Where to from here? 

This note is intended to summarize, for asset-owner clients who could not attend in person, some of the major themes and related actionable insights I picked up from Mercer’s recent Global Investment Forum conference in Toronto. For more on these and other ideas, not just from Mercer but also from our growing number of external publishers, please see the MercerInsightCommunity.

Over the past few weeks, besides participating in the Forum, I’ve had the opportunity to attend four industry conferences, plus some smaller roundtables, and to participate in 1:1 meetings with some very knowledgeable asset-owner CIOs and senior investment professionals from some of our investment management partners. As an industry, we’ve needed to collectively navigate an off-the-charts level of short-term market volatility in the UK, the recent Chinese Communist Party Congress, and ongoing developments around Russia’s invasion of Ukraine. Other areas of close focus have been the information released during the ongoing corporate earnings season, and the ongoing releases of inflation and sentiment data.

Based on all this input, here are four issues that I believe most CIOs of large, sophisticated organizations will want to develop a view on, and potentially act upon, as soon as practicable:

1. Capitalizing on higher long-term yields, while they are available, and preparing for the next time, if a window of opportunity is missed
2. China, and the growing recognition that emerging markets are not one-size-fits-all 
3. Maximizing diversification, factoring in views on the extent to which private ownership really is fundamentally different, and which alternative asset classes offer real diversification potentia 
4. A barbell approach to liquidity management, and more generally preparing governance and operations for crises 

Further detail on the main issues in play in each of these areas is set out in detail below.

As a specific and simple example, we started the year with US 10-year Treasuries trading at 1.5%. As of this writing, they are at 3.8%¹. Across most developed markets, nominal and real yields at the long end of the curve are substantially higher today than at the start of the year. For any investor, there is an opportunity to lengthen the maturity of the fixed income portfolio or trade more volatile assets for less volatile assets, and thereby “lock in” better holding period returns over a long-term investment horizon or lower volatility in the medium term with limited impact on returns.

In my opinion, every asset owner should be reviewing their strategic asset allocation and risk budget allocation in light of this change in available yields, and doing so off-cycle if necessary. If your cadence has been “every three years or as needed”, now is the time for an “as needed” review. This year’s scale of interest rate rise is a one-in-a-hundred-year event, and presents opportunities that haven’t been available to us in most currencies since before the Global Financial Crisis.

A year ago, it had become fashionable to ask “what is the role of investment grade fixed income” in an institutional portfolio, as nominal and real yields had become so low, with the prospect of capital losses if interest rates were to rise. This asset class is now more competitive in the strategic asset allocation and risk budgeting calculus for most types of investors.

A specific aspect of this is that liability-driven-investment (LDI) still makes complete sense for most defined benefit (DB) plans, despite the recent operational challenges some UK sponsors experienced with managing margin calls on leveraged LDI implementations amidst extreme market volatility.

Our opportunity to “lock-in” these returns may be short-lived. There is a growing chorus cautioning us that medium and long-term deflationary risks remain high, on the other side of global central banks’ ongoing battle to rein in a wage/price spiral amidst two exogenous stagflationary shocks (the Russian invasion and a continued zero-COVID policy in China). Globalization continues (see section 2 below). Digitalization and technological disruption more broadly are inherently deflationary. And the energy sector, both renewables and traditional, is experiencing a wave of investment that will likely help keep energy prices substantially lower starting a couple of years out. So, our opportunity to “lock in” the long yields that are currently available could prove short-lived.

To put a point on this, UK investors briefly had an opportunity a few weeks ago to lock in an almost 5% nominal yield over a 20-year time horizon. As of this writing, they can “only” get 3.7%². That is a lot more than was available at the beginning of the year, but it is not 5%.

For DB clients with dynamic de-risking glidepaths, Mercer had historically argued for an implementation approach that involved a daily review of mark-to-market funded status and yield levels against pre-defined trigger points, “automated” de-risking activities (as in, with changes in allocation targets pre-specified for when a trigger was hit, and to be implemented as a default without further review), and delegated accountability for implementation (whether to in-house staff, an LDI manager or OCIO). This daily, automated, and delegated approach was not universally adopted across the industry. Unfortunately, some DB plans have missed de-risking opportunities, and not just in the UK, as rates spiked up temporarily and then dropped.

