Applying an ESG lens to macroeconomic analysis—a starting place

ESG factors are playing an increasingly important role in the formulation of investment outlooks—applying a sustainability lens to every element of macroeconomic analysis is now, in our view, mission critical.

Key takeaways

  • Integrating ESG factors into macroeconomic analysis enables investors to understand how sustainability issues could influence the way financial markets respond to traditional economic developments and data points.
  • Efforts to mitigate the impact of climate change are already having a discernable impact on the global growth outlook in at least one fundamental way: how central banks assess transition risk, which will gradually inform their approach to monetary policy.
  • In our view, integrating ESG factors into macroeconomic analysis is more of a necessity than a choice, and failure to do so could risk getting investment calls wrong. 

Evolving the ESG conversation

Environmental, social, and governance (ESG) investing is often perceived as a bottom-up investment approach with a focus on selecting the right companies and attaining an acceptable ESG risk/return profile for the overall portfolio. It’s also closely associated with opportunities in key future infrastructure, technology, or initiatives that will accelerate the world’s transition to a cleaner, more sustainable, and equitable future. But in our view, there’s now a pressing need to evolve the conversation further and broaden the discourse to include debates on how best to incorporate ESG factors into macroeconomic analysis.

"In our view, the future of macro investing is tied to the industry’s ability to devise ways to integrate ESG factors into macroeconomic analysis, or we run the very real risk of getting investment calls—tactical and strategic—wrong."

To be sure, this involves more than just adjusting, or for lack of a better word, tinkering, with long-term growth and inflation forecasts—that’s a given. It’s about viewing macro events through an ESG lens in a consistent manner, enabling investors to better understand how sustainability issues could tilt the way markets respond to traditional economic developments and data points. In our view, the future of macro investing is tied to the industry’s ability to devise ways to integrate ESG factors into macroeconomic analysis, or we run the very real risk of getting investment calls—tactical and strategic—wrong.  

A less-than-straightforward process

Applying an ESG lens to the macro outlook isn’t always straightforward. Naturally, there are quantifiable ways to integrate shifting narratives such as carbon taxes and government spending on green infrastructure that have already been announced into macroeconomic forecasts through modeling, but qualitative judgments are just as important—being able to calibrate global central banks’ evolving perspectives on how environmental and social risks could affect their mandate and the way they think about growth will likely produce a material difference to projected economic outcomes.

Crucially, the drive to incorporate ESG factors and macroeconomic analysis remains at a nascent stage of development—we’re closer to the beginning of the journey than the end, and as the relevant data, policies, and available technology become more sophisticated, so too will our ability to embed them into our outlook.

Within this context, we highlight three ways in which ESG factors are already altering our macro perspective and three macro themes that we’re increasingly viewing through an ESG lens. 

Climate change and the forecasting process

Climate change is altering the way we assess the global economy


  1. Global warming

    Climate change and more frequent and severe weather can alter GDP forecasts in the long run

  2. Green central banks

    Central bank integration of ESG factors is likely to lead to a lower terminal rate and a slower pace of rate normalization

  3. Government spending

    Fiscal spending on green initiatives is likely to have a higher multiplier effect than non-green government spending

Source: Manulife Investment Management, July 1, 2021.

Many aspects of the E element in ESG are more quantifiable and lend themselves more easily to modeling and scenario analysis than the S and G factors. In addition, an extensive body of work in this area has already been developed, meaning that the set of plausible scenarios relating to climate change are pretty well mapped out. Within that context, we believe the foundation of integrating climate change into any global economic outlook begins with three key factors. 

1   Impact of climate change differs from region to region
The Paris Agreement aims to limit global warming to 2˚C relative to preindustrial levels¹; as such, many economic forecasters, including us, have incorporated a 2˚ rise in global temperature by 2050 into our models.² This enables us to generate scenarios that incorporate different levels of carbon intensity and changes in global temperatures that ultimately feed into our economic forecast. Broadly speaking, such an exercise has enabled us to observe a nonlinear relationship between productivity and changes in global temperature. For example, we’ve learned that colder regions such as Europe and North America are likely to experience a boost in productivity, largely due to an expected rise in agricultural productivity and construction activity, while the reverse is likely to occur in warmer regions such as Latin America and Asia. 

2   Rise in frequency and severity of extreme weather events
A rise in the frequency and severity of extreme weather events can also lead to a slightly different set of challenges in the forecasting process that economists don’t typically come across: While we can measure expected gradual chronic changes in the weather, it’s much more difficult to capture extreme weather events such as typhoons, earthquakes, and droughts—events that can heighten market, credit, and liquidity risks and lead to potential supply chain disruptions as well as demand-side shock. These climate-related risks are also widely expected to drive immigration patterns and create stranded assets. In our view, the rise in the frequency and severity of weather events necessitates the application of a wider confidence band around base economic forecasts.

