Pension funds on the record: Reflections on a sobering year

Traditional diversification will make a comeback

Perhaps we have learned this year that an asset truly free of risk does not exist. One could argue that what counts as ‘risky’ and ‘risk-free’ depends on the economic regime – but one cannot know beforehand in which regime we will end up.

Indeed, to what extent is cash ‘risk-free’ with the current double-digit inflation rates? Of course, real returns on cash deposits have always been uncertain, but in an environment of low and stable inflation that was merely a theoretical consideration as the impact of inflation was very modest. The risk – and risk perception – was asleep, if you will. But now the wild animal has abruptly woken up from its state of hibernation. And that can make things pretty unpredictable.

Another point to make is that diversification between equities and bonds has not worked very well in an environment of rising inflation. They have been falling in lockstep, with drawdowns in 60/40 portfolios not seen in years. By and large, the reason for this is negative supply shocks, mainly related to energy. This type of shocks hurts economic growth, and pushes up prices. As a result, interest rates are rising, obviously hurting bonds, but without resulting in an improvement in the earnings outlook for businesses. Therefore, equities suffer from a deterioration in discounted earnings. Obviously, diversification with alternatives like commodities have fared well.

Looking forward, one would expect traditional diversification to work better. Bond yields have gone up in price, they are no longer ‘return-free risk’, providing more of a cushion in a downturn. Yields could rise further, but probably not as steeply as this year with German and US yields climbing some 250bps. Barring new negative supply shocks, one would also expect equity-bond correlation to come down.

The strategy of our clients has been to move more to alternatives, to have a decent portion in real assets like infrastructure and real estate and to gain exposure to commodities. There are suitable asset classes out there, but of course, not everything is available for every type of investor. 

However, there are indirect ways to cope with inflation. An incomplete nominal interest rate hedge for your liabilities tends to work in your favour when inflation goes up. In a sense, equities are real assets in the long run, so they should help make up for inflation.

It is always good to look out for risks, which is why we do a lot of scenario analysis. There is plenty that can go wrong, which is not to say it will go wrong. One risk is that excessively loose fiscal policies and persistent inflation force monetary authorities to tighten more than they otherwise would have, at the risk of financial instability, akin to recent events in the UK. At the moment, central banks seem willing to err on the side of caution. In order to kill inflation they dare to risk over-tightening. With this they also risk politicians and the public turning sour towards the independence of central banking.

Geopolitical tensions work against globalisation, although a complete reversal is unlikely. In domestic politics we could see the success of more extreme politicians, fuelled by discontent because of high inflation. That is more likely to lead to inaction than to extreme policies.

Liquidity has become a relevant topic. It is one of those things that is there until it is not. Liquidity risk will always have to be managed. The events in the UK have served as a useful warning to the rest of the pension world. In the coming years it should even be more on the agenda with central banks downsizing their balance sheets and excess liquidity falling as a result. Some changes since the 2008 global financial crisis could lead to issues, such as the decrease in market-making capacity due to higher capital requirements. While this should make banks and brokers safer, it hurts market liquidity. As a result, markets could see more bouts of volatility and higher bid-ask spreads. Of course, volatility in itself leads to a greater need for collateral buffers for derivatives positions. So it is absolutely key to manage this well.

We have already seen what can happen. But it is important to make a distinction here. The decision to purchase Gilts in September was not by the Monetary Policy Committee of the Bank of England, but by the Financial Policy Committee. It was about providing short-term liquidity to certain financial market players, not about getting money into the hands of the general public by quantitative easing (QE).

If volatility increases up to the point where there are financial stability concerns, it is very likely that we will see emergency measures by central banks to make sure the plumbing works. But that is likely to be targeted and short term. Yes, it may increase the central bank’s balance sheet in the short term, but it should not be mistaken for QE.

The fundamentals have changed

This has been a sobering year in many respects. It is very unusual that equity and bond markets correct at the same time. Investors have had to reassess strong held beliefs like ‘lower for longer’ rates and ‘there is no alternative’ to equities. Policymakers, meanwhile, have had to adjust the fallback option of fiscal stimulus as the economy is heading for recession. The root cause is inflation.  

