Levelling up

Investing towards a new social contract

As we learn to live with COVID-19, focus is returning to delivering a just transition. This is important to secure long-term investment outcomes, but also presents direct opportunities.

Read this article to understand:

  • Why repairing the social fabric matters for investors
  • What is needed to revitalise communities
  • The opportunities and risks of investing in a just transition
We are living at a time when, in many societies, people feel disappointed by the social contract and the life it offers them. This is despite the huge gains in material progress the world has seen over the last 50 years
Source: What we owe each other: A new social contract for a better society, 20211

Before COVID-19, inequality and ‘left-behind’ communities were a growing focus for policymakers and economic and political commentators. In the wake of the global financial crisis, it became all too apparent how many economies worked for the few rather than the majority, and governments were compelled to explore whether there might be a way for growth to be more inclusive.

The pandemic – understandably – captured all the attention and resources, momentarily interrupting the debate around equity and a just transition, but also widened inequalities with vulnerable communities hit hardest.2 Yet the issue long predates the pandemic, driven by structural changes in economies and societies. In particular, the technological revolution of the last 40 years has transformed economies, destroyed far more jobs than globalisation and left many unskilled workers with few options, while so far failing to deliver inclusive growth.3

Now that the world is learning to live with COVID-19, attention is returning to the fraying social fabric, why it matters and how it might be repaired. In the UK, the Queen’s speech on May 5 set out the Government’s overriding priority “to grow and strengthen the economy, level up opportunity across the country and help ease the cost of living for families”, with 38 bills to be introduced to support this priority.

As author Raghuram Rajan explained in his book The Third Pillar:

“The state and markets have expanded their powers and reach in tandem, and left the community relatively powerless to face the full and uneven brunt of technological change. Importantly, the solutions to many of our problems are also to be found in bringing dysfunctional communities back to health, not in clamping down on markets.”4

With aging populations, climate change and the biodiversity crisis, national and international cooperation is also more important than ever. However, as Rajan emphasised, fraying communities mean the will and ability to act is weak.5

“We often talk about how economic growth and capitalism have pulled millions of people out of poverty around the world and how that has reduced inequality globally, but inequality within countries has been increasing for years, and the digital revolution, the net-zero transition and the pandemic are only going to amplify that,” says Vaidehee Sachdev, people pillar lead and senior impact analyst at Aviva Investors.

“Yet a vast proportion of companies are not meeting their social responsibility to act in the interest of all stakeholders. Sadly, I think we have to compel companies to care, which is ultimately a matter for policymakers – because the imperative to act is now,” she adds.

The war in Ukraine, with its horrendous human cost, adds to the issue through politics, shaping a future where a Russia-China axis could potentially stand against Western democracies, through rising energy and food prices that hurt the most vulnerable, and through mass migration of refugees fleeing the violence. Despite the positive initial reaction of countries to take in refugees, if the conflict lasts over months and years, infrastructures, economies and societies may stagger under the additional weight of demand.6

Fundamental but fragile: Communities today

Robust communities strengthen the social contract [defined as an agreement for mutual benefit between an individual or group and the government or community as a whole]7 and, through people’s social and political engagement, hold the state and markets to account, ensuring they do not descend into authoritarianism and cronyism.8 They are also more resilient in the face of crises and, beyond anchoring people in real human networks and giving them a sense of identity, Rajan said they play other important roles:

“By allowing us to participate in local governance structures such as parent-teacher associations, school boards, library boards, and neighbourhood oversight committees, as well as local mayoral or ward elections, our community gives us a sense of self-determination, a sense of direct control over our lives, even while making local public services work better for us.”9

But the social fabric is deteriorating due to major shifts changing its very nature. The assumptions underlying social contracts are remnants of a bygone era when families had a sole male breadwinner, women looked after the young and the old, people married for life and few had children out of wedlock, the skills learnt at school lasted a lifetime, workers had few employers over their career, and most had only a few years in retirement. These assumptions have lost all relevance today.10

