By Lazaro Tiant, Sustainable Investment Analyst at Schroders

Our latest research examines how sustainability factors, particularly climate risk, education, and sociopolitical stability, influence the way investors price sovereign credit.

In our fast-paced, ever-changing global economy, a country’s sustainability is critical when shaping its future. The interplay of climate change, shifting demographics, political polarisation, and geopolitical instability can profoundly affect a nation’s competitiveness, growth, and inflation.

This makes the integration of sustainability analysis into sovereign investing an essential consideration. At Schroders, we’ve delved into this complex topic, focusing on three key themes - climate risk, education, and socio-political stability - and their impact on a country’s sovereign credit outlook.

1.Climate risk: vulnerability, readiness, and emissions

The physical risks associated with climate change have a direct impact on agricultural activities, food availability, and pricing, which could potentially escalate inflation risks and adversely affect countries reliant on imports. Similarly, countries exposed to extreme heat and flooding can suffer significant economic damage. This is not a new or novel consideration for investors, but one that requires detailed attention as countries evolve climate agendas and implement policies to enable solutions.

Transition risks and opportunities manifest through a country’s climate policy agenda and can include scaling up or rolling back climate efforts. Technological advancements, the availability of natural resources, or the development of transition-focused services provide the rationale for capital deployment in this area. Through strategic policymaking, governments can stimulate economic growth while counteracting the potential GDP losses that could result from inaction.

As it relates to carbon emissions, governments may consider policy which implements pricing mechanisms to reflect a country’s performance. High-emitting economic activity faces penalisation, which will affect sovereign debt valuations. However, given the lack of global carbon policies, considerations such as a country’s share of global emissions are less material in sovereign debt valuation versus its approach to transitioning and demonstrating ‘climate readiness’.

Investors who proactively assess and understand the value of a country’s specific initiatives to facilitate a transition or adapt to physical risks stand to gain insights into possible shifts in yields and the liquidity profile of countries making genuine progress. Countries that are making significant progress in their transition or adaptation efforts should contribute to the reduction of any risks associated with their yield rates.

2. Demographics: education, innovation and “brain drain”

Demographics also play a role, with pressures on long-term debt trajectories stemming from rising age dependency ratios and persistent income inequalities. Education, a value-creating investment in human capital, can offset such inequalities and strengthen fiscal sustainability, as long as the impact of brain drain (emigration of higher educated individuals) is kept to a minimum. However, talent mobility and migration, or “brain drain,” can have significant impacts on a country’s domestic capabilities and future growth.

Countries such as Sweden, Denmark, Australia, and Canada have historically kept talent at home and continue to do so. Net exporters of talent over 10 years include the US and Japan. Our research suggests that the countries that have experienced lower displacements (or brain drain) over the past 10 years saw an average economic growth of 2.4% versus 1.4% for the countries that were net exporters (US, Japan, Portugal, UK, South Africa, France, and Austria).

3. Socio-political stability

Lastly, socio-political stability can affect political risk premia by reinforcing or undermining institutional strength. Polarisation at political levels can reduce government effectiveness, negatively impacting a country’s ability to act on relevant policy with economic necessities and benefits in mind.

Conflicts or wars can put a significant financial burden on a country, mainly due to escalated military spending, which might lead to increased borrowing and higher bond yields. Conversely, politically stable nations often enjoy lower bond yields and reduced inflation volatility. Of particular relevance to emerging markets is that they are more likely to attract foreign direct investment if they are politically stable.

Overall, the negative effects of political instability on sovereign credit are significant. Conflicts and geopolitical divides can disrupt economic activity, discourage investments, and impact growth. For investors, it’s crucial to consider a country’s resilience, adaptability, and ability to navigate geopolitical challenges while remaining competitive. This includes trade, access to financial markets, and consensus-building on domestic policy agendas.

Further reading: “How do sustainability factors affect a country’s sovereign bonds outlook?” in Schroders’ Sustainable investment report Q1 2024.