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Figure 39: MSCI EM relative to DM vs EM-DM relative growth acceleration
MSCI EM relative to DM ($)	EM-DM growth (RHS)	EM-DM growth (forecast)

300																							7
250																							6
																							5
200																							4
150																							3
																							2
100																							1
50																							0
2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020	2021	2022	2023

Source: MSCI; Bloomberg; Renaissance Capital

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12. EM C/As under control

In EM, the IMF expects South Africa and Pakistan to have a 2019 C/A deficit in excess of 3%. FM looks less impressive on this front. Oil importers’ C/As should benefit from the recent decline in oil prices: the IMF’s forecasts assume $72.3/bl for Brent in 2019.

Figure 40: EM C/A and budget balances (brackets = weight in index), 2019E

				Current account balance (% GDP)		Budget
15
10
5
0
-5
-10	Thailand (2.4%)		Qatar (1.1%)		Peru (0.4%)		India (9.0%)	Chile (1.1%)
Taiwan (11.3%)		UAE (0.7%)		Russia (3.7%) Korea (14.0%) Malaysia (2.4%) Hungary (0.3%) China (31.1%) Greece (0.3%) Czech Republic (0.2%) Mexico (2.6%) Poland (1.2%) Turkey (0.7%) Philippines (1.0%) Brazil (7.5%)		Colombia (0.4%) Indonesia (2.2%) Egypt (0.1%)			South Africa (6.3%)	Pakistan (0.1%)

Figure 41: ‘Fragile five’ C/A balances
Largest 12M pre/post-taper		2018E		2019E	3%
0
-1
-2
-3
-4
-5
-6
-7
-8
Turkey	South Africa	India	Brazil	Indonesia

Source: IMF, Renaissance Capital	Source: IMF, Renaissance Capital
Figure 42: FM C/A and budget balances (brackets = weight in index)	Figure 43: BF C/A and budget balances

15	Current account balance (%GDP)	Budget
10
5
0
-5
-10

SriIvory (22.0%)Kuwait ArabiaSaudi (1.1%)Slovenia (1.6%)Croatia(16.1%)Vietnam (0.3%)Estonia (6.7%)Nigeria (0.8%)Kazakhstan (0.2%)Lithuania (1.6%)Oman (4.2%)Bahrain (2.8%)Bangladesh (0.2%)Lanka(16.3%)Argentina (4.6%)Romania (0.1%)Coast (8.0%)Morocco (4.9%)Kenya (1.6%)Serbia (0.7%)Senegal (0.7%)Tunisia (1.2%)Jordan (2.1%)Mauritius (1.9%)Lebanon

Source: IMF, Renaissance Capital

		Current account balance (%GDP)								Budget
10
8
6
4
2
0
-2
-4
-6
-8
-10	Iran		Zambia			Ghana		Tajikistan	Tanzania	Zimbabwe			Georgia
Azerbaijan		Uzbekistan		Armenia	Ukraine		Belarus				Uganda	Rwanda

Source: IMF, Renaissance Capital

End-2019 MSCI EM Index target

Figure 44: MSCI EM Index ($)

