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Schroders Solutions Asset Allocation views - November 2023: 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.

07/12/2023
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Read full reportSchroders Solutions Asset Allocation views - November 2023
5 pages

Authors

Tamsin Evans
Head of Solutions Investment

In this article, Schroders Solutions' Investment Team presents their asset allocation views for pension scheme clients in October 2023. 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 the first half of 2024, albeit a shallow 'soft landing'. We believe a structured equity allocation with downside protection is valuable if sentiment turns sour although we need to be cognisant that market volatility has dropped to relatively low levels.

Buy and Maintain Credit

Following a relatively calm summer, volatility in markets has seen credit spreads increase to levels around long term averages, as investors weigh up resilient corporate health and the potential for a mild recession.

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

Recent economic data highlights a resilient consumer and valuations look fair, which should support equity markets. However, continuing inflationary pressures, tighter monetary policy and a slowing China could lead to a period of below-trend growth. Attractive yields on offer in other asset classes lead us to a neutral view overall.

⚪ Credit

Credit markets continue to provide an attractive yield and some diversification to other assets while valuations are close to historical averages. With strong company fundamentals, disinflation supporting consumption and robust economic growth, we do not see an immediate catalyst for spreads to meaningfully widen. However, as the need to refinance grows in 2024 and onwards, we expect higher-for-longer interest rates will make credit more susceptible to defaults and downgrades.

🟠 Property

Property is vulnerable to higher interest rates and recessionary risks, 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, we remain positive on Alternatives and 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 have therefore lowered our conviction in Quality corporates, which tend to do better than the rest of the market in recessions, based on this.

🔴 Private Equity

The illiquid nature of the asset class and improvement in scheme funding levels has meant that it’s more appropriate to reflect an equity view through listed markets. Tighter monetary policy has yet to feed through to private asset classes, 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 towards the end of 2023 and into 2024, we believe beta-like structured equity has merit as protection against material equity downside.

Credit

🔵 High Yield

Falling inflation has raised hope that policymakers have reached peak interest rates and credit conditions are set to ease, reducing the likelihood of companies having to refinance at punitively high levels. Corporate balance sheets continue to look robust resulting in a relatively benign default environment in the near term. While valuations appear back to fair value, current spreads, even in absence of further spread tightening, still provide attractive returns above government bonds.

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, reasonably attractive yields in High Yield provide a competitive alternative in a benign macroeconomic environment and support a balanced stance between the pair.

 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

We have marginally increased the sensitivity to interest rates in the portfolio to protect against the risks of a slowing economy. We expect to use this return driver increasingly over the next 3 – 6 months if volatility in rates reduces.

Property

Global

With headwinds to UK property, we prefer diversified global exposure. However, property continues to be vulnerable to higher interest rates and recessionary risks, hence we prefer opportunities elsewhere. In addition, sectors such as office and high-street retail face long-term headwinds.

🔴 UK

UK property continues to face headwinds from slowing economic growth and potentially further selling pressure from pension schemes, hence the move to underweight towards the end of 2022. Over the long term, we believe that opportunities still exist in logistics due to long-term structural trends in the economy.

REITs

While the outlook for the UK economy is challenging, 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 H2 2022 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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Read full reportSchroders Solutions Asset Allocation views - November 2023
5 pages

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Authors

Tamsin Evans
Head of Solutions Investment

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