Looking to the future, how concerned should the investment community be about inflation? And has the concept of what is risk-free changed as a result? If so, what does it mean for different asset classes and for strategic asset allocation? These questions are as fundamental as they are difficult to answer.

As long-term investors, we start the analysis by thinking about what might have changed in a fundamental sense. First, we still believe economies will move around their respective equilibrium in business cycles. Second, we do not think that equilibrium has changed dramatically. But the devil is in the detail, and we believe there are some key fundamentals that have changed a little. Third, due to uncertainty around these changes combined with inadequate liquidity and policy mistakes, there is a risk of exacerbating the volatility, making it more difficult for investors to navigate the coming business cycle.

The most obvious fundamental that has changed is inflation. But it has less to do with the current spike and more to do with long-term factors. We believe 2023 can be more benign than expected from an inflation point of view, as the factors that pushed up inflation – strong demand combined with supply disruptions and low base effect – will turn around during the course of the year. But there are a number of underlying factors that may result in structurally higher inflation when the economy eventually normalises. 

De-globalisation, reshoring, climate transition, carbon taxes, and a push for larger margins, with businesses moving from a ‘just in time’ to a ‘just in case’ model, will result in somewhat higher prices. Improved efficiency due to technological development, including digitalisation, automation and green innovation, will offset some of it, but we would not be surprised if inflation levels are above rather than below the target in the coming year.

The other fundamental that we think has changed is the neutral rate of interest. After decades of dramatically falling rates, on the back of weak productivity and high savings, we believe the trend has stopped and may even reverse somewhat. Savings are weaker and we believe investments will increase. Neither the equilibrium inflation nor the neutral interest rate revisions are huge, but even smaller changes are likely to have consequences. It matters a lot for markets if the neutral short-term nominal rate is 2.0%, accounting for a 0.5% neutral real rate plus 1.5% inflation, or 3.5% (1% plus 2.5%).

In the short term, we are likely to see fundamentally diverging views on what the new normal is and that is likely to lead to excess volatility, which may very well be exacerbated by poor liquidity and real or perceived policy mistakes.

Bond yields and equity valuations are a lot more attractive today than a year ago, but the relative value remains less obvious. Alternatives and real assets with an inherent inflation hedge have been useful features in any portfolio this year, but there are some valid uncertainties regarding valuations.

We believe it is key to combine robustness and agility in this environment. Building a robust portfolio, with a strategic asset allocation that can weather volatility, but with a degree of flexibility to seize the opportunity when extraordinary opportunities arise, regardless of asset class, is perhaps more important than ever.  

Inflation will take longer to come down

We rethought our concepts of risk-free rates several years ago, due to the low-yield environment that no longer reflected the risk of the increasing debt burden. Therefore we decided to raise the allocation to real assets like traditional equity, private equity and real estate. In our bond portfolio we lowered the duration, put more effort on due diligence and diversified within the bond universe. Unfortunately, we were a few years too early. Even though the current market drawdown hurts, it raises the long-term return expectations. 

Regarding inflation, we feel quite comfortable with our strategy since real assets are to some extent an inflation hedge. However, we may raise our allocation to bonds again if we feel that the yield environment has changed for the long term.

In our base case we believe that inflation will come down, but it will take longer than expected. In our view, central banks and the markets underestimated the inflationary pressures, which are in hindsight obviously a reaction of years of extremely expansive monetary policy, which was topped by the fiscal policy during the covid lockdowns. Since central banks to some extent lost their reputation in the process, they will do everything to gain it back. No central banker wants to be in the history books as the one who was unable to fix inflation. So there is a risk of central banks being too restrictive for too long, which raises the risk of a global recession.

We do observe that the lack of liquidity within markets has become a substantial risk, so we implemented a long-term and short-term liquidity forecast and decided to hold more cash on a strategic basis. Actually, this decision helped this year. Looking to the near future, we do think that political risks are growing and should be part of the allocation process. Therefore we decided to dive deeper in this topic and perhaps trim our allocations as a result.