1,400

1,300

Bull

1,200

1,167

1,100

Base

1,000

1,081

900

800

Bear

700

771

600

500

Ultra Bear

400

Mar-07

Jul-09

Feb-10

Mar-14

Jul-16

Feb-17

455

Jan-06

Aug-06

Oct-07

May-08

Dec-08

Sep-10

Apr-11

Nov-11

Jun-12

Jan-13

Aug-13

Oct-14

May-15

Dec-15

Sep-17

Apr-18

Nov-18

Jun-19

Source: Bloomberg, Renaissance Capital

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														Renaissance Capital
															14 January 2019
															ESG
	Figure 45: Renaissance Capital MSCI EM end-2019 Index target
	MXEF:	965.67		EPS		%chg.		PER		12M FWD PER	Index	Price chg (%)		Div yld. (%)	Total ret (%)
	Current		2018F	85.1				11.3						3.1
			2019F	92.0		8.2%		10.5						3.4
			2020F	102.2		11.0%		9.5						3.7
	Bull		2018F	85.1										3.1
			2019F	92.0		8.2%				11.4	1167.4	20.9		3.3	24.2
			2020F	102.2		11.0%								3.7
	Base		2018F	85.1										3.1
			2019F	88.6		4.1%				11.0	1081.4	12.0		3.2	15.2
			2020F	98.3		11.0%								3.6
	Bear		2018F	85.1										3.1
			2019F	87.8		3.2%				8.3	771.1	-20.2		3.2	-17.0
			2020F	93.0		6.0%								3.4
	Ultra		2018F	85.1										3.1
	bear		2019F	88.5		4.0%				5.9	454.6	-52.9		3.2	-49.7
			2020F	76.8		-13.2%								2.8

Source: Renaissance Capital

Below we highlight our base and risk cases for MSCI EM in 2019.

Base case – MSCI EM Index target 1,081

2019 EPS growth comes in at half the consensus 8% level given a slowing China, declines in commodity prices. The 2020 EPS consensus growth forecast of 11% is unchanged. 12-month forward P/E re-rates to 11.0x (i.e. returns back to levels of summer 2018, but still well below the recent 13.5x peak of January 2018). 2020E EPS of 98.3. The MSCI EM Index target of 1,081 implies 12.0% potential upside. Adding a 3.2% dividend yield implies a 15.2% total return.

Bull case – MSCI EM Index target 1,167

2019 EPS growth comes in at the consensus 8% level. 2020 EPS consensus growth of 11% is unchanged. 12-month forward P/E re-rates to 11.4x (i.e. returns to the average level since 2005). 2020E EPS of 102.2. The MSCI EM Index target of 1,167 implies 20.9% potential upside. Adding a 3.3% dividend yield implies a 24.2% total return.

Bear case – MSCI EM Index target 771

2019 EPS growth misses by 5%: 3% vs 8% consensus, with a similar miss for 2020 EPS growth: 6% vs 11% consensus. 12-month forward P/E de-rates to 8.3x (i.e. to the 2011 post-global financial crisis low). 2020 EPS of 93.0. MSCI EM index target: 771 gives 20.2% downside. Adding a 3.2% dividend yield implies a -17.0% total return.

Ultra-bear case – MSCI EM Index target 455

2019 EPS growth comes in at half the consensus 9% level. 2020E EPS growth revised to -13%, being the YoY decline in MSCI EM 12-month forward EPS at the trough of MSCI EM in 2008 (the peak-to-trough EPS decline was 49%). 12-month forward P/E de-rates to 5.9x (as seen in the 2008 trough). 2020E EPS of 76.8. MSCI EM Index target: 455 implies 53.2% potential downside. Adding a 3.2% dividend yield implies a -50.0% total return. This scenario assumes an arguably extreme repeat of the 2008 de-rating and earnings decline. A return to the 2008 P/B low of 0.99x would take MSCI EM back to 654, a more modest 33% decline.

Key risks

There are numerous risks facing EM investors.

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Late-cycle US economy. August 2018 saw the US bull market become the longest ever. Next summer will see the current US expansion become the longest on record since records began in the 1850s. Previous Fed Chair Janet Yellen said that she thought “it’s a myth that expansions die of old age”, but in our opinion late-cycle economies can bring with them: 1) less slack (and therefore greater risk of inflation); and 2) greater imbalances (and/or sensitivity to shocks and/or higher rates). At 2.5%, we would hope that US rates aren’t enough to destabilise things. Global debt may have tripled to $247trn over the past two decades, but at the same time, the global economy has grown almost as much (1.7x larger) and interest rates much lower (US 10-year bond yields were 7% back in 1998).