In its ‘Megatrends 2020 and beyond’ report, EY discussed the challenges of such seismic shifts, key among which are endemic loneliness in some countries, with one in seven Britons reporting they are often or always lonely, and increases in financial fragility as economic inequality continues to worsen. These are amplified by weaker community ties that offer individuals less support.11

The price of inequality

However, at the heart of community loss is the economy. From the 1990s onwards, middle-wage jobs disappeared in favour of high-pay/ high-skill and low-pay/ low skill occupations, including many flexible work arrangements in the gig economy, which often do not provide basic rights like a living wage or sick pay (see Tough gig).12

Figure 1 shows that, between the fall of the Berlin Wall and the global financial crisis in 2008, the group that saw the biggest losses in income was the lower-middle class in many advanced economies, who rank between the 70th and 90th decile of global income. Studies in the US and Europe have found this hollowing out continues to this day.13

Figure 1: Global income distribution, 1988-2008 (in 2005 US$ purchasing power parity)
Global income distribution, 1988-2008
Source: The World Bank, December 201314

As a result, some communities in developed countries have seen large job losses. These have been particularly devastating in areas dominated by one or two large local employers that shut or moved production offshore (Figure 2).

Figure 2: Factory jobs have disappeared, but industrial production has kept growing
Note: Shaded areas indicate US recessions.
Source: Federal Reserve Bank of St. Louis, April 2022
15,16

This is a significant driver of political discontent in advanced economies as those with once well-paid jobs and who expected middle-class lives find themselves struggling. Additionally, in some countries like the UK, the costs of basics, including housing, education and healthcare, have risen so fast over the last 20 years they have absorbed any gains in income, making households feel even worse off.17

Vicious cycles

Yet even urban communities have been affected as areas have become more segregated by income levels. Both urban and semi-rural communities that used to have a mix of economic classes are left with less social capital, worse infrastructure, and less wealth with which to raise the capabilities of their members. Community decline tends to feed on itself, and those left behind often feel they have been deprived of the chance to thrive.18

“Part of the challenge is that all these issues are interlinked,” says Andrew Carter, chief executive at the Centre for Cities, a think tank focused on the economies of the UK’s largest towns and cities. “They reinforce each other in a vicious downward cycle, kickstarted by negatively changing economic fortunes of places. Without reasonably performing economies and decent numbers of jobs, including high-paying ones with career opportunities, our ability to deal with associated social and community issues in struggling places will be significantly constrained.”

As a consequence of these changes, more risks are being borne by individuals, from education to job and income security, and from healthcare to pension provisions. Baroness Shafik argued “you’re on your own” societies are not just inequitable, but also less efficient and productive than those where risks are shared.19

Why this matters for investors

“The social impact of corporate behaviour has been one of the great blind spots of the financial industry,” says Sachdev. “This is despite the well-documented damage negative social impacts can have at a company level, as well as at a macro level.”

She explains the financial materiality of social issues is still contested, in large part because the financial benefits of investing in a ‘socially sustainable way’ do not often materialise immediately. This can make it harder to convince companies – and investors – of the financial upside beyond simple risk mitigation (see The social transition).

Yet for Siddhartha Bhattacharyya, senior portfolio manager of buy-and-maintain credit at Aviva Investors, it is particularly important for investors who manage long-term client assets to understand what companies and institutions are doing for the future.

“We don’t know where margins will be in 30 years’ time,” he says. “Looking at a university bond, we want to understand their research and scientific investments, their endowment plans and what they are investing in for future benefits, and that is quite easy. But when we look at a company, it is more difficult, so what they are doing right now for future generations gives us a lot of comfort.

“We buy and hold for long periods so returns meet liabilities. Sustainability is a critical part of making the investment case, and it is important to dig deep to find that information,” he adds.

