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Schroders Solutions Asset Allocation views - March 2024: Insights for pension schemes

This article sets out the asset allocation views of the Schroders Solutions Investment Team for pension scheme clients. This team is responsible for investment decision making for Schroders Solutions traditional advisory and fiduciary management clients.

20/03/2024
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Authors

Tamsin Evans
Head of Solutions Investment

In this article, Schroders Solutions' Investment Team presents their asset allocation views for pension scheme clients in March 2024. The team delves into strategic considerations for various asset classes, including Growth, Structured Equity, Buy and Maintain Credit, and LDI. The report highlights key areas of interest for investors, providing valuable insights to make informed decisions.

Key

🟢 Overweight

🔵 Slightly Overweight

⚪ Neutral

🟠 Slightly Underweight

🔴 Underweight

🔼 Up from last month

🔽 Down from last month

Strategic considerations for Defined Benefit schemes

Growth

The wide range of possible economic outcomes favours a diversified exposure and nimble approach. Generally, the hurdle for illiquid exposure in portfolios is higher in an environment where cash yields on offer are attractive and where opportunities are likely to emerge in liquid asset classes if economic growth weakens.

Structured Equity

Tighter monetary policy is beginning to have an impact and increases the probability the developed world enters a recession in 2024. We believe a structured equity allocation with downside protection is valuable if sentiment turns sour although we are cognisant that market volatility has dropped to relatively low levels.

Buy and Maintain Credit

A strong end to the year saw credit spreads tighten considerably, as investors weighed up resilient corporate health and pushed out expectations for the potential of a mild recession. This must be balanced versus the growing possibility that interest rates stay ‘higher for longer’ as policymakers face the difficult final steps of returning inflation to target.

Liability Hedging (LDI)

To varying degrees, central banks are being pulled in two directions by high but falling inflation and slowing growth. If inflationary pressures persist, it is likely rates will need to stay high. However, we expect the long-term pace of tightening to slow as the lags from higher interest rates take effect. As yields drift higher so too does the temptation to increase hedging but we advocate caution in doing so. Consideration should be made of any increased collateral requirement and resulting asset allocation mix should rates continue to rise.

Growth Assets Views

🔼🔵 Equities

Easing monetary policy, improved corporate earnings, and resilient economic growth should support equity markets. Recent economic data highlights a resilient consumer, while valuations outside of the 'Magnificent 7' stocks that drove 2023 equity performance appear fair.

⚪ Credit

Credit markets continue to provide an attractive yield and some diversification to other assets. With, supported by strong company fundamentals, disinflation supporting consumption, and robust economic growth. As a result, we do not see an immediate catalyst for spreads to meaningfully widen.

🟠 Property

Property is vulnerable to higher interest rates and sectors such as office and high street retail face long-term headwinds. We prefer diversified global exposure, with a bias towards sectors supported by long-term structural themes, such as the logistics and residential sectors.

Alternatives

Given the wide range of economic outcomes possible this year and next, Alternatives continue to justify a role in portfolios given their lack of correlation to traditional equity and credit markets. We must balance the benefits of diversification against the lack of liquidity available with many Alternative assets and the opportunity cost versus high cash rates.

Defensives

With respectable yields, sovereign bonds now provide competitive income versus other assets, and we expect they will re-establish their diversification benefits as inflation continues to fall, interest rates rises slow/stop and/or we fall into a recession. Given the recent rise in yields (falls in price), we have marginally increased the interest rate sensitivity in the portfolio and await further opportunities.

Equities

🔼🔵 Region

With the US economy proving resilient and corporate earnings remaining solid, we believe recessionary fears are reducing but this is largely priced-in. Better valuations can be found elsewhere but should be balanced with a worsening economic backdrop.

Style

Continued strength in US economic data has lowered the probability of a US recession in the immediate future. We therefore favour a more balanced style view while we seek greater clarity on the direction of travel for economic growth.

🔴 Private Equity

The illiquid nature of the asset class has meant that it’s more appropriate to reflect an equity view through listed markets. Tighter monetary policy and its lagged impact is showing signs of feeding through to illiquid assets and there is elevated downside risk over the next 12 months.

🔵 Structed Equity Beta-Like

Given the wide range of outcomes possible for the global economy in 2024, we believe beta-like structured equity has merit as protection against material equity downside.

Credit

 High Yield

Following policymakers’ clearest sign yet that interest rates are set to fall in 2024, valuations have tightened to a level incommensurate with an environment of rising interest costs, weakening fundamentals and rising defaults. While we do not see an immediate catalyst for meaningful spread widening, we expect economic fragility to grow throughout the year, justifying a more balanced allocation to risk within credit assets.

Investment Grade

Underlying fundamentals look healthy and high absolute yields provide technical support, particularly from investors looking to add interest rate sensitivity through high quality credit. However, US valuations look stretched, particularly alongside more risky forms of credit.

 Emerging market debt Hard currency

The premium in yield versus equivalently rated developed bonds supports a holding in hard currency emerging market debt and diversifies credit risk. The slowing economy in China must be considered, with the potential to impact countries throughout the emerging market complex.

