PERSPECTIVE3-5 min to read

Regime shift requires DC plans to switch gears

A regime shift crossing the foundations of global economies is upon us. Defined contribution plan sponsors must understand and adapt to the new reality.

03-08-2023
Shifting-gears
Read full reportRegime shift requires DC plans to switch gears
4 pages

Authors

Deb Boyden
Head of US Defined Contribution

Nothing lasts forever, not even our guidelines and assumptions about effective investment strategies. While plan participants will always need to save for their retirement and maintain a diversified portfolio to drive the greatest returns, the entire world has changed. And it will persist on its new path, which crosses the foundations of global economies: governments, central banks, social wellness and financial markets. We describe this new phenomenon as “regime shift.” Defined contribution plan sponsors must understand and adapt to the new reality.

Hindsight: The last three years have been turbulent

To appreciate the implications of regime shift and what lies ahead, we must first fully grasp what the world has endured since Covid-19 first raided our lives in the winter of 2020. Let’s recap the most salient developments:

  • The world economy shut down and reopened.
  • Global financial markets crashed and rebounded as governments and central banks responded with aggressive stimulus.
  • The long-held fame of growth stocks dimmed to a mere flicker as value stocks outperformed and commanded the market’s attention.
  • Pervasive disruptions to global supply chains affected product pricing from the business level down to consumers. Supply chains have largely recovered but many companies have reorganized their production of goods by nearshoring and onshoring to facilitate smooth operations and gain independence from faraway countries, such as China, that may have unique albeit obstructive policies. We call this deglobalization.
  • Russia invaded Ukraine in the bloodiest European war since World War II, exacerbating turmoil in global supply chains, reducing the availability of traditional carbon-intensive energy, increasing its cost and driving countries to double down on their quest for net zero climate emissions to achieve energy independence.
  • Inflation skyrocketed to highs we have not seen in 40 years. High inflation persists today and we expect to live in a permanently higher inflation environment.
  • Central banks, initially slow to respond to the shock of high inflation, have diligently tightened monetary policy by aggressively raising interest rates and relegating economic growth to a secondary concern.
  • We have witnessed The Great Resignation in our workforce, with millions of Americans leaving jobs and leaving the workforce entirely in unprecedented numbers. This has reshaped many industries and compelled many companies to invest in technology to replace human labor. Consequently, the cost of labor has swelled.

Regime shift: Do the opposite of what you have done in the past

The changes we have enumerated spawned a global regime shift that will revolutionize the next decade to the extent that it bears little resemblance to the past 10 years. Therefore we advise DC plan sponsors and providers to heed these emerging trends. Conditions are changing dramatically and regime shift will render the tactics that prevailed in the past ineffectual.

Trends to consider in the coming years

  • Higher inflation and elevated interest rates are here to stay. The norms of low inflation and low to non-existent interest rates that lasted during much of the past decade appear to be history. Around 2009, after we experienced the Global Financial Crisis, and again around 2014-2015, when energy prices dropped, the Federal Reserve (Fed) actually became concerned about deflation and wanted the inflation rate to reach 2%. The landscape has since reversed and it takes time for the Fed’s monetary policies to work their way through the system. However, when consumer enthusiasm returns, inflation could remain an issue.
  • Central bank monetary tightening has resulted in attractive bond yields.Over the coming year, we expect this global regime shift from concerns about inflation to concerns about growth to set in more. Last year, diversification did not function very well because most price declines were driven by one factor – tighter monetary policy. As most central banks are now in the later stages of their tightening cycle, the market is offering very attractive risk-adjusted fixed income returns and diversification has reemerged as a valuable portfolio management tool. The distortions created by easy money over the last decade are diminishing. Today investors may not have to abandon their natural risk habitats to find attractive returns.
  • Mounting tension between tight monetary policy and stimulative fiscal policy. An interesting policy conflict is surfacing as central bank anti-inflation monetary tightening and pro-growth government fiscal policy clash. The efficacy of monetary tightening could prompt governments to exercise their power to support households and small businesses during an economic downturn. That would challenge the goal of central banks, i.e., to tamp down inflation while fanning the flames of populist anti-austerity political movements. For example, consider the financial and governmental crisis in the UK in September 2022 or the ongoing opposition in France to the prospect of a higher retirement age.
  • Deglobalization trends are inflationary. Over the past year or two, a series of global events has conspired to counteract a strong decades-long trend toward globalization. These circumstances include Covid-19-related supply chain disruptions, further goods shortages created by the Russia-Ukraine war and China’s zero-Covid policy. With such protectionism comes a loss of efficiencies leading to higher production costs and rising retail prices, as well as deconstructing supply chains and rebuilding them at home or closer to home.
  • More companies are investing in technology. As companies face rising production costs created by higher commodity and staffing costs, some will seek to improve productivity through greater use of technology, including artificial intelligence. Demographics are also intensifying the need for technological productivity. An aging population and lower birth rates are reducing the workforce, resulting in fewer available workers. The result is wage inflation, which drives up overall inflation. The trend of investing in technology that can perhaps do the work of three people will likely deepen because it is more cost-effective than human workers. We expect to see higher unemployment, which the Fed would like to see, and social disruption.
  • Climate change drives decarbonization, which is inflationary for now. The need to address climate change is irrefutable as many countries seek sustainable, green, renewable energy alternatives. Until countries reach economies of scale in their transition from carbon-intensive energy to sustainable energy, they are apt to spend more in meeting their energy needs, further stoking inflation.