On a broader scale, inequality – and thereby the breakdown of communities – impedes economic growth, fuels social unrest and raises the likelihood of financial crises and poor policy decisions (Figure 3). For instance, a 2014 OECD study across member countries showed a one per cent increase in GDP per capita inequality lowered overall GDP by 0.6 per cent, while the World Economic Forum’s 2022 risk report found ‘erosion of social cohesion’ to be one of the biggest threats to society.20,21,22

Figure 3: Socio-economic implications of inequality
Socio-economic implications of inequality
Source: Aviva Investors, May 2022. Original sourced from The Geneva Association, 202023

As Matt Kirby, portfolio manager of the Aviva Investors Social Transition strategy, explains, if growth is weak, societies are unstable and poor policy decisions are made, most companies will be impacted, reducing investment returns.

“We have seen this before,” he says. “A prolonged period of higher income inequality in advanced economies played a role in the global financial crisis, by overextending credit against a backdrop of declining mortgage underwriting standards and financial deregulation.”

A prolonged period of higher income inequality played a role in the global financial crisis

Governments have begun to recognise this threat and are putting measures in place to address it. US President Joe Biden is aiming to use the Build Back Better bill as a vehicle to tackle inequality – through social services, welfare and infrastructure – while in China, President Xi Jinping has emphasised the Common Prosperity policy is aimed at narrowing the wealth gap, and the European Union’s Just Transition is defining emerging corporate expectations around the social agenda. In the coming months and years, government support, crackdowns and potential legislation can all impact investments in different ways.24,25,26

Companies – and markets at large – may also lose their social ‘licence to operate’ if people continue feeling they are unfair and serve only the wealthy. While pursuing shareholder value maximisation has broadly moved companies toward greater efficiency, it has undermined their public support by legitimising actions the community believes are unfair. This could be harmful in terms of lost sales, strike action and reputational risk.27

Mending our social fabric requires investment

Revitalising left-behind communities is therefore important. In the UK, Carter says this means prioritising growth in the big cities outside the Southeast.

“Compared to their European counterparts like Munich, Hamburg and Lyon, big British cities like Birmingham, Manchester and Glasgow underperform on a range of economic indicators. It is not really feasible to have a more prosperous North or Midlands if the biggest cities are underperforming,” he says. “The good news is that investors, entrepreneurs and firms are increasingly interested in these cities as attractive locations to live, work and invest.”

Big British cities like Birmingham, Manchester and Glasgow underperform on a range of economic indicators

To harness this interest and support communities, governments, both local and national, need to rebalance healthcare and labour risks. Healthier people can be more productive, and more easily plan, retrain and seek new and better work if they bear less of the labour risk.

Governments should also invest in training – skills of the future and lifelong learning in particular – to help those regions gain a critical mass of higher-skilled, higher-paid jobs so they can connect with the leading economic activity in national centres.28

Thirdly, governments should improve infrastructure, from affordable housing to transport and digital connectivity. “In some remote parts of the UK, it is difficult to get an internet or even a 4G connection, never mind 5G,” says Bhattacharyya. “Greater government support to improve this could allow more people to work remotely, for instance for a London-based company, while still living in more rural areas.”

As Rajan explained in The Third Pillar, “only countries where housing is broadly affordable across the country, public transport is available and inexpensive, and public schools are well funded, can avoid the residential sorting by incomes that is the source of resentment.”29

High costs for a high return

These are all areas tackled in the UK government’s Levelling Up white paper, but investing in health, housing, education, transport and connectivity will come at a significant cost. Carter says that, while no significant new funding was expected when the white paper was published given the government had just gone through a three-year spending review, what will be of interest is whether the paper has an influence as we reach 2024 and the next spending review.30

The challenges the levelling-up agenda is seeking to address are large and long-term, at least 100 years in the making

“If the white paper is true to its word, we would expect a significant increase in investment into levelling up post-2025,” he says. “Think about German reunification; that's 30-plus years, €2 trillion spent and still going. That averages out at about €70 billion a year.31

“The funding involved will need to be large because the challenges the levelling-up agenda is seeking to address are large and long-term, at least 100 years in the making. Post-2025, if the government – any government – is serious, the funding made available will need to increase considerably,” he adds.

