Following years of steady, globally synchronized growth, volatility is back. In the final weeks of 2018, North American stock markets were especially hectic, posting losses in December to round out a relatively challenging year.
Virtually every asset class, with the notable exception of commodities, has done well over the past decade, says Bert Clark, president and chief executive officer of the Investment Management Corp. of Ontario. “That’s a place that should make any investor nervous, because eventually things are going to return to normal.”
After double-digit gains in equity portfolios, institutional investors were expecting the return of more dramatic price action, says Clark, who also notes gradually rising interest rates are underpinning some of the market unease. “It’s not a bad thing to start 2019 with interest rates at more normal levels and with people making sure they’re more comfortable with their portfolios given more normal volatility.”
With all of that in mind, where are pension plans looking to put their energy in 2019?
Macro and micro
The persistence of a populist or nationalist narrative can be considered a risk on a macroeconomic scale, says Clark, noting the U.S. administration’s continual promotion of unilateralism is certainly a reason to be wary.
However, apart from ideological concerns, the practical results of protectionism have both macro and micro effects, says Benoît Durocher, executive vice-president and chief economic strategist at Addenda Capital Inc. “If you do run pro-cyclical or protectionist trade measures at a time when resource utilization is running up against capacity limits, then you run the risk of stoking inflation,” he says. “You run the risk of central banks, particularly the Fed in this instance, moving away from gradualism and tightening more than the economy can withstand in the short run to quell inflation bursts. And then you run into a classical recession.”
While this scenario would take time to roll out and may not be fully realized in 2019, it’s certainly a worry on the horizon, says Durocher.
At a more micro level, protectionism is already affecting some pockets of the global economy, says Richard Beaulieu, vice-president and senior economist at Addenda Capital. “Quite a few firms are already complaining about having to put in higher input costs,” he says, referring to automobile producers as one example. He notes these producers are confronting higher tariffs on steel and aluminum at a time when their profit margins are already under enough pressure from a still very high degree of overall competition, as well as labour costs that have been firming up lately. “So if you add pressures that come through the international trade channels because of these protectionist measures, you certainly have some more serious headwinds to confront than otherwise.”
Italy is one developed market where a shift away from a globalist mentality is creating instability, says Rahul Khasgiwale, head of Americas investment director at Aviva Investors. “The Italian saga continued to rattle the market throughout 2018. We saw . . . Italian markets and assets come under pressure on multiple occasions.”
The Eurosceptic sentiment surrounding the country’s recent election resuscitated the potential for a euro crisis, he says. In particular, Italian government and sovereign bonds came under major pressure, with Moody’s Corp. rating them one level above junk bonds, he adds.
“They could become ineligible for a number of world bond indices and even potentially from [European Central Bank] asset purchase programs, so if something like that were to come to fruition, that would cause questions on Italy’s sustainability,” says Khasgiwale.
“Generally, we think being long Italian assets at this point is a little premature, and we think the situation is likely to get worse before it gets better. Certainly, more credible political and structural reforms [are] needed to reduce some of the current vulnerability of the Italian economy.”
On the other hand, in a less developed market, the transfer of power to a more populist government isn’t necessarily going to have the same ill effects, says Matt Benkendorf, chief investment officer of Vontobel Quality Growth, a boutique of Vontobel Asset Management Inc. He notes sticking to investments in Brazil over the past year has been painful, with the turbulence boosted by a dramatic presidential campaign. But with conservative Jair Bolsonaro taking office on Jan. 1, 2019, Benkendorf anticipates an improvement in Brazil’s investment environment.
“Emerging markets elections do matter as they do in developed markets like the U.S., clearly,” he says. “Sometimes they matter a little bit more in emerging markets. But just the uncertainty of a choice or a big potential shift coming up really throws markets and currency into a tizzy there.”
The conclusion of the election removes a significant amount of uncertainty, says Benkendorf, noting Bolsonaro is already appearing more market-friendly than many predicted. “He’s doing all the right things. I think the market has vastly underestimated his potential. The market still does.”
Within any market, fundamentals reign supreme during asset analysis, especially in a potentially contentious and complicated investing space like Brazil, adds Benkendorf. Regardless of geography, the best way to approach potential investments, he says, is to take a bottom-up approach in analyzing the best companies with solid stories and a clear, strong business strategy. Companies that provide life’s staples, such as beer producers or fuel suppliers, are excellent choices, especially when their values are being pushed down by worries over political upheaval. “We own very resilient businesses, despite what I’m giving on the top-down and the politics,” says Benkendorf.
