Institutional investors are grappling with historic levels of geopolitical tension, with multiple pain points contributing to a shifting macroeconomic landscape.
But amid the whooshing sounds of headlines, quickly forgotten with the arrival of the next tweet, Canada’s pension plans are eyeing trade, interest rates and, ultimately, investment fundamentals, no matter which hashtags are trending.
“Within the industry, there’s some level of awareness of our limitations, and I say that across the entire investment industry, that none of us have been here before,” says Calum Mackenzie, partner and head of investment for Canada at Aon. “This is the longest economic cycle ever. This is our longest bull run, unprecedented monetary policy. We’re probably in unprecedented political territory around the world.”
Tension is as tension does
The so-called phase one trade deal between the U.S. and China has been cause for cautious celebration in boardrooms and on trading floors. “We need to see follow-through on trade,” says Dale MacMaster, chief investment officer at the Alberta Investment Management Corp. The questions remain whether the more positive tone can stick and where these two global giants will go from here.
“The phase one deal is essentially a cease fire — it’s a détente, not a long-term solution to the imbalances between the U.S. and China,” says Candice Bangsund, vice-president and portfolio manager for global asset allocation at Fiera Capital Corp. “If anything, it defers, in the near term, that overhanging risk of driving the global economy into a global recession. Longer term, they still have a lot of issues that need to be sorted out.”
Indeed, while the focus has been on the skirmishes between the U.S. and China, there’s still potential for further trade conflict between the U.S. and other parties, says Kristina Hooper, chief global market strategist at Invesco. “It’s also trade wars between the U.S. and certain South American countries like Argentina. It’s the potential for a pretty significant trade war between the U.S. and the European Union. . . . It’s not going away and it could get worse.”
For the coming year, at least, trade issues will likely be sidelined by President Donald Trump’s activities leading up to the U.S. election in November, adds Bangsund. And, with the election in mind, U.S. markets may be rockier during the first half of the year, as the Democratic party chooses a leader, says Hooper.
“We’re going to see more volatility in the front half of the year than in the back half of the year because so much volatility will be driven by primary results. . . . Something like 60 per cent of delegates for the Democratic National Convention will be chosen in the first quarter,” she says. “So I envision a scenario where we have a high-profile win by a candidate not favoured by Wall Street and you could see a stock market sell-off. But as you get closer and closer to the convention, clarity forms, so I think you won’t see as much volatility in the back half of the year. But certainly, this should be a year for surprises and some level of episodic volatility all year.”
On the theme of elections, U.K. Prime Minister Boris Johnson’s landslide victory in December 2019 may be a sign that the ongoing paralysis of uncertainty faced by Europe in the wake of Brexit may be finally coming to an end, says Bangsund. Mandate in hand, Johnson will likely be less impeded in bringing an orderly Brexit forward.
“An orderly Brexit scenario is one in which there is not the cliff-edge exit where you get the exit without agreements, particularly on the trade side,” she says. “An orderly situation is our base case — that has increased now with Boris Johnson’s victory and that means less economic fallout when they do leave the E.U.”
Risks remain, however, as Johnson’s messaging since his re-election point to an exit by the end of 2020 no matter what, adds Bangsund. “That brings in the question, ‘Can we get this agreement done by then?’ This is uncharted territory for a lot of these policy-makers. They don’t know what that scenario is going
to look like.”
Meanwhile, amid all the uncertainty, central banks are demonstrating just how amenable they are to helping the global economy chug along as routinely as possible. But at some point, they will run out of the tools to do so, says Hooper. “Central banks have a reason to be concerned about the effectiveness of their tools, because we are reaching a level of exhaustion. And we’ve also seen so much accommodation that it really begs the question of what dry powder is available for a real crisis.”
Indeed, the U.S. Federal Reserve cut interest rates three times in 2019, and joined the European Central Bank and the Bank of Japan in beginning to expand its balance sheet. The ramifications of these monetary policies have yet to come to light, says Bangsund, noting it takes about six to nine months to see their full impact on financial systems, so further boosts will come as 2020 rolls along.
“When equity markets fall out of bed or economies appear to be slowing, we now have a Fed that is in easing mode,” says MacMaster. “It’s pretty clear the Fed and the Bank of Canada are both there to promote growth, and there’s no sign of inflation either. Inflation continues to come in around two per cent, so we’re not as concerned as we were.”
With some long-standing geopolitical tensions beginning to ease and monetary policies adding some breathing room, Canadian pension plans saw a major boost to their solvency levels in the final quarter of 2019, lifted by more robust gains in stock markets worldwide, according to data by both Aon and Mercer. But it remains to be seen whether there are enough tailwinds to push stocks even higher, or if momentum will start to fizzle.