The EU is taking this type of approach in the Action Plan released by the European Commission in March 2021, aiming to tap into the job growth potential of lagging countries and regions, suggesting a return to the concept of social policy as a productive factor. The view is that expanding social provisions such as active labour market policies or lifelong training will boost employment.32

Companies and investors need to play their part

Baroness Shafik argues this should form the basis of a new social contract, focused on creating more winners and promoting innovation and productivity. While this can partly be achieved through regulation and public spending, the private sector has an important role, both in terms of investment and economic activity.33

Businesses can address social mobility concerns by thinking about the basics – treating people well should not be a revolutionary idea

“One obvious way businesses can address concerns about social mobility is simply by thinking about the basics – where they set themselves up, who they hire, what kind of flexibility they give workers, what support is given to workers from different backgrounds etc., as well as the more fundamental things like paying a living wage and engaging in constructive dialogue with workers and their representatives,” says Sachdev. “This isn’t rocket science – treating people well should not be a revolutionary idea.”

Governments and investors will need to incentivise this behavioural change, as well as investing in the infrastructure and workforce skills needed to revive communities. Much of the funding can also be put to more efficient use if it scrutinised by outside investors, including patient investors willing to provide seed money or finance long-term infrastructure projects. Local banks and finance companies also have close ties with community businesses and can reinvest in the most relevant areas for their communities.34

The UK’s Levelling Up paper recognises the potential for institutional investment to support infrastructure, housing, regeneration and SME finance, giving the example of the Local Government Pension Scheme: if it allocated just five per cent of its more than £330 billion of assets to local projects, it would unlock £16 billion in new investment.35

Finding opportunities

The Centre for Cities has set out two goals the levelling-up agenda should aim to achieve: improving living standards, and helping every place reach its productivity potential.36 For CEO Andrew Carter, this will create lots of opportunities for investors. “We need to be clear what the characteristics of more productive places are, and then focus on how to replicate these in less productive places,” he says.

More enlightened investors, developers and firms are already looking to invest and support in a wider range of places than they previously considered

This includes improving skills, transport and communications infrastructure, but also commercial real estate and public spaces. “More enlightened investors, developers and firms are already looking to invest and support these characteristics in a wider range of places than they previously considered,” adds Carter.

Ed Dixon, head of responsible investment for real assets at Aviva Investors, says a tie-in between town-centre regeneration and long-income real estate has provided significant opportunities in recent years.

“Partnerships between local authorities and long-term investors can benefit local authorities, investors, and the communities they operate in. Long-dated real estate leases make it more cost effective to regenerate town centres, in comparison to short-term financing,” he says. “With new investor appetite for place-based impact investing, we could see the volume of patient capital investing through long income increase, creating huge opportunities for local authorities and investors. If we can replicate the success of town centre regeneration schemes like in Aberdeen and Stevenage, with impact metrics embedded from the start, everyone would benefit.”37

George Fraser-Harding, real estate fund manager at Aviva Investors, also says opportunities can be found in commercial real estate and family housing. On the commercial side, he mentions a site in the former East Germany, in an area where jobs and population have been declining.

“Normally, an area with a declining population and jobs doesn't seem like somewhere you would invest, but we have engaged directly with the municipality, which has government support to offer incentives for companies to move there, so there may be an opportunity to develop a large logistics park,” he says. “We will be able to attract tenants because they will receive large subsidies to go there, and the project is cost-efficient.

“The local municipality is excited about the project because they can see this turning the tide for their area, and their level of engagement has attracted us. By working together to enable sites to be created in the right way, we can achieve our goal of built, occupied and income-producing buildings and the municipalities can achieve their goal of job creation and population growth,” he adds.