Even with 2018’s rising volatility, many pension plans experienced their greatest move towards fully funded status since the 2013 surge in U.S. Treasury yields, says Timothy Braude, managing director of global portfolio solutions at Goldman Sachs Asset Management. “As such, we expect to see some fairly reasonable movements in asset allocation, particularly away from equities and into long-duration investment grade fixed income. That means longduration provincials, corporate bonds and longduration government securities as well.”
With a broader move into fixed income on the horizon, the effects of economic events on this asset class will be integral to watch in the year to come, says Braude. “As accommodative central bank policy is gradually withdrawn, we also see many pension plans adding market-based triggers to de-risking glide paths.” he says. “So rather than merely focusing on funded status, [they’re] looking at where interest rates are, thinking about things like the 10-year Bank of Canada yield or the 10-year U.S. Treasury yield as ways to make sure they’re modulating the overall exposure based not only on funded status but also where the market is going.”
Braude says implementing a more active strategy like this will take nimbleness on the part of pension funds, and further diversifying from a dependence on equities will push them towards innovating with liquid alternatives. Since these assets have gained in popularity, the number of managers servicing them has also risen, he adds, noting the investment community may begin a culling of the less successful players in the space in 2019.
But plan sponsors will continue to focus on liquidity this year, says Braude. “In Canada, you’ve actually seen a record number of plan annuitizations and plan terminations, or partial lift outs or buy-ins with insurance companies,” he says. “In order to do that you have to have a liquid portfolio.”
At the same time, he notes, institutional investors are paying attention to private assets, seeking ways to balance their inclusion in portfolios with liquidity. As well, investors are looking for private assets that have already shown some growth over an outlined trajectory, says Braude.
“You are seeing a lot more interest in things like secondaries, so being able to invest in private assets when they are already along the J-curve, not having to worry about allocating money and figuring out when that’s going to be committed.”
Demand for other alternatives, such as real assets, isn’t going to abate in 2019, says Calum Mackenzie, partner and Canadian investment consulting leader at Aon. While many investors have already jumped on core markets like New York City, especially for real estate, he notes pension plans still looking to buy have to look in less obvious locales and focus on fundamentals. “[They’re] moving from places like downtown Manhattan and putting more of an emphasis on an Austin or a Nashville.”
Available assets for infrastructure are also limited, adds Mackenzie, so plans will have to seek out holdings that require more effort to become completely healthy income generators. “The very core assets have been heavy targets from all global investors, so we’re encouraging plans to look at the assets that require a little more value add, assets that need a little more of that manager focus, so you’re buying a little more of that manager skill,” he says.
“Rather than going into simple public/private partnership assets, which might have been oversold, perhaps look at transport assets, for example. Take an airport that needs some asset management, so it’s not ready just to be taken on. You can’t just buy it and use it as a yield play. You’ve got to buy it and use it as a refurbishment. You’ve got to change some of the layout, deal with logistics with the building. You’ve got to put some work into it.”
However, when moving out of equities into any alternative, Mackenzie notes it’s important not to expect a true proxy from assets that simply don’t behave the same way as stock markets.
Allocation, allocation, allocation
In seeking diversification, equities have offered a less varied exposure, says Clark, and the traditional advantage of investing internationally has been weaker due to the tight-knit global synchronicity between stock markets.
As well, spreading out geographically by establishing positions in Canadian, U.S., European, international and emerging market stocks doesn’t guarantee the same true diversification it did in the past, he says. This is just one of many reasons he believes the most important investing choice a pension fund can make is the asset mix. “The biggest thing that we’re going to be doing in 2019 is working with our two initial clients to revisit their strategic asset mixes. For most investors . . . it dwarfs any other individual decision.”
Establishing an asset mix is the ultimate in getting back to basics for institutional investors. For Clark, a key rule to follow is diversification, not allowing a single choice to dominate the outcome of the portfolio’s return as a complete entity.
“You don’t want to take a position that dominates everything you do. If you have an outsized weighting to any of those things, you can find that, if the world plays out how you hope it will, things are great. But if it doesn’t, all of the other investment activities are overshadowed by that one decision.”
Martha Porado is an associate editor at Benefits Canada.