It’s important to remember that sentiment is fairly weak at the moment, notes MacMaster. “There’s a very high amount of cash sitting on the sidelines — some $3.5 trillion — so investors are skittish.”
This cautious atmosphere is a good sign for contrarian strategies, he adds, and a number of helpful factors — including trade — are also playing into positive potential for stocks. “It may be largely symbolic, this sort of phase one trade deal, but the market is taking stock in that while we’re at new highs.”
Homeward, but not range, bound
Even as Canada’s institutional investors become more global in their positioning, domestic stocks look especially attractive compared to other markets, says MacMaster. Overall, equities have been on the rise, but Canadian companies don’t look overextended in their valuations, which have been partially dampened by weaker earnings in recent quarters.
Indeed, in sizing up developed markets, Canadian stocks may prove more deserving of a tilt this year than public equities in Europe or the U.S., says Bangsund. “We’re setting the stage for 2020. We think investors are going to be looking for more compelling value propositions. And this should bode well for the economically sensitive sectors and regions of the world.”
If commodity prices and interest rates both rise over the coming year and beyond, Canada’s energy- and financial-heavy stock market is set to benefit, she adds.
“The fact that close to two-thirds of the TSX is concentrated in these value, cyclically biased sectors, such as resources, financials and industrials — these are sectors we think will do well should the global economy revive itself in 2020. . . . The Canadian market is also trading at a significant discount to the U.S. and we think that gap is going to close.”
Canadian pension plans could also stand to include more domestic allocations in private equity, says Senia Rapisarda, a managing director at HarbourVest Partners. Opportunities for growth exist, especially in the technology sector where assets are waiting to be snapped up, she adds, noting agricultural technology is one area set for imminent growth.
“Canada is fabulously positioned because we’ve been doing that for quite a while. We have centres of excellence, whether it’s in Alberta, Ontario or Quebec. Agtech is an area where people will say, ‘OK, let’s tackle a better way to save, produce and make long-lasting food.’ And that’s an industry that hasn’t really been a subject in private equity [discussions].”
Overall, private equity is becoming more popular among all sizes of pension plan, with the increased demand leading to a proliferation of vehicles allowing smaller plans to get in on the action.
This trend comes as European and U.S. equity markets appear fully valued, growth in newly listed stocks appears sluggish and, in some cases, markets are even shrinking. Globally, just 1,237 companies made initial public offerings in 2019 — the lowest number in three years, according to data from financial markets platform Dealogic.
In turn, the popularity of the private equity market is causing the secondaries market to grow, says MacMaster, and it’s becoming a more common arena in which Canadian pensions can find new places to allocate.
Indeed, Mackenzie highlights how some investors were able to dip their toes into the secondaries market in the aftermath of the financial crisis, because it forced certain asset owners to sell at prices under heavy pressure. “
At that time, we were looking at the market and saying, ‘Is this a temporary phenomenon?’ Or is this secondaries market really here to stay?’ And actually, what we’ve seen is the secondaries market has been reasonably resilient and the funds that were being launched around that time have gone on, and there have been a number of more iterations of new vintages launched.”
Fast-forwarding to today, the secondaries market is becoming a faster way for pension plans to implement a private equity strategy, quickly injecting a shot of diversification, adds Mackenzie.
And that diversification is becoming all the more important in an environment where more traditional asset classes aren’t behaving the way they have in the past.
“We’ve started, for the first time, ever since I can remember, looking at gold as a potential diversifier and defensive asset within institutional portfolios,” says Mackenzie. “And so part of the rationale for that, . . . the big argument against gold has always been, well, there’s no income from it. But when you’ve got bond yields at zero, sometimes below, or not far above zero, that income argument starts to go away. And so again, you look for what else would diversify us in a big downturn.”
As well, with so much negatively yielding debt floating around in major markets — Europe being the worst offender — capital that’s normally allocated to developed market fixed income will have to find a different home, says Kurt Reiman, chief investment strategist for Canada at BlackRock. “Our favourite tilt is in the direction of emerging markets fixed income.”
With both monetary and fiscal stimulus improving the cyclical outlook, emerging markets fixed income looks like an attractive option for investors seeking to generate income, he adds, noting that searching out bonds further afield does amp up the risk factor. “There’s no free lunch. If there’s an income objective and [they] can tolerate the added risk exposure, it seems to be an attractive opportunity set.”
These instruments, especially emerging markets sovereign debt, have existed in an environment of structural ratings upgrades, with many sitting at a yield level on par with the high yield bond market, says Reiman.
But in the first week of the new year alone, tensions between the U.S. and Iran skyrocketed, mind-bending swathes of Australia burned in wildfires and the Bank of Canada was recruiting for its new governor. So it remains to be seen what new risk may be lurking around
Martha Porado is an associate editor at Benefits Canada.