An update on our ESG scores

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Mildred Lewis
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1 An update on our ESG scores FRANKLIN TEMPLETON THINKSTM GLOBAL MACRO VIEWS

2 In this Issue In February 18, (TGM) published Global Shifts issue 9 Environmental, Social and Governance Factors in Global Investing [GMS-9]. The paper explored how we evaluate environmental, social and governance (ESG) factors in our macroeconomic research process, and described the process of codifying the team s research discussions into quantifiable scores. GMS-9 formally introduced our proprietary ESG scoring system, the ESG Index. Going forward, we intend to publicly update our scores on a recurring basis. This paper is the first of these updates. It contains a brief background on our ESG philosophy and our scoring process, along with updated TGM-ESGI scores for 56 countries. We also include brief case studies for three countries that have improving projected scores and three countries with deteriorating projected scores. TGM s ESG Philosophy and process Before delving into the specific scores, we would like to summarize a few key points on how TGM views our internal ESG process. These points also reflect how TGM believes ESG can be best utilized by investors in the sovereign space. 1. ESG is most effective when fully integrated into the other components of research, including traditional economic analysis and on-the-ground visits. These issues contribute to core macroeconomic views on a country. ESG factors are then expressed through analysis of economic issues such as growth and inflation. 2. We focus on forward-looking data points. Rather than current ESG performance, which is strongly correlated with income levels, TGM believes that momentum, or change in score, is the measure that truly matters for both potential investment performance and for determining where capital could be deployed for the greatest positive impact. 3. ESG is an important tool for identifying investment opportunities in addition to highlighting areas of risk. TGM is most interested in the tails signaling major ESG shifts in either direction. 4. In order to benefit from ESG analysis, investors must have a sufficiently long time horizon. ESG factors guide a country s fundamentals, which can be overshadowed in the short term by cyclical or temporary conditions. We believe conviction in the view and patience to see that view come to fruition are requisites to successful ESG investing. 5. Emphasis on a country s long-term fundamentals provides an effective base for TGM to open communication with policymakers interested in discussing best economic practices. This dialogue is important for our ability to serve clients, and for government officials interested in the perspectives of private markets. 2 Global s Views / An update on our ESG scores

3 TGM-ESGI: Methodology and scores The TGM-ESGI is a composite of 13 subcategories (see GMS-9, page 4) determined to be material to macroeconomic performance, scored from 1. 1 The research team assigns numbers by overlaying their views on a benchmark created by global indexes for current scores. Analysts then provide projected numbers in anticipation of how conditions will change in the medium term. The final scores are calculated with weightings of % for governance, % for social and % for environment. The environment receives a lower weighting because its effects on macroeconomic performance take place over a significantly longer-term time horizon. The change in score, the metric TGM places the greatest emphasis on, is simply the projected score minus the current score. The results from our February 19 scoring are shown in Exhibits 1 and 2. We have expanded the number of countries to 56 from 44 previously. ENVIRONMENTAL, SOCIAL AND GOVERNANCE SCORES BY COUNTRY Exhibit 1: s: 1 Venezuela Nigeria Tanzania Ecuador Kenya Egypt Zambia Ukraine Philippines Indonesia Sri Lanka Uganda India Ghana Brazil Russia Turkey Vietnam Colombia Greece Peru Mexico South Africa Argentina China Serbia Thailand Uruguay Croatia Chile Italy Malaysia Hungary Poland Slovakia Lithuania Spain Portugal Korea Israel France Japan Czech Republic UK Netherlands Ireland Germany Australia New Zealand US Sweden Norway Singapore Switzerland Canada Denmark Exhibit 2: s: Change Poland Italy US Venezuela Hungary Turkey Czech Republic Singapore South Africa Spain Germany China UK Russia Tanzania Uganda Sri Lanka Japan Netherlands Israel Sweden Nigeria France Korea Ukraine Malaysia Zambia Croatia Lithuania Slovakia Switzerland Denmark Norway Uruguay Mexico New Zealand Australia Canada Philippines Ireland Portugal Kenya Ecuador Vietnam Greece Egypt Chile Colombia Thailand Ghana Peru Indonesia Serbia India Brazil Argentina Source: Calculations by Franklin Templeton Capital Market Insights Group using data sourced from Bloomberg, Central Bank News. 1. The scale has been expanded to 1 from 1 since the methodology s original publication. Global s Views / An update on our ESG scores 3