Fraser-Harding also lists housing projects aiming to provide long-term, affordable rental housing for families in the Netherlands, Spain and the UK to meet increasing demand as families who can no longer afford to buy move into long-term rentals.

We can create a product built specifically to be let for its lifetime, giving families certainty

“In the UK, the rental market for family houses is almost entirely in private hands,” says Fraser-Harding. “That comes with a lot of uncertainty for young families looking for a long-term home. We can create a product built specifically to be let for its lifetime, giving families certainty they can stay for as long as they want, and that the property will be maintained.”

This also responds to societal changes, like the decline of multi-generational homes in Spain, which means many young people now want a place of their own, or unaffordable rents in some city centres. For example, the project in the Netherlands is specifically designed to provide affordable rental housing to schoolteachers, nurses and other healthcare professionals.

Dixon adds that, provided the financing is structured in the right way, the net-zero transition provides similar opportunities to level up and improve buildings. “We have structured over one billion pounds of sustainability-linked loans to encourage borrowers across the UK to improve their properties. That creates green jobs and delivers better places for the communities who use those buildings,” he says.

“We can’t forget the importance of renewables. Energy resilience has become a critical subject. The more land and roof space we give over to solar, which is now cheap and easy to deliver, the easier it is to provide cheap energy to companies or homes. And you can provide scalable, institutional-quality investments off the back of that, which could end up benefitting savers and pensioners in those communities,” he adds.

On the credit side, Bhattacharyya mentions opportunities via investments in “transitioning” businesses making efforts to improve their ESG profiles. He adds fundamental research and engagement with companies is important to invest in the right firms.

Recognising the risks

Yet there are risks, from gentrification to implementation with unintended consequences.

“There are key risks in implementation. If the financing of a social housing project, for example, is not structured in the right way, you may end up with perverse outcomes tying housing authorities into overly onerous leases or debt structures that contribute to negative social outcomes. On the flip side, structured financial incentives can create a partnership between lenders and borrowers where both sides, as well as their stakeholders, benefit from a better outcome,” says Dixon.

As net-zero industries develop, governments must think carefully about what they replace closing industries with

The policy side is probably the area that presents the greatest risks, and continued dialogue with governments is important.

For instance, as net-zero industries develop and new jobs take the place of carbon-intensive ones, governments must think carefully about what they replace closing industries with, particularly where one factory or industry is central to a community and its closure will create mass unemployment. At the same time, climate change could make some areas unliveable within a few years due to rising natural disaster risks.

“In the UK’s green job strategy, Yorkshire and the Humber are due to get a big renewables and green hydrogen investment, but has it been thought through whether rising sea levels and changing flood maps could mean that's going to be regularly underwater in ten years?” asks Thomas Tayler, senior manager at Aviva Investors’ Sustainable Finance Centre for Excellence. “Investors need more detail of the sector pathways needed so we can work out where to invest in the net-zero transition, but there also needs to be a read across to the levelling-up agenda.”38

Short-term political and economic incentives also need to be better aligned with what we know we need to do in the long term, for the transition and levelling up alike.

Governments need to build social safeguards into their energy transition plans to make sure people aren't being put into energy poverty

“People are worrying about inflation, and energy prices in particular,” adds Tayler. “An economist at the European Central Bank recently talked about the fact inflation shouldn't be a reason to slow down the transition, but governments need to step in and make sure that the transition isn't achieved off the back of those least able to afford it. They need to build social safeguards into their energy transition plans to make sure people aren't being put into energy poverty.”39

Carter says short termism could mean politicians decide to give every place some capital rather than focus on a smaller number of places where investment could make a real difference. “The ‘something for everywhere’ approach means we never hit the critical mass of investment and activity that could mean meaningful change in at least a few places, even if it's not in all places,” he says.

