September 01, 2017
Asset owners face unprecedented headwinds today, not least of all the need to meet return targets in a lower-return environment while liabilities burgeon. The volatility of investment returns is a concern in this context, but so too is the absolute level and volatility of potential funding gaps, which depend on both assets and liabilities.
Low interest rates have contributed to ballooning liabilities, as they have a bearing on the discount rate used to calculate the present value of future pension obligations. A lower discount rate results in a higher net present value (NPV) of a liability stream. The tepid economic growth in the developed world in the aftermath of the 2008/2009 global financial crisis led central bankers to inject significant liquidity into the financial system. This has kept interest rates at very low levels until quite recently, with the concomitant effect of raising pension fund liabilities.
On the asset side of the equation, returns have held up quite well in many asset classes in the past year. Since Trump’s election in November 2016, US equity markets have posted strong performance. However, there are valid concerns about valuation levels and the sustainability of the Trump reflation trade. While equity market volatility is benign at present, it is unlikely to remain at these levels. The Chicago Board Options Exchange (CBOE) Volatility Index, commonly known as the VIX, a popular measure of the implied volatility of S&P 500 Index options, is currently very low. In the past, when the VIX has been this low, it has tended to move higher in relatively short order. All this to say that we believe that volatility will likely come knocking before too long.
Cyclical and secular risks
Numerous factors, both cyclical and secular, warrant consideration as one surveys potential volatility at the plan, portfolio and security levels. The cyclical factors include the political risks associated with populism and the ongoing policy uncertainty following Brexit and the election of President Trump. The Brexit “divorce” will almost certainly take longer and be more difficult than originally anticipated. In the interim, the United Kingdom and the European Union, to a degree, will operate under a cloud of uncertainty. There are also closely watched elections taking place this year in France and Germany, and possibly also in Italy, where populist parties are serious contenders.
On the economic front, the sustainability of the current elongated business cycle is a key open question, particularly against the backdrop of central bankers’ efforts to normalize monetary policy as the global economy shows signs of nascent strength. Will the US Federal Reserve’s rate rises prove well timed or risk overshooting and tip the economy into recession? How will the markets react when the European Central Bank begins to taper its bond-buying program? These are just a few of the questions on investors’ minds at present.
What is certain, though, is that the current crop of central bankers and policymakers have virtually no experience managing the unique financial and economic conditions that exist following the global financial crisis. The captains of the fleet are steering us in uncharted waters. We best acknowledge the risks — and be sure that we are wearing our life preservers.
There are, in addition, some key secular themes that frame the dynamics in the global economy that present risks and opportunities from an investment and liability perspective. Debt, demographics and the disruptive nature of technology are three of these themes.
Debt — Countries in the developed world hold an astonishing level of both public and private debt — even higher now than the high-water marks of 2008 — and these debt levels continue to rise. High debt levels often preclude interest rates returning to “normal” because economies would have difficulty meeting the debt service burdens that accompany higher rates.
Demographics — Aging populations and low fertility rates characterize most of the developed world (and, increasingly, also the developing world). This results in fewer workers in the labor force, working shorter work weeks at lower levels of productivity, which leads to lower economic growth. The rise in the old-age dependency ratio (the proportion of retirees relative to the working-age population) in the developed world, to the current level of 27%, is sobering enough without considering that by 2035 the ratio is projected to be about 40%. Few have even begun to comprehend the impact this will have on economies and societies.
Technology — Artificial intelligence (AI) and technology are undoubtedly accelerating in their power and application. And while technology has enhanced our lives immeasurably, it also has an unpleasant underbelly: It is highly disruptive and deeply deflationary. Contrary to popular opinion, many more jobs are being lost to automation than to global outsourcing, and this trend will only continue at a rapid pace.
E-commerce is great for consumers, as it affords comparison shopping and lower prices, but it has also dislocated many industries and led to widespread job losses. One need only look at how online shopping is disrupting the brick ‘n mortar retail industry and commercial real estate market to see the disruptive effects of technology. Amazon’s success is a case in point. The online behemoth is now larger than the seven top US retailers combined (Walmart, Target, Sears, Kohl’s, Best Buy, Macy’s, JC Penney and Nordstrom) with a market capitalization that is 20 times larger than it was a decade ago.
The upside of volatility
Volatility — dispersion of returns — often has a negative connotation, but we should bear in mind that it also creates opportunities for active managers to show their mettle and potentially earn alpha for client portfolios based on perceived mispricing of risk.
Defensive approaches: Managing drawdown risk
Risks and uncertainties undoubtedly abound. From an investment perspective, the question is how best to manage these while capturing returns. For some, particularly asset owners with a longer-term time horizon who are considering a strategic allocation, it may be appropriate to consider an active defensive approach such as a low-volatility strategy. These strategies are designed to manage downside risk in falling markets while providing potential upside market exposure. They are well suited to strategic allocations since their benefits are typically harvested over a minimum of one market cycle.
While it is true that low-volatility strategies tend to underperform when rates are rising, our analysis suggests that sharp market corrections tend to follow rallies led by high-volatility stocks in rising rate environments — and that, over time, it has usually been better to maintain exposure to low volatility during periods of rising rates and not try to time the market. The market rotation from defensive to cyclical stocks in the second half of 2016 also had the effect of reducing the valuation premium in low- volatility equities, which makes them a more attractive investment proposition now than they were nine to 12 months ago.
These defensive approaches are based on understanding just how corrosive drawdown risk can be in an equity portfolio. Indeed, one earns alpha by not losing ground on the downside, where losses require substantial market returns (beta) and potential alpha to make up. We believe this is achieved by prudent active investment management. In essence, winning by not losing.
1 UN Population Division – World Population Prospects (2015 revision). Current levels represent 2015 data.
2 Factset and Bloomberg, as of 12/31/16.
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