At a time when institutions can deploy billions swiftly at the touch of a few buttons, there is increasing focus on deploying capital well. A notable buzzword of late has been ‘resilience’ as pension funds look to downside risks.
The 2020 returns of leading European pension funds largely masked the dislocations of the early part of last year. Looking at the figures out so far, they range from 3.3% at the bottom end for Denmark’s PFA to 10.8% for ATP, the Danish labour market scheme, at the top of the scale.
Dutch pension funds’ bond portfolios soared to record levels in 2020, reflecting both structural allocations in light of maturing liabilities, but also the increase in value of fixed-income holdings over the year as expanded QE programmes supported credit markets. This increase in fixed-income weightings increases fragility if euro-zone yields do tick meaningfully higher for whatever reason – as well as to inflationary pressures.
Having mostly escaped major trouble last year, many investment committees will be focused on their resilience to downside risks and there are signs that inflation is on the agenda.
In Q1 2021, markets digested inflationary concerns as US Treasury yields rose. Here the point has been to distinguish between short-term market fluctuations and long-term trends.
Central banks remain supportive towards continued asset purchases, but there are concerns about an inflationary outcome from Biden’s $1.9trn (€1.6trn) stimulus programme, whose longer-term effects are hard to gauge.
European yields have not seen anything like the rises in 10-year Treasuries: from lows of -0.6% in December, German 10-year Bunds remained below -0.2% at the end of March.
In its latest staff macroeconomic projection, the ECB expects consumer prices to peak at 2% in Q4 2021, before settling at 1.2% in 2022.
Real assets such as secure property and infrastructure debt have been bid up by pension and other institutional money in recent years, making long-term inflation protection expensive.
Unlike their UK DB counterparts, which are obliged to index pension accrual to a limited price inflation metric, Dutch DB schemes are mostly nominal in nature with an inflation ‘ambition’ that many have been unable to meet in any case in recent years.
This means the immediate need to hedge against inflation from a liability-funding perspective is less great.
But funding ratios remain under pressure, leaving many with reduced risk-bearing capacity, and vulnerable to shocks due to regulatory constraints. The impact of inflation on portfolios remains an important concern.
Some consultants report interest in inflation-linked bonds and swaps but the small volume of the market makes it difficult for very large funds to operate here.
As the consolidation trend continues in the Dutch pension market, an unintended consequence is a lack of agility of huge asset silos when seeking to deploy capital at scale in illiquid assets that can provide inflation protection.
One alternative is commodities. Dutch pension funds like PFZW were pioneers in commodities futures strategies 20 years ago, when investment banks were proclaiming a commodities supercycle. Many such strategies were abandoned in the 2010s as returns diminished.
Now much more widely accessible in the form of ETFs, exposure to a basket of industrial commodities is fairly easy to obtain.
Not to be overlooked are the inflation-protecting characteristics of equities – in terms of free cashflow and dividend generation – which can be accessed at scale by all investors.
For now, equities still look like one of the most supported asset classes given the Biden stimulus – or maybe the least challenged – even taking into account the fears of traditional value investors like Jeremy Grantham, founder of GMO, who in January warned of a “fully-fledged epic bubble”.
As Amundi’s CIO, Pascal Blanqué points out in a recent note, Robert Schiller’s reworked Excess CAPE Yield, which now considers interest rates in its equity valuation, “gives some comfort in the current valuations for equities”.
Strategy and implementation will come to the fore in equities; the Canadian pension strategist Keith Ambachtsheer has pointed out the virtues of quality cashflow generators like Uniliever, as well as their sustainability characteristics.
Alecta in Sweden is one pension fund whose equity strategy is focused on sustainable cashflow generation. Yet, Magnus Billing, Alecta’s CEO, believes a small allocation to venture capital can help increase a portfolio’s resilience.
Aside from diversification, this allows the fund to track technological developments, with a view to giving its fundamentals-focused investment team an edge it would otherwise not have. It can also help dilute frothier, and interest rate-sensitive, big tech exposure.
Ultimately, resilience will come in many shapes – operational agility and knowhow are key components alongside portfolio robustness and downside protection.
Liam Kennedy, Editor