How can your DC plan benefit from regime shift?

Expect and prepare for higher inflation

Central banks’ rapid and aggressive interest rate hikes have cooled inflation down from its peak but inflation remains high.

Consequently, we must reset our expectations and change our strategies. Plan for greater loss of purchasing power over time. Thus DC plan participants might benefit from considering the following recommendations:

  • Save more
  • Invest for growth
  • Retire later if necessary and possibly work part time in retirement

Embrace higher bond yields

Fixed income yields have risen considerably in a short period (Figure 1).

Figure 1: Rising 10-year US Treasury yields

Date

Yield

February 1, 2021

1.17%

February 1, 2022

1.91%

February 1, 2023

3.52%

Source: Wall Street Journal.

The ascent of US Treasury yields is a gamechanger for many investors. The classic 60% stocks and 40% bonds allocation did not serve investors in 2022 when the majority of asset classes suffered losses. The juggernaut has been central bank tightening at a time of slowing growth, when in the past central banks were inclined to lower rates under similar circumstances.

In the new world we face due to regime shift, we recommend investing in bonds. We expect fixed income securities, especially high quality ones, to offer attractive yields. In our view, climbing up the yield curve or compromising on credit quality is no longer necessary in the search for yield.

Take advantage of active investing

When markets become more volatile, complex and challenging, active investment management could provide a critical advantage. Active managers are equipped to make strategic and tactical decisions about allocations to regions, industries and companies. Security selection is paramount as investment managers focus on timely opportunities, risks, industry competition, management quality, balance sheet strength and profitability.

Include commodities for inflation protection and diversification

Commodities are well-established inflation-sensitive assets. Because of their relatively low correlations with stocks and bonds, they offer renewed potential as portfolio diversifiers.

Focus on risk management

In the face of everything we have experienced during the past three years, including a pandemic, war, global economic disruptions and rampant inflation, effective risk management strategies are essential. This applies to the construction and management of an effective defined contribution retirement plan and its use by plan participants.

Conclusion – Actions to take or consider

  • Maintain and promote a diversified plan lineup. Include diverse emerging markets investment opportunities beyond Russia and China.
  • Include real assets, such as commodities, for inflation protection.
  • Recognize climate change and decarbonization as key themes. Identify renewable energy investment opportunities and risks pertaining to non-renewable energy assets.
  • Include actively managed funds in your plan lineup.
  • Encourage participants to save more and protect their investments against inflation.
  • Help your plan participants become more savvy and financially successful. Make financial education accessible to plan participants so they can make smart decisions in an increasingly nuanced and ever changing world.

Forget about what worked in the 2010s. A new regime is upon us. Prepare yourself and help your participants navigate the new world.

Read full reportRegime shift requires DC plans to switch gears
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.

Authors

Deb Boyden
Head of US Defined Contribution

Topics

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