 Emerging market debt Local currency

Current yields look attractive, as do many emerging market currencies. As emerging market central banks were quicker to raise interest rates in response to higher inflation, they have ample room to ease policy in an economic slowdown. However, many emerging market countries remain vulnerable to high energy and food prices, which are headwinds to economic growth.

🔵 Structured Credit

Some sections of the securitized market have spreads that are appealing relative to other credit asset classes. However, there is a need to be selective here and these opportunities need to be judged against the underlying quality of the structures and their collateral backing.

🔵 Regulatory Capital

Ongoing regulatory changes and current yields present an attractive investment opportunity for clients with an illiquidity budget. Current pricing and credit quality have improved over the last few years and offer a compelling risk/ reward dynamic.

Defensives

Cash

Current cash rates have boosted the appeal of this asset class. Yields on offer are attractive whilst we wait for opportunities to arise elsewhere.

Sovereign Bonds

After a strong rally for sovereign bonds in Q4, interest rate markets have since unwound some price gains as recent inflation data appears less supportive of future rate cuts. We anticipate recent increases in yields will present future opportunities to increase interest rate exposure, particularly if needed to move more defensive later in 2024.

Property

Global

We continue to prefer diversified global property to mitigate specific country economic risk. We expect higher quality sectors such as industrials and logistics will prove more robust than other sectors such as office and high-street retail which face long-term structural headwinds.

🟠 UK

After a significant price correction post Gilts Crisis, valuations more accurately reflect the readjustment in interest rates and demand. This is evident in the stabilisation of UK property prices of late, increasing our conviction that the worst of the market falls are behind us. We continue to advocate a steady reduction to the asset class in favour of more diversified global exposure that best realises the intrinsic value of current assets.

REITs

While the outlook for the UK economy is uncertain, many REITs are trading at discounts relative to their long-term valuation levels, which is usually consistent with a recession. There may be some value from these discounts. However, we must weigh this against the risks of a more difficult recession than predicted and the fact that many REITs employ a reasonable level of leverage.

Alternatives

Insurance Linked Mortality

The diversifying and low-risk nature of this asset class can be complementary to other asset classes. We continue to like extreme mortality risk. However, as pricing is less attractive than in previous years, adding other Life Insurance risks can benefit the portfolio.

🔵 Insurance Linked Natural Catastrophe

Capital exiting the insurance-linked securities market in recent years means investors can enter the asset class with a double-digit yield markedly ahead of traditional listed credit.

Hedge Funds

A more challenging and volatile environment for traditional assets should continue to present trading opportunities on both the long and short sides. However, with cash rates as appealing as they are, and a lack of liquidity available with many hedge fund positions, opportunities elsewhere now provide a greater appeal.

Precious Metals

The latest move in real yields coupled with a stronger dollar have unsurprisingly corresponded with a pull back in the gold price from close to all-time highs. Meanwhile, higher yields on offer elsewhere mean that the hurdle rate for an allocation is higher. We remain neutral as the path of real bond yields remains uncertain.

 Broad Commodities

A higher inflationary environment would support a higher allocation over the long term, and, in the near term, tight global supply dynamics are supportive. However, global demand has weakened amidst growing economic uncertainty which could continue to weigh on prices.

🔴 Structured Equity Low-beta

Given volatility has fallen back from recent highs, strategies that offer less upside and diversified exposure are now less attractive.

Buy and Maintain Credit (B&M)

🔵 Short duration cashflow matching

Where making B&M allocations to public assets, we see greater value in short to medium term credits. Spreads at these maturities look fair considering recent economic data. However, we advocate a phased investment approach given ongoing recession risk may present better entry points later in the year.

🔵  Medium duration cashflow matching

Where making B&M allocations to public assets, we see greater value in short to medium term credits. Spreads at these maturities look fair considering recent economic data. However, we advocate a phased investment approach given ongoing recession risk may present better entry points later in the year.

 Long duration cashflow matching

With long-dated UK spreads now below long term averages, we believe shorter maturities offer better value.

🔵 Senior Direct lending

Senior direct lending opportunities offer an attractive premium versus public credit. Tighter bank lending standards and a reduced appetite for lending in public markets in recent years have strengthened terms for lenders in this space.

🔵 Real Estate Debt

Strong risk-return profiles in senior lending and European market dynamics are more attractive. Good security is available relative to spread levels, which we believe will present opportunities for new capital.

🔴 Senior Infrastructure Debt

Given considerable demand from certain investors for this asset class, we have seen spreads compress to levels where we do not believe there is a meaningful benefit versus more liquid credit.

Liability Driven Investment (LDI)

Interest rate Duration

In the short term, whilst we expect the majority of financial tightening is behind us, UK inflation dynamics may continue to make rate moves volatile. Over the longer term, we expect rates to fall as growth disappoints and inflation moderates. Current market rates look fairly valued. Any hedge increases should be done only after careful consideration of collateral and asset allocation impacts in the event of further rises.

 Inflation Duration

It is likely that inflation expectations are close to their peak but will remain ‘sticky’ at higher levels for some time and above central bank targets. In particular, European and UK inflation remains notably above target, but central banks must be wary of tipping already vulnerable economies into outright recession.

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Authors

Tamsin Evans
Head of Solutions Investment

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