Schroders Autumn Conference 2016 - Highlights
We held another packed annual autumn conference in London on 27th September. Our chief economist, Keith Wade, threw his searching gaze on markets increasingly dominated by political risk. We also looked at the role of multi-asset investing in a low-yield environment, how factor-based investing can uncover reliable long-term sources of returns in growth portfolios and examined what effective implementation of a “solutions-based approach” might look like for trustees. Finally, we took a contrarian approach and asked whether now was the right time for a reappraisal of commodities.
The global macro outlook
Nine years on from the financial crisis, the world economy remains far below normal cruising speed:
- Interest rates remain at historic lows, while 30% of developed market government bonds are offering negative yields.
- Economic growth remains subdued and global trade growth is virtually nil.
- Extraordinary intervention by central banks is trumping market fundamentals.
In the UK, consumer spending has bounced back after June’s Brexit vote, but:
- Business confidence has fallen and investment is likely to be hit as Brexit uncertainty drags on.
- The pound has fallen significantly, (again in the week commencing 3rd October following the announcement of the triggering of Article 50 in the first quarter of 2017). Further falls could undermine foreign support for gilts.
- Political risk has returned in Europe, with key general elections impending in Italy, France and Germany in 2017.
Further US rate rises are likely next year, a Trump presidency could see stagflation as his tax and spending cuts combine with higher tariffs. We predict a lacklustre 2.5% in global growth in 2016 and rising political risk as political populism continues to gain support. Fiscal stimulus also is back on the agenda, whilst secular stagnation appears to be the risk most feared by investors.
Harvesting long-run sources of return
Factor investing is an approach to investment that breaks assets into their underlying sources of return, “risk premia”. For example, the return of a corporate bond comes from a number of risk premia including credit risk and duration risk. Proponents, including ourselves, claim two primary benefits:
- Diversification: through exploitation of different risk premia, we can access new sources of return
- Transparency: by breaking asset classes into their underlying return drivers, we can achieve a laser-like focus on the specific factor and source of return we wish to access
“Dynamic” or style factors such as value and momentum provide an additional source of diversification. However effective investment in these requires skill. Similar-sounding approaches can yield very different results: for instance, over the past 19 years, MSCI’s three closely-correlated “value” indices have provided active returns ranging from close to zero to more than 100%. Creating a portfolio of dynamic risk premia requires sorting signals of lasting value from those that are ephemeral or illusory; concentrating factor exposure on securities where it is rewarded; broadening exposure across asset classes; and staying on the leading edge of financial research.
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The role of multi-asset in a low yield environment
Quantitative easing has effectively borrowed returns from the future, especially for lower risk assets. The resulting low and negative yields have presented a new challenge for the multi-asset investor and for schemes on a de-risking path – how do we deliver the returns required by schemes, with bond-like levels of risk?
One way to square this circle is to use alternative risk premia (extracting the specific factor that you wish to be exposed to in an asset and removing the market return). Combining these alternative risk premia enables us to create a more diversified portfolio uncorrelated with market direction.
Further, the use of techniques, such as relative value strategies, which express views on one equity market versus another, or one currency versus another can be attractive because they are potentially independent of market direction. An example of such a pair trade would be Long US Energy versus the S&P 500.
A warning however, just because a portfolio looks diversified, does not mean it is. Trades that on the surface appear independent, such as long UK vs Swiss equity and long Canada vs US equity have a correlation with oil. If there is a downward shift in oil, you would find these trades underperforming at the same time. This is why assets need to be broken into their component risks to understand their linkages. We also need to be cognisant that correlations are not static and will shift over time.
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Real solutions to real challenges – effective implementation of a solutions approach
For too long, we in the pensions industry have been focussing on the means of attempting to reach the end goal (benchmark setting, manager selection etc) rather than the end goal itself. How do we ensure that we can meet pension obligations with the least amount of deficit risk possible. We believe that our approach needs to change to one that’s far more collaborative, through adopting a solutions mind set.
Under this solutions mind set, trustees have a number of options. One is to work directly with an asset manager to squeeze as much as possible from the portfolio. This should free trustees to devote more time to their strategy and overview roles, leaving the investment side to specialists. We recommend a four-step process in implementing a fiduciary manager approach:
- Discover trustees’ and sponsors’ objectives (e.g. funding level, timetable, constraints).
- Translate into an investible strategy (e.g. growth portfolio return targets, desired level of liability coverage).
- Implement in an efficient way (e.g. a diversified growth portfolio accompanied by liability driven investment strategies).
- Review and adapt to changing circumstances (e.g. using comprehensive reporting).
This approach ensures the trustees are in control of the overall journey to full-funding but benefit from swifter decision making and a greater focus on managing funding level risk. Times are tough, but the solution needn’t be if trustees are willing to consider increasing their level of delegation.
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Reappraising the case for commodities
We believe that investors should be thinking again about commodities:
- They have proved an effective diversifier to equities over many periods during the last 30 years.
- They are down 60% to 80% from peaks in the early noughties.
- They should benefit if the dollar continues to turn down from its recent highs.
Three areas of the market are worthy of closer inspection:
- Oil: over-supply by oil producers can’t continue, while surplus stocks are likely to be run down by next year: we forecast prices rising from below $50 to above $65 a barrel.
- Precious metals: with populism rising and up to 30% of sovereign bonds negative yielding, investors are turning back to gold, which is well correlated with rising interest rates.
- Agricultural products: good harvests have kept prices down, but demand is rising and the El Niño and La Niña weather phenomena are likely to hit production and raise prices.
More generally, commodities can provide a hedge against both inflation and political risk which is both uncorrelated and investible.
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