Soapbox

›CLAIRE JONES

Rethinking economic growth

Talk about ‘growth’ in politics and business generally means economic growth measured by real increases in gross domestic product (GDP). But is GDP an appropriate way of measuring economic performance? And should growing it be a central public policy aim?

The Institute and Faculty of Actuaries recently commissioned a research report entitled Resource Constraints: Sharing a Finite World (bit.ly/limitstogrowth), highlighting the potential for resource constraints to limit future economic growth. These constraints arise because our planet is fi nite. As well as limiting the economy’s physical size, the research suggests that monetary measures such as GDP and asset returns will also be restricted, leaving society facing some tough decisions in the years ahead.

Instead of making general calls for ‘growth’, we fi rst need to be clear about what we’re trying to grow and why we’re trying to grow it. We then need an informed debate about the desirability, feasibility and aff ordability of meeting these objectives.

GDP measures only a single dimension of economic performance – the scale of economic activity calculated with reference to the market prices of the goods and services produced within a particular geographic area. It does not provide any information about the social outcomes of that economic activity.

For example, it includes spending on cigarettes, healthcare costs arising from obesity and the clean-up costs of environmental disasters, while excluding most voluntary and domestic work. It gives no indication of how the benefi ts fl owing from economic activity are distributed among the population, so countries with the same mean GDP per capita can have very diff erent levels of inequality. GDP says nothing about the manufactured, natural and social assets on which economic activity depends. We need to understand how the quantity and quality of these assets are changing over time to ensure the sustainability of economic activity.

Growing the scale of the economy is a means to an end, not an end itself. Those calling for

Claire Jones calls for an overhaul of how we measure the success of our economy and urges a move away from GDP growth as a primary goal

economic growth may well have diff erent ends in mind. Individuals may want higher GDP because they equate it with a greater chance of employment, more aff ordable bills and more comfortable lifestyles. Governments may want higher GDP so they can fund more public services without increasing tax rates or public-sector debt. Businesses may hope that an increase in GDP will lead to increased sales revenues and profi tability. Actuaries will be mindful of the link between GDP and asset returns, and society’s structural dependence on asset returns to fund pensions and long-term care.

Once these diff erent aims are stated, it becomes clear that they won’t automatically be met by increasing GDP. Meeting them depends instead on the composition of economic activity (including activity that occurs outside markets) and the distribution of the associated income. Other aspects of wellbeing, such as health, education and personal relationships, are even less directly linked to GDP. However, GDP still holds sway in policy debates.

It seems likely that we’re facing a future in which achieving real growth in GDP will become increasingly diffi cult. Moreover, by focusing on maximising GDP in the short term and overlooking the state of the resources on which our economic activity depends, we risk making decisions that undermine society’s ability to deliver high quality of life in the long term.

Now is the right time to rethink how we measure the success of our economy and to cease to treat GDP growth as a primary goal. Rather than simplistically trying to pursue ‘growth’, we need to be clearer about the social outcomes we wish to achieve and have an informed debate about how best to achieve these, given the constraints we face. This will help us select appropriate alternative measures of success and give these measures the legitimacy they need to gain widespread support. Claire Jones is a qualifi ed actuary with an MSc in sustainability (ecological economics). She is the sustainability and economics manager at the Institute of Chartered Accountants in England and Wales. The views expressed are her own and not necessarily those of her employer. ● For more on sustainability, see also ‘Green Guardians’, p30

“Instead of making general calls for ‘growth’, we fi rst need to be clear about what we’re trying to grow and why we’re trying to grow it. ”

A SMARTER APPROACH TO CREDIT INVESTING

BENCHMARKS WEIGHTED BY MARKET CAPITALISATION WORK WELL FOR EQUITY FUNDS, BUT THE FINANCIAL CRISIS HIGHLIGHTED THE FLAWS INHERENT IN EMPLOYING THE SAME APPROACH TO CREDIT MARKETS.

Credit indices can be categorised by their broad characteristics, such as whether they are composed of investment grade corporate bonds, high-yield bonds or mortgage-backed securities. They may also be based on the credit rating or duration of the underlying securities. However, when it comes to deciding which bonds are included in the indices, the most common approach is to weight by market capitalisation. By Adam Mossakowski Credit Fund Manager, Insight Investment

Market capitalisation weighting has an intuitive appeal in equity markets. The stock market is a voting machine. Companies that investors are buying have rising share prices. This increases their market capitalisation. These companies tend to be the most important businesses in an economy.

But assigning the biggest weight to the largest issuers of debt is more problematic. It means investors will have the greatest exposures to companies that have the most outstanding debt. They may also be the most financially leveraged. Passive indextracking funds and managers with an index relative performance objective have little choice but to buy these names, regardless of the credit fundamentals.

This problem came to the fore at the height of the financial crisis in 2008 and 2009. The weighting of bonds issued by the financial sector ballooned from less than 30% of the iBoxx Sterling Non-Gilt Index to almost 40%. This was at a time when the spreads on these bonds gapped from an average of 100bp over equivalent maturity UK government bonds (gilts) to over 800bp.

Market capitalisation weighting can create unwanted exposures even in normal market conditions. These indices typically have high exposures to low-yielding sectors such as supranational bonds issued by the World Bank, European Investment Bank and others.

With exposure to individual issuers uncapped, some names currently account for in excess of 5% of benchmarks. In short, slavishly following an index can leave investors with sizeable exposures to the most prolific issuers.

There are a number of ways this problem can be addressed. One is to invest in credit on an absolute return basis, where a fund aims to generate positive returns in excess of a cash benchmark. The fund can use directional long and short strategies as well as relative value trades (picking off-setting pairs of markets and instruments) in order potentially to benefit from both rising and falling markets.

Another option is to invest in credit on a buy and maintain basis. This approach involves taking exposure to a diversified range of high-quality corporate bonds, with strict sector and issuer concentration limits. The aim is to hold the bonds to maturity, unless there is a material change in credit quality. This can allow investors such as pension schemes greater certainty in terms of the timing of their cashflows.

This approach improves on both passive index tracker funds and actively-managed funds measured against a traditional benchmark by putting stock selection, the “Buy” element of the strategy, first. Long term fundamental credit quality, not benchmark weighting, drives the investment decisions. The “Maintain” element is to seek to avoid loss from default or deterioration in credit quality. It allows the manager discretion to refrain from forced sales as a result of a rating downgrade, index rebalancing, or a security leaving the index. This in turn minimises transaction costs, which can be significant for benchmarked credit portfolios.

Insight has been a leader in managing buy and maintain strategies since early 2009 and currently manages more than £7bn in segregated accounts. The strategy uses income from coupons and modest secondary turnover to keep duration constant and continually refresh the portfolios to reflect the most up to date credit views of the manager. Absolute return and buy and maintain strategies are a smarter approach to credit investing, reflecting both market conditions and client needs.