3   Transition risks
The transition to an environmentally sustainable future is also likely to introduce new forms of risks to our base-case outlooks, both positive and negative. For instance, a fall in clean energy prices—an outcome of technological advancements—could lead to a drop in demand for fossil fuels, a development that could affect the financial health of traditional energy companies as well as banks and insurers that have underwritten loans for these firms. From a macroeconomic perspective, such an event could have implications for productivity, capital expenditure, and the direction of investment flow, among others. Arguably, the wheels are already in motion: The cost of producing solar power and wind energy has been declining steadily, while breakthroughs in carbon capture and sequestration technology could herald important changes in the future.³ It’s also important to take into account transition risks associated with public policy changes—carbon taxes and carbon emission schemes come to mind. It’s worth noting that these policy decisions could have knock-on effects on growth and should be incorporated into macro analysis as well; for example, official income derived from these initiatives that flows back into the economy through wages and associated capital investment. Understandably, some transition risks will continue to fall into the known unknowns category—changes in private sector sentiment and consumer preferences or the unexpected emergence of disruptive business models that threaten long-held industry norms. What this means is that macro analysts will need to pay close attention to changes in sentiment and technology. Incidentally, the very nature of known unknowns implies that a larger confidence band around base-case forecasts, particularly those over a longer horizon, could be needed.

It’s important to note that the three areas that we’ve highlighted represent no more than a starting place—the list is long and will continue to grow. As the industry uncovers more sophisticated ways of capturing and measuring sustainability factors, we’ll all get better at incorporating issues such as coastal flooding, water scarcity, and migration into our analysis. 

Central banks and interest-rate outlooks

Growing ESG awareness has also influenced the way we study global central banks and their policy decisions. In fact, we have a more dovish view of the future path of policy rates globally than would have been the case because we recognize that many central banks have begun to incorporate the impact of climate change into the way they assess economic growth and risks, and several of them are in the process of transitioning their mandates—formally and informally—to include more equitable growth.⁴ Indeed, all major central banks have been vocal and deliberate in their recognition of these issues. The Network of Central Banks and Supervisors for Greening the Financial System, which counts most developed-market central banks as members, has commissioned much in-depth research into ESG issues that we believe will inform central bank thinking going forward. In our view, disregarding this clearly discernable shift among policymakers could risk misreading central bank intentions and lead to overly hawkish macro forecasts. 

Central banks and ESG: an evolving landscape

Climate change can increase financial, credit, and liquidity risk

• All else being equal, growth can be more erratic, with asymmetric downsides

• A more cautious approach to monetary policy, delayed rate hike cycles

Climate transition can lead to lost economic growth, potentially through supply-and-demand shocks A later, gentler rate hike cycle
Climate change may lead to higher household savings rate, and a higher risk premium may lower the natural rate of interest

• Central banks have a lower terminal rate to their rate hike cycles

• Central banks have less policy room to maneuver

Changes in price levels could become more commonplace as climate transition progresses Central banks may become increasingly comfortable with the idea of structurally higher inflation
A growing focus on equitable policies that can benefit households more evenly Central banks may broaden their mandates beyond inflation and pay more attention to the makeup of the labor market, taking into consideration race and gender equality, thereby necessitating a more dovish stance on monetary policy
Source: The Network of Central Banks and Supervisors for Greening the Financial System, Manulife Investment Management, July 1, 2021.

Fiscal spending and the growth calculation 

We’ve previously written about how the COVID-19 outbreak could lead to structurally higher fiscal spending, bigger governments, and a much higher level of government bond issuance. It’s no secret that economists have tried and tested ways to integrate higher government spending into our economic outlooks; however, how governments spend their cash and what they spend it on have important implications for growth.

"We broadly expect the green sovereign bond market to become an important part of many countries’ debt management strategies and fiscal construct." 

For context, the amount of government spending that’s been earmarked for green investments among developed economies in the aftermath of the COVID-19 outbreak is unprecedented: Roughly half of the Biden administration’s American Jobs Plan will be related to green initiatives,⁵ while 37% of the EU recovery fund is climate friendly.⁶ Crucially, these initiatives are expected to have a higher multiplier effect relative to non-green infrastructure spending.⁷ Higher levels of green government spending are also likely to reduce overall carbon transition costs and lower risks that might dampen growth as a result of climate change. These are important elements that need to be factored into macroeconomic forecasts.  