China-US relations. President Trump’s sensitivity to the performance of US equities (and the economy) is well known: recent equity market declines could make it more likely, in our opinion, that some trade agreement can be found by the 1 March deadline, leading to a relief rally for markets, but a superficial agreement may not last: Trump has been espousing protectionism for over three decades, and there may be a more profound (and bipartisan) shift emerging in US attitudes towards China’s potential rise as a geopolitical rival. If so, the implications could be long-lasting and destabilising, not just for EM (where China accounts for nearly one-third of the MSCI Emerging Markets Index).

China economy. Economists have worried about a potential for a hard landing in China for at least a decade. China’s economy has long been being forecast increase in debt levels in China is a longstanding concern, and renewed stimulus of the economy to sustain growth given trade related head winds risks postponing progress on corporate deleveraging and improving the quality of growth in China.

Global politics shifting from the centre. We cannot ignore rising nationalism/patriotism/populism/balkanisation/protectionism in the world at the expense of multi-lateralism. Symptoms include Brexit, the Trump presidency, the Gilets Jaunes protests in France, Italian politics, the emergence of populist parties in Europe, as well as in the politics of a whole host of EM leaders (including Xi, Putin, Modi, Erdogan, Orban, Bolsonaro, AMLO, Duterte, etc). Blame it on inequality, social media or whatever, but the trend appears to be moving away from the Washington consensus and the liberal centre.

EM equities in a bear market, despite inflows. At their peak, EM equity outflows this year were 1.7% of AuM. After recent inflows, full year data shows that this was fully recovered, with cumulative inflows ending 2018 above the prior peak, causing investors to wonder how EM equities would cope with more sizeable outflows; however, this does fit with anecdotal feedback we have heard from fund managers that asset owners may be allocating fresh cash to EM on weakness to reduce their underexposure to the asset class.

The tech gap. Within EM, it can be argued that EMEA and Latin America are not leaders in the global tech revolution. Mega trends such as AI taking over low-end jobs (e.g. call centres, data processing, making automation more flexible) and as the price of robotics/3D printing declines and as big ticket items become shared (e.g. car/bike/scooter sharing) or simplified (the Chevrolet Bolt has 24 moving parts vs 149 in a VW Golf) the demand for EM labour may suffer. Bulls would argue has always been with us, and the world currently has record employment: 3.3bn in 2018 vs 2.8bn in 2014.

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Figure 46: EM / FM election calendar

	Country		Election type	Date		Notes
	Nigeria		General	16/02/2019
	Thailand		General	24/02/2019
	Moldova		Parliamentary	24/02/2019
	Nigeria		Gubernatorial, State Assembly	02/03/2019
	Estonia		Parliamentary	03/03/2019
	Ukraine		Presidential	31/03/2019
	India		General	01/04/2019		Exact date TBC
	Indonesia		Legislative, presidential	17/04/2019
	South Africa		General	01/05/2019		Exact date TBC
	Philippines		Senate/House	13/05/2019
	Turkey		Local	31/05/2019
	Ukraine		Parliamentary	01/10/2019		Exact date TBC
	Argentina		General	01/10/2019		Exact date TBC
	Greece		Legislative	20/10/2019		Exact date TBC
	Poland		Parliamentary	01/11/2019		Exact date TBC
	Romania		Presidential	01/12/2019		Exact date TBC
	Tunisia		Presidential	01/12/2019		Exact date TBC

Source: MSCI; Bloomberg; Renaissance Capital

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ESG

La crise climatique est une guerre contre les pauvres4

Summary

▪ESG investing is becoming increasingly important right along the investment value chain – from asset owners to asset managers to corporates.

▪The Global Sustainable Investment Alliance estimates some $23trn of assets globally are managed under some form of ESG. Morningstar’s database contains $1.05trn of publicly-available ESG funds, and in EM, we have identified $21bn of publicly-available ESG equity funds, up from just $5bn at the start of 2016. Including non-public funds and non-ESG designated funds which have incorporated ESG in to their investment processes would certainly boost this figure.

