At the best of times, selecting an optimal asset mix for a defined benefit pension plan is challenging. The times of today are downright turbulent.
Last year, inflation reached 8.1 per cent in Canada as a result of a prolonged period of government stimulus spending to manage the fallout of the coronavirus pandemic. In response to rising inflation, the Bank of Canada raised the overnight rate from 0.25 per cent to 4.5 per cent, ending a 15-year period of low interest rates.
At the same time, the global energy supply has been disrupted by the Russia-Ukraine conflict. Oil prices spiked following the invasion, adding to the inflationary pressure, and they only began to moderate this year.
The rise in interest rates have put the breaks on Canada’s quarterly GDP growth, which slowed from 1.67 per cent in Q4 2021 to 0.01 per cent in Q4 2022. In turn, the yield on five-year Canadian bonds has climbed to three per cent and the five-year fixed mortgage rate has risen to 5.5 per cent.
A similar situation has been seen before. In the 10-year period from the early 1970s to early 1980s, global economies were experiencing high levels of inflation, triggered by rapid increases in oil prices. Oil prices were impacted by rapidly rising energy demand, combined with a drop in oil production, due to the Organization of the Petroleum Exporting Country’s embargo in 1973 and the Iranian revolution in 1978.
This rapid inflation was accompanied by a steep decline in GDP, which is an economic state known as stagflation. In Canada, inflation rates peaked at 12.9 per cent and interest rates rose to all-time highs. At the tail end of the U.S. Federal Reserve’s aggressive interest rate policy in 1980, it raised its policy rate to 20 per cent. In Canada, it went even higher, reaching 21 per cent the next year.
This era was characterized by two periods of negative economic growth in Canada and three in the U.S. Traditional assets, including stocks and bonds, both performed poorly.
In the U.S., the S&P 500 had a 4.1 per cent annualized return over this period. The S&P/TSX, buoyed by high energy and materials exposure, fared better, realizing an annualized return of eight per cent. U.S. government bonds saw an annualized return of 8.2 per cent. Since Canada’s annualized consumer price index was 9.5 per cent during the period, all of these asset classes generated negative real returns.
During this time, commodities, particularly precious metals performed well, with gold realizing an annualized real return over the period of 23.6 per cent. Other commodities, including agricultural and other base metals, also generated positive real returns.
Why does this matter today? DB pension plan sponsors can draw from the history of the period to better navigate today’s troubled economic landscape.
- Go long on bonds
With interest rates rising over the last year, many DB pension plans have benefited from bond duration in their pension portfolios that are shorter than the duration of liabilities. This mismatch has resulted in an improvement in solvency positions.
However, this is likely to change in the near future. The yield curve is a good predictor of future interest rates, as it reflects the consensus expectations of market participants of future interest rate movements. The current inverted yield curve implies that investors expect rates to fall over the next 12 to 18 months. Since falling rates have a higher positive impact on the valuations of longer dated bonds, it may be time to consider lengthening bond durations in anticipation of declining interest rates.
Additionally, bond investors should improve the quality of their bond portfolios. Credit spreads tend to rise in stressed economic environments, where investors seek higher quality investments.
- Favour value over growth
Value managers tend to outperform growth managers in recessions because growth companies tend to have more of a discretionary nature to their revenue streams. Value funds tend to have a higher tilt towards sectors that produce non-discretionary goods such as consumer staples, health care and telecommunications, which see more stable earnings in economic downturns.
Value funds also focus on companies with stronger pricing power, which allows them to better pass through inflation and maintain their operating margins.
- Reconsider cap size
Smaller cap companies tend to fare worse than larger cap companies going into economic downturns. They tend to have less robust revenue streams and limited access to financing, which becomes more restricted in a recessionary environment. A tilt towards large cap companies may provide some protection to portfolios in a recession.
- Diversify equities
The benefits of investing across multiple countries and regions becomes apparent in periods of global instability. By diversifying globally, pension plan sponsors can minimize the volatility in their portfolios from idiosyncratic risks.
While Europe has struggled due to energy supply disruptions, the Canadian stock market — and, to a lesser extent, the U.S. stock market — have benefitted from higher oil prices. Companies in Brazil and Mexico have benefitted from a weakening U.S. dollar relative to local currencies in 2022 as many of the inputs to production are priced in U.S. dollars.
- Increase allocations to alternatives
Alternatives asset classes can help protect against inflation and enhance diversification.
Infrastructure investments benefit from stable income streams and often have inflation adjustments built into contracts. Infrastructure also tends to benefit from government spending, when countries try to spark growth through stimulus programs.
Other real assets such as commodities, agricultural land and timber have also historically risen with inflation and can help hedge portfolios in an inflationary environment.
Changes in valuations brought on by reduced utilization due to the coronavirus pandemic are still working through the commercial real estate market. As a consequence, real estate debt may be preferable to real estate equity, which may have its performance weighed down by future capital losses in the office and retail sectors.