Going forward, if non-DB investors start targeting longer durations than whatever happens to be the duration of the entire fixed income market (the common default benchmark), and take a dynamic approach to attempting to lock in higher yields when and if these become available, they may also want to adopt a daily, automated and delegated implementation approach.

Foreign investors have received relatively little encouraging market or economic policy news out of China in recent years, other than last week’s rumors of phasing out zero COVID, as this week’s announcement that the government will provide more meaningful support to the property sector. However, this comes after the party congress in October after which foreign investors grew more concerned over the economic policy path the country may take over the next decade as attested by the market reaction following the congress. Most strikingly, in contrast to past party congresses, we didn’t even see an economic growth target specified for the Chinese economy. This departure from past practice seems to communicate a relative de-emphasizing of the Chinese government’s recent decades-long, highly successful focus on driving economic growth. The rapid growth of the Chinese economy over the past several decades has lifted most of the Chinese population out of poverty, and been an engine of growth for the global economy, but China is now forecast to deliver “only” around 3% GDP growth for 2022³, extremely low by Chinese standards. The temporary withholding of the normal economic data release until after the congress, while it is apparently aimed at releasing some good economic news to help celebrate the conclusion of the congress, also demonstrates a striking departure from routine developed market practice regarding how to maintain the confidence of market participants. It is becoming increasingly hard for foreign investors to maintain confidence in the Chinese government’s management of its economy. The government seems to be focused on other priorities.

On the other hand, Chinese valuations reflect this. The trailing P/E ratio of the onshore A-Shares market is around 16X, as of this writing and even after the strong rebound in mid-November, versus 19X for the S&P 500⁴. Also, when China does reopen from COVID, after a 2.5 year+ national shutdown, it will presumably experience the same boom in growth as developed market economies did, following much shorter shutdowns (typically in the neighborhood of three months). In other words, we could in the near term see a big boom off a relatively low valuation level.

In my opinion, every investor should take an explicit weighting decision on China. That weight, under certain objectives and considerations, might end up being zero, or partial or full market cap, or closer to GDP weight (which would be above market cap). In other words, the China position is unlikely to be one-size-fits-all, nor is the market index weight likely to be an optimal allocation. The major market index providers have arrived at their “inclusion factors” for China, e.g., 20% for the on-shore A-shares market in the case of one major provider, using transparent methodologies. However, those methodologies by their nature can’t capture any specific asset owner’s unique objectives, risk tolerance and constraints, and can’t reflect what else the asset owner holds in their portfolio.

To put a point on it, the Chinese economy, even without adjusting for purchasing power parity, is the second largest economy in the world⁵. And yet, an investor applying the MSCI ACWI index will have lower weight in China than in Apple, a single company. Now let’s turn from China to the rest of the emerging and frontier markets. Year-to-date, as of this writing, North Asian markets (China, Korea, Taiwan) have underperformed the S&P 500 by roughly 10-15%, even if emerging markets outside China as a whole have performed roughly in line with the S&P 500⁶.

Because of ongoing US/China tensions, there is an exceptionally strong case emerging (pun acknowledged) for investment in the “non-aligned” emerging markets. These are countries that can accept investment from both the US (and from “coalition” countries that align their policies with those of the US) and from China, and trade with both “blocs”. These are the countries that will benefit from multinationals seeking to diversify or make their supply chains resilient, including by “friend shoring” but also more generally by shifting or diversifying production to somewhere other than China due to concerns about the ongoing zero-COVID policy and the potential for other heavy-handed policies that may affect the Chinese economy. These are the countries that will benefit as wealthy entrepreneurs contemplate the potential for the confiscation of assets without normal due process, such as that experienced by Russian oligarchs after Russia’s invasion of Ukraine. A shift of their investments into non-aligned countries is therefore a hedge against any expropriation risk that may exist in North America or Western Europe should geopolitical tensions spill over into more overt conflict.

Demographics in these non-aligned emerging and frontier markets are also much more favorable than in China, which as a result of the historical one-child policy has now moved into negative growth territory for its population and is verging on negative growth territory for its labor force. Finally, many of these countries still have an opportunity to move up the growth and development curve from low to middle income in terms of per-capita GDP, a path China has already successfully followed. Historically and across many countries, this stage of economic growth has proven much easier to achieve than moving from middle to high per-capita income (the tougher challenge now facing China).

