With the new year almost here, there are some interdependent themes investors should watch, such as central banks tightening policy, trade tensions and an increased focus on sustainability according to Mercer’s most recent paper on themes and opportunities for 2019.
Chance of ‘white water’ turbulence
There is evidence that credit is overextended, the paper said, with outstanding corporate debt increasing and quality decreasing. At the same time, the report highlighted expectations that a positive macroeconomic backdrop coupled with pro-business policies and business optimism will assist the equity market in the near-term.
“When these contrasting equity and bond market currents meet, there is scope for white-water turbulence,” the paper said. “Navigating such an environment will require investors to be alert, prepared and tenacious. Investors should examine and waterproof their fixed income portfolios. The return of inflation, thought to be long banished, is an additional threat that investors cannot afford to ignore.”
There isn’t a single answer to how an investor can waterproof their portfolio as different plans would need to take different actions depending on their needs, says Dave Makarchuk, the strategic growth leader for Mercer’s Canadian Wealth Business in a conversation with Canadian Investment Review.
“For investors who are . . . looking to the fixed income portfolio to provide returns, provide yield, provide something better than you can get from traditional government bonds, then I think ‘waterproof’ is more about diversifying your exposures within that space, maybe moving to more absolute return strategies, strategies where you can be more flexible on duration, strategies where you’re more flexible on your [geographic exposure] and things like that,” says Makarchuk.
While fixed income offered a high degree of protection during the last crisis, it may not be able to bolster portfolios through future challenges, the paper said.
The paper suggested investors revisit or stress test their strategic asset allocation to ensure that it is “fit for purpose and robust enough to take the knocks that the rapids ahead may present.”
Central banks retrench from market involvement
Central banks are easing back on their market involvement, which raises questions about what this will mean for liquidity.
“If the world’s major central banks proceed with their stated intentions to deleverage their balance sheets, the coming years are going to see a significant withdrawal of liquidity,” the paper said.
As the economic environment shifts, investors need to understand their illiquidity tolerance, the paper emphasized.
“Essentially we’re referring to central banks either stopping or reversing the significant purchases of fixed income investments that they made starting in 2009 an onwards,” Makarchuk says, noting that a reversal could be negative for the day-to-day economy and could be tougher on small businesses or even large businesses because credit spreads could potentially rise, yields could push higher and the cost of borrowing could increase.
“In terms of actual investors – the impact on their fixed income portfolio generally is – if there’s a lot less demand in the space, because there was a lot of demand from the central banks to buy bonds, so if they pull that off that’s going to push prices [down] a little bit, that’s going to push yields up as well and potentially portfolios of ordinary fixed income start to suffer because there’s not a lot of price support,” he says.
“If that happens in a controlled way, i.e. not all at one time, that might be fine because that actually is going to naturally just bring yields up a little bit,” he says. Further, he notes that pension funds that are de-risking may actually be the ones who fill the demand void.
Political fragmentation and trade tensions
Another theme to watch is global political upheaval, like current U.S.-China trade tensions.
While the turbulence will likely continue to impact markets, the situation could create a more favourable environment for certain opportunistic strategies, according to the paper.
“An environment of global economic divergence has the potential to present a favorable investment environment for unconstrained investors with global macroeconomic insight, but it could lead to more volatility in currency markets, prompting a review of how currency risk is managed within investor portfolios,” the paper noted.
Increasing focus on sustainability
Governments, regulators and beneficiaries will increasingly expecting those responsible for allocating capital to take a broader perspective of risk and return; although there are strong regional differences in expectations, the paper said.
Globally, Makarchuk says Europe and the Northern European countries are the furthest along in terms of environmental, social and governance issues coming up in conversations with pension plan sponsors, while North America is not nearly as far along.
“It’s not because they don’t care about E, S, or G,” he says. “I think [many small and mid-sized plan sponsors] have concluded it is more efficient and in their best interest as fiduciaries at the end of the day to delegate those decisions to the underlying investment manager as opposed to debating those topics at the committee level where time is otherwise really precious.”
Investors can potentially focus on managers with strong ESG principles, look at ESG-focused indexes or look to impact investing through private market strategies, the paper noted.