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Survey Report

Five-Year Capital Market Outlook — 2019 Europe

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By David Hoile | February 26, 2019

Surviving and thriving in a late cycle environment

We expect that 2019 will bring a trilogy of challenges to Europe. In particular:

  • We anticipate a material slowdown in growth in most of the major economies in 2019, with downside risks rising as we move into 2020. We believe that this will put pressure on the operating environment of many corporate sponsors.
  • Relative to our medium-term outlook, we think valuations for growth-related assets are still high and expect low returns on average over five years. In our opinion, this will undermine defined benefit (“DB”) funded ratios and defined contribution (“DC”) members’ savings pots.
  • Volatile bond yields could create further challenges to DB funding ratios and the savings adequacy of mature DC members.

Here is an overview of our Outlook. Download the report to read more.

Key actions from a macro viewpoint also make sense through other portfolio construction lenses

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At Willis Towers Watson, we believe no single approach to portfolio construction can yield “the answer.” Therefore, we consider the problem through multiple "lenses," four of which are displayed below — our delegated/"outsource-CIO" portfolios capture more but we simplify for illustration. Doing so shows that ideas make sense based on our macro views will tend to make sense anyway.

Five portfolio priorities for a surprise-free 2019

We think the chances of nasty surprises has gn. How can we deliver needed returns, whilst reducing the risk of unexpected events?

1. Diversify

Why? Diversification is always a good idea and is an especially good idea now. However, the perception, and often the reality, of doing so is costly, time consuming and complicated.

How? Diversification doesn't (always) have to be burdensome. Ideas which are consistent with our macro outlook are:

Many investors could still benefit from diversifying equity risk. Simple ways of doing so include investing in:

  • Real assets: Increasing exposure to skilled core real estate managers is an “easy win”, but smart listed real asset (REITs and listed infrastructure) strategies are also a good diversifier. Well-sourced and managed Secure Income Assets are attractive to most European plans, particularly those considering long-term cash-flow-driven approaches.
  • Alternative credit: Many institutions have added credit to their return-seeking portfolio through one variant of this: direct lending. Our approach looks beyond this and seeks to lend against assets we like in niche, undercapitalized areas of the market. Private debt (bridge financing) and parts of securitized markets are key examples.
  • Alternative beta: Some hedge fund strategies are really just novel forms of beta. Over the years we have sought to strip away the complexity and fees, and provide these betas to investors cheaply. These strategies include reinsurance and momentum, which have the benefit of being much less macro-sensitive than equities. Selectivity, innovation and clout – if it doesn’t exist, create it through networks – are required.
  • US equities remain richly priced relative to economic prospects and other equity markets. Diversity may be as simple as temporarily reducing US equity exposure in favour of non-US or EAFE mandates, although this is governance-and price-dependent (see priority #3, Dynamism).

2. Reduce unrewarded risks

Why? Because risk should only be taken if it is rewarded.

How? Subject to the local regulatory environment, for maturing DB schemes, interest rate, inflation and longevity risk will become a dominant form of overall risk. Managing this liability risk in the current environment means considering:

  • Full hedge ratios: Despite low starting bond yields, we believe the rational choice for many DB schemes is to target full liability hedge ratios. This is particularly true now, when political risks introduce further uncertainty. One area to watch in the UK is the possibility of Retail Prices Index (RPI) reform.
  • Capital efficiency: Efficient use of capital across the total portfolio is key: If an asset is not moving the risk or return dial, it likely has no place. Some form of derivative-based overlay may also be required.
  • Longevity risk management: A priority may also be controlling longevity risk. A ging suite of instruments is available.

We also encourage investors to integrate scenario analysis into risk management. This has two dimensions:

  • Macro scenarios: We believe we are approaching an inflection point in the business cycle and have passed it in the capital cycle. This creates additional uncertainty that traditional risk management approaches will struggle with. Considering the impact of, for example, a Japan-style deflationary equilibrium emerging in the US or Europe through deterministic scenarios is worthwhile.
  • Climate risk scenarios: Climate change is, in our view, one of the most important forms of systemic uncertainty long-term investors face. Grappling with its impact on a portfolio is daunting, but we strongly believe scenario analysis can help. Even an approximate understanding of portfolio exposures can help indicate the easy wins to reducing financial exposures and, for those inclined, to improving the nonfinancial impacts that are likely to become more important.

3. Macro and dynamism

Why? Understanding the range of outcomes is an important way to reduce uncertainty. That understanding can be used to dynamically manage risk or to create value. The latter is hard and should only be undertaken by those with the governance budgets and beliefs required. But using dynamism to manage risk is more widely accessible.

How? The easiest step towards dynamic risk management is implementing a journey plan. Where are you going and how will you get there? The analogue for DC is the length and nature of accumulation and retirement phases.

