healthy ESG+G discussion is especially timely. If nothing else, informed advisers can help investment teams and trustees identify where their portfolios might contain a blind-side risk that hasn’t received enough attention.
And whether or not there is an actionable economic risk, public-plan professionals must always anticipate and deal with media headlines, public perception and political potshots. Without obsessing on the topic to invite theatrical overkill in public meetings, reports documenting investment-committee discussion may provide air cover for fiduciaries who operate in the goldfish bowl of public pension oversight. Whether anybody actually tweaks their portfolio as a result will remain to be seen.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be considered investment advice.
Related Content