▪ESG covers a broad scope of strategies including traditional negative screens (e.g. not owning tobacco or weapons manufacturers), positive screens and best- in-class strategies (e.g. portfolios focused on the best ESG-scoring names), norms-based screens (excluding companies which breach international norms), thematic investing (e.g. portfolios focused on alternate energy) and impact investing (where there is a measurable impact expected, for example, on carbon emissions). ESG integration has been introduced more recently, and is where much of the focus is at present.

▪The aim of ESG integration is to integrate ESG throughout the investment process with the aim of improving risk-adjusted returns – this is an important factor in ESG going mainstream as many pension funds, insurance companies and the like have a fiduciary duty to maximise risk-adjusted returns.

▪ESG is not without its challenges. The field is still a new one, and the tsunami of data (of varying quality) risks overwhelming fund managers. Materiality of different factors to investment returns is still unclear, with ESG data providers boasting of tracking thousands of metrics. Many of the reports purporting to demonstrate outperformance use back-tested data rather than real-life portfolios.

▪There is an ongoing debate as to whether ESG should be ‘just’ another investment tool alongside more orthodox financial modelling and valuation metrics – or whether ESG portfolios individually or in aggregate should somehow be able to demonstrate contribution to a measurable environmental or societal improvement. In the end, asset managers will provide whatever solutions asset owners demand, but as Bloomberg pointed out, one ESG ETF holds 400 of the 500 stocks in the S&P index, another has Exxon Mobil as its largest holding and also owns Philip Morris and at least three defence contractors.

▪As ESG assets grow, and with it, corporate disclosure, companies which score well on ESG metrics should find themselves better positioned to attract a wider pool of capital and thus achieve a lower cost of capital and higher valuations.

▪What metrics should corporates target? There are thousands of ESG parameters being collected and the list is ever growing. We have developed a model focusing on: greenhouse gas emissions per unit of sales; social factors such as women in the workforce and in management roles, worker safety and conditions; governance issues such as board independence and size, state ownership, and responsibilities to shareholders. We found that companies with

4 ‘The climate crisis is a war against the poor’, Graffiti, Gilets Jaunes protests, Paris, December 2018

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lower government ownership, smaller boards and a higher representation of women in management tended to outperform.

▪Do high-scoring stocks outperform? MSCI’s ESG Leaders indices have outperformed in EM, but not in DM; and the bulk of EM’s outperformance comes from the fact that China’s ESG Leaders index outperformed its parent. Examining baskets of ESG funds with a long history, we find no real evidence of outperformance over the long term; in EM, ESG funds managed to roughly equal the return on the standard MSCI EM Index, but lagged the EM ESG Index. Our ESG model shows some evidence for outperformance, particularly when focusing on governance; our model also suggests that companies that improved their environmental scores outperformed companies that did not.

▪Using our ESG-scoring model, we can aggregate our results to determine which countries are relatively better on ESG metrics. Finland, the Netherlands and Israel top the list for overall ESG, while India, China and Indonesia score worst. The best EM countries for ESG are Korea, Brazil and South Africa. By sector, healthcare, IT and communications score best, while utilities, energy and materials score worst. Our ESG scores show Natura Cosmeticos, the Brazilian cosmetics giant famed for its sustainable practices, as the top ESG company in EM, followed by Lojas Renner and China State Construction and Engineering. At the other end of the spectrum, we find China Airlines, Gail India and Ambuja Cement. We also look at the best-in-class in EM on a sector basis.

▪We examined financial and valuation characteristics of high-scoring ESG stocks. High-scoring non-financial ESG stocks tend to have higher RoE, higher revenue growth, higher margins, lower leverage (on debt/equity and net debt/EBITDA), and higher valuations on a 12-month forward P/E and EV to 12month forward EBITDA basis. For financial stocks, top-scoring companies show higher RoE, higher valuations on 12-month forward P/E and trailing P/B, and higher dividend yields; they also tend to be larger in market cap. The higher returns and valuations of high-scoring ESG companies is a powerful argument for corporates to focus on ESG in opinion, but the higher valuations issue could mean that the market has already noticed this – and that outperformance of such companies is not necessarily a given.