Aggressive tightening could be damaging

The world is changing. After decades of Pax Americana, it is clear that geopolitical risks are increasing. On the one hand, this alone creates more demand for risk-free assets. On the other hand, we see that the US economy, the ultimate safe-haven, is changing. The dollar will probably remain the most likely risk-free asset of choice for now, but as US society is changing, we cannot rule out that investors are going to look for alternatives or alternative regions. Completely risk-free assets probably do not exist.

There are no true secure inflation-linked assets except for maybe inflation-linked bonds (ILB) and swaps, but the market is limited. These are only interesting when an investor expects inflation to increase. Outside the US, country risk is also a major factor playing a role when buying ILB. Some asset classes have a better connection to inflation than others. Real estate, including infrastructure, and equities can be seen as assets with a link to inflation, but with a longer horizon. On a shorter horizon, short duration assets offer the best hedging properties.

We think central banks are currently a bit too much focussed on dampening demand to rein in inflation. They seem to have excluded the possibility that inflation will fade by itself, when supply disruptions ease. There is also a possibility that demand destruction will run its course in curbing inflation. Applying such an aggressive tightening policy on top of those dynamics might not be the most sensible course of action and contains the risk of unnecessary economic damage.

We cannot rule out liquidity risks. Uncertainty around the globe has not settled yet. Liquidity events typically occur during headwinds, such as rising interest rates or slowing economic growth. In previous occasions, liquidity events were associated with a shortage of collateral/bond. The Fed has started quantitative tightening and is increasing rates at the same time. We also see that US banks are not following the rate hikes, so investors may buy US Treasuries as an alternative. TINA has become TARA (there are reasonable alternatives), making bonds an alternative for yield-hungry investors.

With inflation still well above target, imminent QE does not seem likely. But a lot of scenarios are possible from this point on, so we can’t rule out a return to QE entirely. One can imagine a situation in which inflation drops too fast because of quickly fading supply-chain disruptions and oversupply, in combination with over-tightening by central banks. They would then have to make another huge pivot to prevent deflation, in which QE could become again the preferred tool. Another scenario in which QE could resume is, of course, an impending debt crisis.

If a recession occurs, this is likely to be contributing to a desired cooling of inflation. In the situation, deflation hits or is expected to hit, a mild version of QE could become likely.

Reduced risk exposure

We have reduced our risk exposure this year, not because of the market environment but in response to the upcoming pension transition. In normal circumstances our investment horizon equals the average duration of our liabilities, which is approximately 21 years. But because of the pension transition, our investment horizon has temporarily become much shorter. We plan to make the transition to the new DC system in 2025, and we’d also like to protect our buffer, which has risen above 120% this year, during the transition period. This  has led to a slight reduction in the risk profile. 

In practice, we have increased our interest rate hedge from 50% at the end of last year to 65% now. Besides, we have sold our 5% exposure to commodities this year and are replacing this allocation with a private debt fund. A few years ago we had already decided to sell our commodity investments because it’s an investment category that doesn’t generate income. Commodities sometimes do well, and sometimes badly. But the long-term expected return is zero. Commodities come in handy as an inflation protector, but that’s about it. ESG considerations were also part of our reason to sell. If you buy derivatives in for example wheat, there’s always a risk this may impact the price of physical wheat and increase food prices for people in developing countries. 

We will redeploy the proceeds from the sale of our commodities exposure in a private debt fund managed by Barings, which invests in asset-backed loans such as company mortgages and company financing. This is a new category for us. We chose private debt because the excess returns above our liabilities should allow us to provide some indexation to our members in the long term. The switch from commodities to private debt also reduces the tracking error to the liability benchmark of the fund. We expect to be fully invested in this new fund by the end of 2023 as it will take some time for our commitments to be invested. We expect the first capital calls to come in shortly.

Interviews by Carlo Svaluto Moreolo and Tjibbe Hoekstra