We also encourage investors to dynamically manage downside risk. Diversity is the first answer here, but there are others:

  • Levered high-quality bonds as a return-seeking asset: Return-seeking assets tend to do well when GDP growth does well. The flipside is they don’t when growth is weak. Adding a levered exposure to US bonds is capital efficient, positive returning in “normal” times and does well in the downside economic outcomes we expect.
  • Controlled unhedged FX exposure: FX exposure adds risk but this can be rewarded. Unhedged exposure to currencies like the US dollar and Japanese yen can add downside protection.

In the UK, another dynamic risk management idea is replacing index-linked gilts with US TIPS. RPI-linked gilts are imperfect hedges against uncertain UK liabilities; therefore, an asset providing exposure to US inflation is not necessarily that inferior of a hedge. It provides more return though: The yield pickup is significant (c.1.5 — 2.0 ppts) and may overcome some investors’ concerns about increasing hedge ratios. However, harvesting this yield requires exposure to the US dollar – if anything a little expensive on a long-term basis – which means this risk management position needs to be dynamically monitored and managed.

Ideas to dynamically create value, which we consider for the portfolios we manage, include:

  • Reduce macro risk temporarily: Our outlook suggests taking less risk now in order to take more later. The difficulty of this decision is not to be underestimated, nor is the complexity of managing it. But underweighting equities in favour of less macro-sensitive assets (alternative credit, alternative beta, real assets) or temporary derisking through options should be considered.
  • Reduce exposure to tighter liquidity: Some parts of emerging markets are vulnerable to tighter US liquidity, but US corporate debt is a key area of concern. For example, in our view, vanilla leveraged loans face a set of medium-term fundamental pressures.
  • Reduce exposure to “great expectations”: At the time of writing, earnings growth expectations in the US remain excessive. Consequently, forward-looking returns for US equities in particular are weak. We remain underweight.
  • Look to the next cycle: Risk premia will not remain unattractive forever, creating an opportunity to redeploy capital when they are reasonable. While the near-term pathway for some emerging markets is risky, medium-and long-term prospects are strong. Understanding and managing the macro, in particular FX exposure, is critical though.

4. Innovate through alpha

Why? The reality investors face is, in our view, one of generally low returns – due to low cash rates and low starting risk premia – and elevated volatility as the business and capital cycles move through their late phases. In this environment, the value of genuinely skilled active management is outsized.

How? Finding skilled managers is not easy. However, it is possible as demonstrated by our track records. With alpha in your toolkit, you can consider the following:

  • Reduce beta risk by replacing foregone return with alpha.
  • Better, more concentrated equity portfolios: Diversifying exposure to specific risk premia or the economic cycle is one thing, but stock diversification is another and often goes too far within active equity portfolios. Provided you can find a number of truly skilled equity investors with complementary styles to run your portfolio, concentrating your holdings in their 10 to 20 best ideas and combining those portfolios together captures their alpha, moves the dial, controls costs and, we believe, delivers superior equity returns in most environments.
  • Skilled fixed-income managers can help you navigate the late stages of the business and debt cycles in bond markets. Our approach is to own assets we like, provide capital where.

5. Innovate to find diversity: China

Why? The world economy can increasingly be simplified to three centres of gravity:

  1. The US: a $20 trillion economy, ging at c.4% nominal
  2. The Eurozone: a $14 trillion economy, ging at c.3% nominal
  3. China: a $14 trillion economy, ging at c.8 — 9% nominal

These centres of gravity operate in economic terms (quantified above), political terms and, more recently, investment terms. Until now, locally listed Chinese assets have been hard for foreign investors to access. But China’s gradual financial liberalization means this is no longer true. This third opportunity set is now open to European institutional investors and, in our view, cannot be ignored.

How? From an opportunity set perspective, it makes sense to access this large and ging set of cash flows. But, the attraction of China’s markets is not about stellar returns but stellar diversity. Because its economy and capital markets are still relatively closed, its economy and its assets will operate on a different (albeit not entirely decoupled) cycle to the rest of the developed world economies and capital markets. Assets that behave differently mean diversity, – which is what makes China’s local capital markets attractive to investors.

However, capturing that diversity is not that straightforward:

  • China’s economy will continue to liberalize and manage its reliance on debt growth, which creates a manageable but challenging economic outlook.
  • That, and the wish to capture economic diversity and a broad range of asset risk premiums, means we want to own exposure to both positive Chinese economic outcomes and negative ones.
  • Moreover, there are a variety of issues with existing equity and fixed-income benchmarks – concentration, patchy accounting disclosure, volatile prices – which means being highly selective when investing passively.

Therefore, we want exposure to both risky assets, (e.g., equities and private markets) and bonds. These assets also need some form of cost-effective active or smart beta management. This is possible to create separately, but is time-consuming and resource-intensive. Cost-effective ‘one stop shops’ combining well-structured equity portfolios plus bond exposure are rare but available. Investors will need to be somewhat brave and innovative to capture the early diversification benefits on offer. 

The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific advice.

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