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ESG – Introduction

ESG ought to be of interest to anyone who has choked on Beijing’s smog, found themselves caught up in a French gilets jaunes fuel price protest, been shocked by the unconstrained ‘wild east’ capitalism of Russia in the 1990s, been impacted by a corporate collapse, felt dismayed at gender pay gaps in the UK, disappointed by EU car producers gaming emissions standards, wondered why multinationals’ aggressive tax optimisation is tolerated, or simply felt a sense of foreboding about the Orwellian future promised by social scoring in China. There is no requirement to be a “lentil-munching, sandal-wearing watermelon” to consider such issues important.

ESG does not seem to be going away any time soon – if anything the shift towards ESG investing appears to be gaining momentum as issues such as climate change, corruption, tax transparency, data privacy, corporate governance, mass migration, urban pollution, demographics, #metoo and deforestation continue to hit the headlines. Social media is playing a role in exposing issues and there growing pressure on companies to act responsibly, together with a trend towards society ‘repricing’ of ESG costs via: 1) carbon, pollution and water pricing; 2) increased taxes on diesel and accelerating the adoption of low/zero emissions vehicles; 3) taxes on unhealthy goods (tobacco, sugar); 4) fines for data breaches; 5) opposition to aggressive tax optimisation (and taxes on tech companies); and 6) legislation and regulation against corruption, bribery, modern slavery, etc.

Demographics too is playing a role: a 2018 survey by the Defined Contribution Investment Forum found that (among defined contribution savers), 41% of 55-65 year olds are interested in responsible investing, but this almost doubles to 80% of 22-34 year olds, so there may well be a generational shift at work.

As ESG-managed assets continue to grow, the carrot of accessing a wider pool of capital and potentially a lower cost of funding is likely to be a powerful drive for corporates. Social media, too, has a role, with ESG ‘underperformers’ subject to greater exposure, potentially affecting customer sales and staff morale alike, as well as putting pressure on shareholders to act (via engagement or divestment) potentially impacting share prices. With demand for ESG solutions clearly increasing from underlying asset owners (sovereign wealth funds and corporate and self-invested pension funds alike) we believe there is certainly a business case to be had for fund managers to provide ESG solutions. Such strategies may be higher margin and could help protect active managers from the onslaught of passive investing. ESG ETFs tend to rely on indices constructed using inconsistent third-party ESG scores and in general lack the ability to engage with corporate management) make it tricky for passive funds to incorporate ESG, though there is plenty of work being done in the space.

We hear plenty of debate about how ESG should be used. Some argue that ESG should be used as an active tool to achieve a measurable reduction in pollution, carbon emissions and the like, and to help improve social issues such as the quality of jobs created. At the other extreme is the neoclassical view (espoused most famously by Milton Friedman) that companies should focus solely on the pursuit of (legal) profits. The middle ground emerging is those who seek to use ESG to help maximise risk-adjusted returns, by using data to understand risks facing a company’s business model from ESG issues now and in the future, and to help improve engagement with management. This is important for ESG going mainstream as many asset owners (pension funds, insurance companies and the like) have a fiduciary duty to maximise risk-adjusted returns.

Such strategies tend to prioritise governance above environmental and social factors – research, including ours, typically suggests that over short time frames companies with strong governance have tended to outperform those with high social or environmental scores.

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What is ESG?

ESG can be broadly defined as the incorporating of environmental, social and governance metrics in to the investment process.

A list of typical ESG factors is shown in the table below, but ESG data providers are collecting thousands of much more granular ESG datapoints (we show MSCI’s ESG matrix in Appendix A).