Not everything is “rosy” for these non-aligned countries. Some will be severely challenged by the strength of the US dollar, as they either have dollar-denominated debt or have effectively dollarized their economy, importing contractionary US monetary policy even if they don’t currently share the US’ need to rein in a wage/price spiral. And, while the path from low to middle income is well trodden, it is by no means easy.

Whether a given investor ultimately overweights or underweights China, the rest of North Asia, and/or the “non-aligned” emerging and frontier markets, I hope we will see a general shift away from effectively defaulting these important decisions to the major index providers. The index providers give us a useful starting point, but these are important calls that, in my opinion, should reflect a specific investor’s objectives, risk tolerance, and constraints in a way that fits well with the rest of the portfolio.

Some asset owners are explicitly focused on or implicitly influenced by peer group medians and the performance of their peer group. For US investors, specifically for the 10 calendar years ended 12/31/21⁷, this tended to reinforce continued home country bias (as US equities outperformed) and an implicit comfort with the increasing concentration in mega-cap tech stocks at the large end of the US market. As of this writing, the top five companies represented in the Russell 1000 index of US large-cap stocks, all tech stocks, account for close to 20% of the total index. Apple’s weighting remains above 5% in the index⁸.

In my opinion, the case for investment in diversifying asset classes – international and emerging market equities, and also private equity and debt, real estate and infrastructure – remains strong. Liquid alternative strategies, including those implemented using hedge funds, can also provide alpha and diversification potential not available through other strategies. Many asset owners remain structurally overweight to past success, and structurally underweight to important sectors of the real economy that are more readily accessed through the private markets, and to disruptive technological innovation accessible through venture capital and growth private equity investment.

We don’t know what will happen with interest rates across the curve in the medium to long term. We don’t know what will happen with China, how the Russian invasion will be resolved or the exact path of policy and action around climate change, etc. In this environment of massive uncertainty, aggressive diversification will generally make sense for most asset owners. Markets haven’t been “grinding away” with gradual returns, they have been “gapping” with major shifts up or down. This is an environment in which diversification is highly valuable.

Some industry pundits argue that private equity is just a levered form of public equity. I fundamentally disagree. Private ownership is different from public ownership. Each has its place, but the market appears to be voting in favor of increased private ownership over time. In other words, there are fewer publicly traded stocks available in the developed markets now than 10, 20 or 30 years ago. Anecdotally, the “Wilshire 5000” Index of US stocks hasn’t been able to find 5,000 stocks to include for many years now⁹.

In the real estate and infrastructure asset classes also, private ownership remains common and different in important aspects from what is available in common publicly traded forms of these asset classes.

Not all investors will agree with my views on these asset classes, but for those that do, maintaining the pace on aggressive diversification will likely make sense. The years 2009 and 2010, coming out of the Global Financial Crisis, appear likely to have been two of the best vintage years ever for most private market asset classes. So, if we do get a recession soon, maintaining the pace of deployment in private markets, or increasing this in line with longer-term strategy targets, may make sense.

As more investors further increase their allocations to relatively illiquid private market investments, and therefore need to maintain liquidity to fund capital calls, liquidity management needs more explicit consideration. Liquidity can also be useful for funding opportunistic or dynamic investment opportunities when markets experience volatility. And, for clients that hedge currency risk, engage in tail risk-hedging, or make other uses of derivative overlay such as for LDI, liquidity can be needed to fund margin calls.

For investors that can borrow in the physical markets and invest the proceeds in investment grade bonds of similar duration to the debt issued, doing so can make available (at some cost depending on borrowing cost versus the net yield on the bond portfolio) a liquidity buffer that is not subject to the ability to sell physical assets in the capital market. (Many not-for-profit healthcare systems, some higher educational institutions, and some sovereign wealth funds can borrow in the physical markets, for example.) This liquidity buffer would also not be subject to the continued availability of lines of credit. So, it would provide a more reliable form of liquidity than other common means of maintaining “dry powder”.

Another means of maintaining “cash” is to replace either a passive index fund or active public market equities exposure with a cash plus futures or cash plus swaps “equitized cash” portfolio, an approach commonly referred to as “synthetic equity”. When there is a need to fund capital calls for private market investments, or margin calls on derivative positions, or an opportunity to buy suddenly unwanted holdings of any type from forced sellers, or just to pay benefits, fund grants, cover student scholarships, etc., this cash is readily available, regardless of the market environment.