4 Case studies As stated earlier, what TGM pays greatest attention to are the tails, countries in which there is a drastic change with regards to projected ESG scores in either direction. We have highlighted six of these countries, three showing projected improvement and three showing expected deterioration. Three Countries with Improving ESG Scores Indonesia President Joko Widodo looks poised to win a second term, reflecting public support for his reform agenda and rejecting the elite background and nationalistic rhetoric of his rival, Prabowo Subianto. We expect further progress on president Widodo s reform agenda following elections. This includes building infrastructure, reducing regulations on businesses and fighting corruption. There will also likely be an emphasis on reducing poverty and inequality. Economic management has become increasingly orthodox, with an emphasis on prudent budgets and consistent monetary policy. The number and quality of technocrats within the administration have strengthened. Social cohesion in Indonesia is expected to deteriorate with the rise of fundamental Islamic groups and their greater influence over politics. INDONESIA Exhibit 3: Indonesia: and Conditions Brazil Recent elections in Brazil represent a new direction for the country, including a firm rejection of systemic corruption under ex-president Luiz Inacio Lula da Silva and the Workers Party (PT). The cleanup of Lava Jato a corruption scandal also known as Operation Car Wash and public enthusiasm for its efforts has empowered the judiciary to launch a campaign against graft. The administration has assembled a capable economic team that is intent on addressing fundamental challenges facing Brazil, notably social security reform. The business climate in Brazil is expected to improve significantly with reduced red tape and corruption, along with the administration s push for the privatization of state-owned enterprises and reduction of trade barriers. We are cautious of potential deterioration in certain ESG factors due to the current administration s inclinations, paying particular attention to institutional strength, social cohesion and unsustainable practices. BRAZIL Exhibit 4: Brazil: and Conditions Global s Views / An update on our ESG scores

5 Argentina Argentina has maintained commitment to politically challenging but necessary reforms in order to rebalance its economy. Decisions to float the exchange rate, enact pension reform and reduce subsidies have caused short-term economic pain but are critical to the country s long-term potential. Despite a tougher economic environment, including recession and high inflation, President Mauricio Macri s government has continued to navigate Congress and pursue orthodox economic policy, including passing a balanced primary budget for 19. President Macri and his Cambiemos party have retained core public support. We continue to expect a Cambiemos victory in the October presidential elections on this base and the split in the Peronist party, but are carefully monitoring developments. The government has moved to rectify many of the previous administration s corrupt practices by publishing accurate economic statistics and punishing corporations that engage in graft with public officials. Energy security in Argentina is expected to improve as a free-floating currency will encourage investment within the natural gas industry, reducing the country s reliance on expensive imports. ARGENTINA Exhibit 5: Argentina: and Conditions Three Countries with Deteriorating ESG Scores Italy Elections in March 18 cemented populist leadership with unprecedented victories by the League and the Five Star Movement, bringing Italy into the growing ranks of euroskeptic countries within the European Union (EU). The new government stands for populist measures such as tax cuts, anti-immigration efforts and the abolishment of pension reform. These policies, while popular, are counter-productive in the face of Italy s challenges with high debt levels and low productivity growth. Italy is set up for increasing conflict with Brussels as its government seeks less EU oversight into its domestic affairs. While the first major clash, on the 19 budget, was resolved, we can expect further confrontations down the road. Social discord and support for hard-right parties can only be expected to increase as both Italian and broader euro area growth are slowing. ITALY Exhibit 6: Italy: and Conditions Global s Views / An update on our ESG scores 5