Figure 47: Typical ESG factors

Environmental	Climate change – including physical risk and transition risk
	Resource depletion, including water
	Waste and pollution
	Deforestation
Social	Working conditions, including slavery and child labour
	Local communities, including indigenous communities
	Conflict
	Health and safety
	Employee relations and diversity
Governance	Executive pay
	Bribery and corruption
	Political lobbying and donations
	Board diversity and structure
	Tax strategy

Source: Principles for Responsible Investment

There are many ways ESG can be incorporated by investors. The Global Sustainable Investment Alliance outlines seven major ESG methodologies (some of which can be used in combination):

Figure 48: Types of ESG investing

	Negative/exclusionary	The exclusion from a fund or portfolio of certain sectors, companies or practices based on
	screening	specific ESG criteria
	Positive/best-in-class	Investment in sectors, companies or projects selected for positive ESG performance
	screening	relative to industry peers
	Norms-based screening	Screening of investments against minimum standards of business practice based on
		international norms
	ESG integration	The systematic and explicit inclusion by investment managers of environmental, social and
		governance factors into financial analysis
	Sustainability themed	Investment in themes or assets specifically related to sustainability (for example clean
	investing	energy, green technology or sustainable agriculture)
		Targeted investments, typically made in private markets, aimed at solving social or
	Impact/community	environmental problems, and including community investing, where capital is specifically
	investing	directed to traditionally under-served individuals or communities, as well as financing that is
		provided to businesses with a clear social or environmental purpose
		The use of shareholder power to influence corporate behaviour, including through direct
	Corporate engagement and	corporate engagement (i.e., communicating with senior management and/or boards of
	shareholder action	companies), filing or co-filing shareholder proposals, and proxy voting that is guided by
		comprehensive ESG guidelines
		Source: Global Sustainable Investment Alliance

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A brief history of ESG

ESG in one form or another has been with us for at least 3,500 years. Jewish law saw that ownership brought with it not only rights but responsibilities as an owner. Later, the Koran established guidelines to prevent exploitative gains – or usury – and ruled out investment in alcohol, pork, gambling and gold. By the eighteenth century, Methodists and Quakers were rejecting the slave trade, as well as investment in liquor, tobacco and gambling.

The 1960s saw campaigners opposed to the Vietnam War putting pressure on university endowments to divest from investments in the defence sector. The 1980s saw companies exposed to apartheid South Africa come under pressure to exit, while ecological disasters such as Bho Pal, Chernobyl and Exxon Valdez triggered greater environmental awareness. By the 1990s onwards, corporate scandals such as Polly Peck, BCCI International, Enron, Tyco, WorldCom, Satyam, Olympus and Tesco added greater focus on corporate governance. In the 2000s, the gig economy, data protection, inequality and the impact of globalisation (as well as the aftershocks of the global financial crisis) have been added to the mix, and social media has become an important tool.

Early forms of ESG investing introduced in the 1970s (as socially responsible, values-based or ethical investments) were generally negative screens, that is to say, excluding companies which failed to meet certain criteria (e.g. companies involved in tobacco, fur or controversial weapons). Restricting the investment universe had its constraints on performance over time (MSCI World Tobacco has significantly outperformed MSCI World over the past 15 years for example), and one response to this challenge was to introduce positiveor best-in-class screening strategies (these are often used to create the ESG indices tracked by ETFs). Impact and thematic investing focuses holdings on a specific objective (e.g. reducing carbon emissions, financial inclusion, alternate energy).

More recently, the fastest-growing segment has been ESG integration, which gives active managers greater freedom to invest across the investment universe, but where ESG is integrated in to every part of their investment process, with the aim of using ESG data to maximise risk-adjusted returns via better informed investment decisions, and giving a dashboard of ‘early warning’ signs for risks that could become apparent, and allowing more comprehensive engagement with corporations in meetings and proxy-voting.

Figure 49: ESG integration adds ESG assessment to every part of the investment cycle

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Source: Principles for Responsible Investment

One significant boost for ESG integration came after a 2015 Harvard Business School analysis, showed that “firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing”. In other words, there was a way to incorporate ESG without sacrificing

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