Stronger liquidity management needs to be paired with stronger operational management to be effective. During the recent extreme volatility in the UK, many DB sponsors were called upon to do in hours or days things they would have normally done over weeks or months. Considering ahead of time the known range of operational scenarios, pre-defining what should be done dynamically or opportunistically in response to these, and delegating accountability for that implementation either to in-house staff, to a sub-committee of Investment Committee members, or to outside professionals, should help ensure an institution can respond with agility to both crisis and opportunity.

Even if the specific scenario that eventuates doesn’t fit the anticipated scenarios, an institution that has gone through the exercise of defining policy and delegating implementation may benefit from that “muscle memory” and be able to react faster to something “new and unforeseen”. By definition, we probably can’t predict the nature of our next “crisis”, nor the investment opportunities it will create.

One exercise we like to do periodically with our clients is a “scenario” test. (These are sometimes called “fire drill” tests.) The Investment Committee and Staff enter a conference room and open an envelope, which tells a story about a crisis or opportunity in the economy and markets. This can be a real historical scenario, such as the GFC, a flash crash, or the March 2020 COVID drawdown. Or it can be a fictional but plausible future scenario. The team then identifies what it would like to do in line with its strategy if this scenario were to happen. Then, the committee seeks to identify whether there is any further dynamic or opportunistic policy development, or pre-delegation of authority or accountability, that could facilitate the actual implementation of its desired actions in practice, if such a scenario were to come to pass. Some current scenarios not modeled on the past include (a) a China/Taiwan conflict (massive stagflationary shock, an order of magnitude larger than Russia/Ukraine), (b) passage of a carbon tax in the US (stagflationary stock but with a massive boost to sustainable assets), or (c) discovery of a cure for cancer (good news but most national social security systems, healthcare systems and corporate DB plans rendered immediately insolvent).

If any of us had gone to sleep a year ago and woken up today, we’d find the world and its investment opportunities to be shockingly different in important ways. Like the proverbial frog in the water being heated to a boil, having lived through the past year, some of this may have snuck up on us. A review of objectives, strategy, and implementation may be timely now for most investors, before new risks emerge or the resolution of current risks becomes clear. Keeping objectives, strategy and implementation trued up can help us respond to threats and capitalize on opportunities with greater agility, even if the specific future scenario is different from anything we’d considered.

With best wishes amidst what are indeed interesting times, Rich Nuzum

Footnotes:

1. Source: Refinitiv, Market Yield on Bloomberg U.S. Treasury Bellwether: 10-Year, as of November 11, 2022.

2. Source: Refinitiv, Market Yield on FTA UK Gilts 20 year average gross redemption yield, as of November 11, 2022.

3. Source: International Monetary Fund, World Economic Outlook, October 11, 2022, China GDP estimate of 3.2% for 2022.

4. Source: Bloomberg, S&P 500 Total Return index in USD and MSCI China Onshore Net USD Return index, trailing P/E ratios (last twelve months) as of November 11, 2022.

5. Source: World Population Review, accessed on November 11, 2022 (https://worldpopulationreview.com/countries/by-gdp)

6. Source: Refinitiv and Bloomberg, total USD returns for S&P 500 Composite, MSCI China, MSCI Korea, MSCI Taiwan and MSCI EM ex China, as of November 11, 2022.

7. Source: Excess return is on a portfolio of 60% stocks (as represented by the S&P 500) and 40% bonds (as represented by the 10-Year US Treasury) over cash (as represented by the Fed Funds rate). Stocks & bonds data as of 10-year period to 31 December 2021: Robert J. Shiller (Data Used in “Irrational Exuberance” Princeton University Press, 2000, 2005, 2015, updated) http://www.econ.yale.edu/~shiller/data.htm). Cash data: Board of Governors of the Federal Reserve System (US) VIA FRED. For illustrative purposes only.

8. Source: Refinitiv, index constituents of Russell 1000, as of September 30, 2022.

9. Source: Wilshire website, accessed November 14, 2022 (https://assets-global.website-files.com/60f8038183eb84c40e8c14e9/62f158f90ae83f59cf4a6ab8_FT_Wilshire5000_IndexSeries_WhithoutMidCap.pdf)