“It is essential to recognise the risks and build them into forward planning for deciding where to allocate resource and focus,” says Tayler. “When it comes to levelling up or addressing the impacts of climate change and biodiversity, policy needs to take a holistic view and think across all those together.”

References

  1. Minouche Shafik, ‘What we owe each other: A new social contract for a better society’, Princeton University Press, April 2021
  2. Edoardo Campanella, ‘Social capitalism’, Project Syndicate, April 12, 2021
  3. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  4. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  5. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  6. Andy Bounds et al, ‘Russia’s invasion of Ukraine forges new unity of EU purpose on China’, Financial Times, March 31, 2022
  7. Source: Dictionary.com
  8. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  9. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  10. Minouche Shafik, ‘What we owe each other: A new social contract for a better society’, Princeton University Press, April 2021
  11. EYQ, ‘Megatrends 2020 and beyond’, EY, January 24, 2020
  12. Minouche Shafik, ‘What we owe each other: A new social contract for a better society’, Princeton University Press, April 2021
  13. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  14. Christoph Lakner and Branko Milanovic, ‘Global income distribution: From the fall of the Berlin Wall to the Great Recession’, The World Bank, December 2013
  15. ‘All employees, manufacturing’, U.S. Bureau of Labor Statistics. Sourced from Federal Reserve Bank of St. Louis, April 28, 2022
  16. ‘Industrial production: Total index’, Board of Governors of the Federal Reserve System (US). Sourced from Federal Reserve Bank of St. Louis, April 28, 2022
  17. Minouche Shafik, ‘What we owe each other: A new social contract for a better society’, Princeton University Press, April 2021
  18. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  19. Minouche Shafik, ‘What we owe each other: A new social contract for a better society’, Princeton University Press, April 2021
  20. Martin Sandbu, ‘Building back better must address regional inequality’, Financial Times, April 15, 2021
  21. Orsetta Causa et al., ‘Growth and inequality: A close relationship?’, OECD, 2014
  22. ‘The global risks report 2022’, World Economic Forum, 2022
  23. ‘The role of insurance in mitigating social inequality’, The Geneva Association, August 2020
  24. ‘The Build Back Better framework: President Biden’s plan to rebuild the middle class’, The White house, as of April 11, 2022
  25. ‘China's Xi Jinping defends 'common prosperity' crackdowns’, BBC News, January 18, 2022
  26. ‘The Just Transition Mechanism: making sure no one is left behind’, European Commission, as of April 11, 2022
  27. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  28. Martin Sandbu, ‘The everyone economy: how to make capitalism work for all’, Financial Times, July 3, 2020
  29. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  30. ‘Levelling up the United Kingdom’, Presented to Parliament by the Secretary of State for Levelling Up, Housing and Communities, February 2, 2022
  31. Kathrin Enenkel, ‘What can German reunification teach the UK about levelling up?’, Centre for Cities, October 14, 2021
  32. László Andor and Robin Huguenot-Noël, ‘The Janus’ face of Europe’s new social rulebook’, VOX EU, May 5, 2021
  33. Minouche Shafik, ‘What we owe each other: A new social contract for a better society’, Princeton University Press, April 2021
  34. Raghuram Rajan, ‘The third pillar: The revival of community in a polarised world’, William Collins, 2019
  35. ‘Levelling up the United Kingdom’, Presented to Parliament by the Secretary of State for Levelling Up, Housing and Communities, February 2, 2022
  36. ‘Levelling up’, Centre for Cities, as of April 22, 2022
  37. Sarah Forster et al., ‘Scaling up institutional investment for place-based impact’, The Good Economy, Impact Investing Institute, Pensions for Purpose, May 2021
  38. ‘Coastal risk screening tool: Land projected to be below annual flood level in 2030’, Climate Central, as of March 7, 2022
  39. Isabel Schnabel, ‘Looking through higher energy prices? Monetary policy and the green transition’, European Central Bank, January 8, 2022

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