Multi-Asset Strategies: Worrying developments
Investors face multiple challenges
• China’s deleveraging could mean slower growth – exacerbated by the intensifying trade war with the US
• A no-deal Brexit worries investors, as does the conflict over the Italian budget
• Late-cycle dynamics are a concern, as is market liquidity and illiquidity risk
• Pension funds would be wise to undertake stress-testing and scenario analysis
Most key indicators show that the developed economies are late in the economic cycle, a cycle that is one of the longest in history and might still beat the record of the 116-month cycle between 1991 and 2001. Peaking growth in developed regions, fiscal tightening and higher inflation are set to have an impact on most asset classes as fundamentals weaken further in the coming year or two. In addition, geopolitical tensions, trade wars and uncertainty surrounding Brexit are making investors jittery.
Cecilia Thomasson-Blomquist, CIO of PP Pension, the media pension fund in Sweden with SEK15.4bn (€1.5bn) in assets, says valuations look set to become more important again. “With central banks raising rates, although slowly, you need to evaluate what you have in your portfolio. I believe there will be buying opportunities going forward, but first we probably need a correction phase. When we see the drops in liquid indexes that we recently have seen, there is a need for some time for prices to adjust. Some prices will probably adjust even more on the downside before there is a buying opportunity,” she says.
Olivier Rousseau, co-CEO of FRR, the French reserve fund, says there is a fight between risky and bad investments. “In equities there are good returns to be found but there are several negative scenarios impacting markets, increasing the level of risk. In fixed income, returns are bad with low yields and negative real yields.”
Risk to equities globally are slowing growth in countries such as China. “China is deleveraging, particularly through forcing the shadow banks to deleverage, and there is a risk that this would compound the slow-down as the trade-war with the US intensifies,”. says Rousseau. “In Europe, a no-deal Brexit would be bad news, and renewed worries about the Italian budget is mounting. There is a two-thirds probability for a Brexit deal but the Italian issue is a bigger concern, as is the EU elections in 2019.”
FRR, with €34bn in assets, is looking for active managers for a €1.1bn European small-cap equity mandate and a €600m French small-cap equity mandate. ESG capabilities are high on the wish-list for appointing new managers.
Richard J Tomlinson, head of investment strategy at Local Pensions Partnership (LPP) in the UK, says the long-term nature of the fund means an approach that seeks to align the portfolio with the liabilities, which allows for a more thoughtful and measured approach to asset allocation, paying special attention to market and portfolio liquidity. This approach lends itself to scenario – and worse-case scenario – analysis, thereby ensuring that the £16bn fund does not overextend itself. “The key is to be prepared and have a game-plan in place. We want to be a provider, and not a demander, of liquidity in stressed markets,” he says.
Looking forward, Tomlinson says LPP would not be expanding its risk budget with later-cycle concerns and volatility increasing. “Considering the backdrop there could be room for more illiquid assets but not at any price. Are you being rewarded for the risk? Credit will likely be very interesting in the next few years but not just yet. The challenge is to make sure we have dry powder when we want it,” he says.
LPP has a large cash-equity portfolio which could be used to free cash if needed, either by synthesising the exposure with derivatives or for use as collateral for a credit facility. But that, of course, comes at a price. “There are clearly implementation challenges and if these are not pre-negotiated terms it can be even more difficult,” Tomlinson says.
Recently the UK local authority pension fund partners, LPP and the Northern Pool, committed another £550m to the GLIL pensions infrastructure platform, taking the allocation up to £900m.
Joanne Holden, CIO, UK wealth DB business at Mercer, warns that by focusing on Brexit and US President Donald Trump, analysts may be missing something really big – the unwinding of decades of internationalism, deregulation and trade liberalisation. “Until the problem of those that feel ‘left behind’ is solved, if it can be solved, political risk should be high on the agenda of all investors, but especially pension funds with funding challenges, or uncertain sponsor covenants,” Holden says. She urges pension funds to make contingency plans into action plans. “We recommend that trustees seek to undertake or revisit scenario analysis and stress testing of their portfolios and of their covenant risk, and consider the case for equity options to provide a ‘hard’ form of protection in equities.”
Despite increasing volatility, a large drop in markets is not on the cards in the near future as economic fundamentals still support a broadly positive sentiment. Barbara Saunders, managing director of investments at River & Mercantile Solutions (formerly P-Solve) says: “This correction [in October] has brought equities back closer to fair value and, therefore, for more dynamic portfolios, a slight increase in equity allocations might be warranted once we’ve seen the markets bottom out,” she says, adding that the rally is likely to be short-lived and de-risking would be on the agenda for the end of 2019. She says that if you take a longer-term view, it might pay to remain cautious until a larger market sell-off presents a better buying opportunity, likely in 2020.