6 Turkey Institutions have been broadly weakened under the executive presidency, including abolishment of the office of prime minister, the right to dismiss senior civil servants and the ability to appoint judges. The numerous purges since 15 have dismissed tens of thousands of individuals from the civil service, military, judiciary, media and academia intimidating and severely damaging the capacity of those institutions. Economic policies have consistently been misguided, including the erosion of central bank independence and over-extension of credit. Government spending has also been pro-cyclical, concentrated in construction and defense, adding to the overheating. Volatile political and economic conditions in Turkey have eroded its credibility among foreign investors. Escalating tensions with the US and European countries will also likely have negative impacts on Turkey s attractiveness as an investment destination. TURKEY Exhibit 7: Turkey: and Conditions South Africa Economic fundamentals are gradually deteriorating, including poor fiscal management and deindustrialization in the face of increasing reliance on commodities. The government does not have sufficient political capital to engage in an orthodox reform agenda. Low growth and significant inequality have caused greater public demand for redistribution rather than growth. An example is the debate over land expropriation without compensation. This leaning toward populism has damaged business confidence, which has been on a declining trend. The African National Congress (ANC) continues to battle factionalism between the supporters of President Cyril Ramaphosa and ex-president Jacob Zuma. This is particularly damaging to administrative effectiveness as the ANC governs by collective policymaking. There are also significant tensions between the ANC and its coalition partners, SACP and Cosatu. The Ramaphosa administration has worked to fight corruption and graft. The government has turned over the heads of the state security agency and the Hawks, a specialist anticorruption police unit, and dismantled the Gupta empire. SOUTH AFRICA Exhibit 8: South Africa: and Conditions Global s Views / An update on our ESG scores

Global Views is a complementary publication that will update and/or amplify the periodic research-based briefing on global economies called Global Shifts. Both feature the analysis and views of Dr.

This economic team, trained in some of the leading universities in the world, integrates global macroeconomic analysis with in-depth country research to help identify long-term imbalances that

Shin, Ph.D. Vice President, Senior Global & Research Analyst Diego Valderrama, Ph.D. Senior Global & Research Analyst Attila Korpos, Ph.D. Senior Global & Research Analyst Shlomi Kramer, Ph.D. Senior Global & Research Analyst Vivian Guo Research Analyst WHAT ARE THE RISKS?

investment strategy. It does not constitute legal or tax advice. The views expressed and the comments, opinions and analyses are rendered as at the publication date and may change without notice.

All investments involve risks, including possible loss of principal.

Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets smaller size, lesser

7 Global Views is a complementary publication that will update and/or amplify the periodic research-based briefing on global economies called Global Shifts. Both feature the analysis and views of Dr. Michael Hasenstab and senior members of. This economic team, trained in some of the leading universities in the world, integrates global macroeconomic analysis with in-depth country research to help identify long-term imbalances that translate to investment opportunities. Primary contributors to this issue Michael Hasenstab, Ph.D. Executive Vice President, Portfolio Manager, Chief Investment Officer Calvin Ho, Ph.D. Senior Vice President, Portfolio Manager, Director of Research Hyung C. Shin, Ph.D. Vice President, Senior Global & Research Analyst Diego Valderrama, Ph.D. Senior Global & Research Analyst Attila Korpos, Ph.D. Senior Global & Research Analyst Shlomi Kramer, Ph.D. Senior Global & Research Analyst Vivian Guo Research Analyst WHAT ARE THE RISKS? This material reflects the analysis and opinions of the authors as at 15 February 19 and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. It is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed and the comments, opinions and analyses are rendered as at the publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market, industry or strategy. All investments involve risks, including possible loss of principal. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Global s Views / An update on our ESG scores 7

IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or

8 IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. 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