There’s one other key aspect to the green spending narrative that’s relevant to global capital markets: surging demand—and, therefore, an expected ensuing rise in supply—for green sovereign bonds.⁸ Several 2021 European green bond auctions were heavily oversubscribed; these are typically longer maturity bonds with higher yields that have the potential to alter the global government bond landscape.⁹ We broadly expect the green sovereign bond market to become an important part of many countries’ debt management strategies and fiscal construct. 

Additional macro topics that should be viewed through an ESG lens

We firmly believe that the ESG lens can and should be applied to most traditional macro factors that flow through to investment decisions. While the impact of choosing to embark on such a path may seem subtle initially, we have no doubt that it will soon become a critical component of the macro outlook. We highlight three areas we’ve been focusing on.

Transitional risks we should take into account


  1. Macro signal bearers

    Commodities’ traditional role as a macro signal bearer might require a rethink as climate transition alters demand dynamics

  2. Labor force participation

    Efforts to increase the female labor force participation rate through childcare programs could have a positive impact on growth

  3. Rising cost of living

    Rising inequalities coupled with rising food costs could hurt growth and pave the way for the redistributive policies

Source: Manulife Investment Management, July 1, 2021.

1   Strategic shifts in commodities demand and their value as macro signals 
The green transition will likely shift supply/demand functions for a variety of assets, particularly in the commodities space. This transition isn’t only about the opportunities within those asset classes, it’s also about thinking differently about their predictive power and value as macro signals. For example, macro analysts have historically used copper as a cyclical indicator, but the ESG transition is likely to affect the demand/supply dynamic for the commodity in a way that may muddy its predictive abilities. Meanwhile, the price of lithium and cobalt—key to manufacturing batteries for electric vehicles—could become an important macro indicator as consumer adoption of electric cars gathers pace. Put differently, viewing changing market dynamics through an ESG lens encourages analysts to evolve their perspective of a historically accepted view that may alter the value we attach to different commodities. 

2   The upside risk of rising labor force participation rates
Rising government focus on national childcare programs aimed at increasing female labor force participation rates in a post-COVID-19 environment is a component of the S element in ESG that we believe will have clear implications for growth, inflation, and labor costs. Our preliminary work on this topic suggests that national childcare programs can meaningfully support labor supply, boost growth, and reduce pressure on wages. That said, shifting dynamics within the labor force and the nature of work available aren’t restricted to childcare programs and working parents—an increased policy focus on the economic consequences of gig workers is likely to press on the S in ESG in a more meaningful way. In our view, it’s time to start actively considering how diversity, equity, and inclusion policies will inform macroeconomic analysis going forward. 

3   Challenges from rising food inflation and growing inequality
Income inequality is widening globally—it’s an important issue that needs addressing, particularly at a time in which we’re also experiencing rising food price inflation. We see this as a growing risk to the global economic outlook, particularly within the context of a rising global population and sustained deforestation, which could have an adverse impact on food supply. These developments can dent aggregate demand, especially in emerging markets, and lead to political instability, increasing the need for us to add a geopolitical risk premium to our analysis. 

Applying an ESG lens: choice or necessity?

Over the course of the last few years, we’ve come to view the integration of ESG factors into macroeconomic analysis as less of a choice and more of a necessity. We are, after all, in the business of identifying emerging trends and evaluating how they could lead to opportunities or translate into headwinds to growth. In our view, failure to apply an ESG lens to all aspects of macroeconomic analysis would hinder our ability to do our work and do it well. 

1 The Paris Agreement, 2021. 2 The assumption that global temperature will rise by 2˚C by 2050 reflects the mitigation policies that have already been announced, but does not take into account additional mitigation policies. 3 Renewable Power Generation Costs in 2020,” International Renewable Energy Agency, June 2021. 4 Survey on monetary policy operations and climate change: key lessons for further analyses,” Network of Central Banks and Financial Supervisors for Greening the Financial System, December 2020. 5 Does Biden’s American Jobs Plan Stack Up on Climate and Jobs?” World Resources Institute, April 1, 2021. 6 Commission welcomes political agreement on Recovery and Resilience Facility,” European Commission, December 18, 2020. 7 Building Back Better: How Big Are Green Spending Multipliers?” International Monetary Fund, March 19, 2021. 8 Borrowers tap hot ESG demand to sell green bonds at a premium,” Financial Times, April 9, 2021. 9 Bloomberg, as of July 1, 2021.

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