There is broad agreement that equities trump bonds in the current climate and Casper Hammerich, principal at Kirstein in Copenhagen, predicts that search activity for fixed income would be muted in the coming year. “However, we do see investors gradually rethinking the conventional approach to listed credit – for example, by swapping cash-bonds with derivative strategies or by moving from either pure active or pure passive to enhanced mandates,” he says. The theme of uncorrelated assets is continuing into 2019, Hammerich says. “Particularly private equity, direct lending and infrastructure were significant asset classes in 2018, and we expect this in 2019 too,” he says. On the listed side, emerging markets equity, and sustainable investment themes such as the United Nations Sustainable Development Goals could boost interest in impact funds on the global equity side, he says.
Keeping the rocky road ahead in mind, Jignesh Sheth, head of strategy at JLT Employee Benefits, questions whether a passive approach would be the most appropriate going forward. “The pockets of opportunities that exist within most asset classes are best exploited by an active approach in an environment with increasing volatility,” he says. On the credit side, he urges investors to adopt a global approach to take advantage of a broader set of opportunities. “Some of the more illiquid areas offer premiums and help dampen volatility but being selective is key,” he says.
Larry Hatheway, chief economist, GAM Investments, says the middle of 2018 was as good as it gets. The main risks are slowing global growth which will affect confidence which, in turn, will be compounded by political uncertainties, he says. In addition, inflation is gradually picking up, which poses risks for both equities and bonds. “Should inflation accelerate sharply, which we think is still unlikely, investors would find few places of refuge,” he continues. “Given this backdrop, equities are likely to only modestly recover from their recent sell-off. Duration fixed income remains unattractive. Investors will struggle to look for alternatives. But Japan, where valuations are modest and profitability is rising, is better positioned.”
According to Robert-Jan van der Mark, senior portfolio manager in the multi-asset group at Aegon Asset Management, the economic backdrop translates to a fundamentally positive outlook but with a lot of risks that could dent the story. He says expected equity returns should be muted, even if supported by growth but still in positive territory, as opposed to fixed income. “I think we have reached as-good-as-it-gets level in the traditional fixed-income markets,” he says.
Aegon’s focus is alternative categories such as consumer-related debt, asset-backed securities (ABS), mortgages and consumer credit which have healthy spreads. “Floating-rate ABS also do well, even if rates go up,” he says.
Serge Pizem, global head of multi-asset investments at AXA Investment Managers, remains optimistic as global equities valuations multiples are now below their 20-year average following the October correction.
AXA IM has reduced overall risk in recent weeks but remains overweight in equities by 3.5% mainly in the US, despite profit-taking from those positions, and neutral in the euro-zone. AXA IM has also closed its overexposure to emerging markets equities. AXA IM is underweight in European investment-grade credit where the level of risk premium on offer is not enough to compensate for the negative impact of rising interest rates.
“In terms of risk diversification, we recently bought US bonds which we believe can benefit from the flight to quality in the event of a sustained crisis,” he says.
Jeroen Blokland, senior portfolio manager at Robeco, does not expect a recession any time soon, despite slowdown in growth in areas such as the euro-zone. “For the US, however, risks of overheating still linger, and the Fed is very aware of that. This means short-term rates will go up further.
“In emerging markets, we have become more constructive on the back of the massive decline in emerging currencies, which has reduced a number of imbalances. Over the course of next year, the growth differential between EM and DM [developed markets] will probably slowly start to increase, after three years of decline. A widening gap between EM and DM GDP growth has often coincided with outperformance of emerging market equities,” he says.
Christian Hille, head of multi asset at DWS, says that even if expected returns are likely to be lower, risk-taking is expected to be rewarded and also required to achieve suitable results. “This view is consistent with our late-cycle investment strategy that favours equity versus developed market credit.
“As volatility increases we continue to like emerging market hard currency debt from a carry point of view within fixed income. While we prefer US and emerging market equities from a regional standpoint, given structural growth drivers, we apply a much more tactical approach to equity investments at this stage of the cycle, with wider ranges. Over in Europe, low valuations are there for good reasons as we expect the political backdrop and lack of earnings power to remain a headwind for the foreseeable future.
“With the yield curve already flat and the US-Fed cycle quite mature, adding exposure to US Treasuries or going longer US fixed-income duration is one of our calls going into 2019.”