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June 28, 2018

High level overview of key market trends of Australia, Hong Kong, Japan, the Middle East, Netherlands, UK and US.

Australia

The themes that have preoccupied strategists and policymakers in Australia over the past year reflect those affecting the investment industry globally. The following have been a particular focus:

  • The impact of technology: Most of the focus is on robo-advisers and other advances that will allow the industry to tailor financial services to individuals as opposed to demographic averages. The prospect of suiting post-retirement options to individuals remains the ‘holy grail’ for a number of superannuation funds.
  • Governance: The focus on governance that we observed in 2016 has continued and is now deepening into a focus on two particular areas relevant to larger clients: a total portfolio approach and developing a high-performance culture. There is an increasing awareness that an investment in these, although difficult, can be increasingly important sources of competitive advantage as we progress through a period of great acceleration.
  • Tail risk: Portfolio construction discussions continue around the potential ways to diversify assets as investors get ready for the end of this very long economic cycle and face the risk of a material fall in equity prices and/or rise in bond yields. Clients are investigating a number of diversification strategies and, at the same time, are finessing their fixed-income portfolios to reduce the potential for defensive portfolios to deliver sustained negative returns. This has generally involved reducing duration exposure and increasing credit, liquidity and/or complexity exposure, in various guises.

The Australian regulators have had an active year with a number of key events:

  • A Royal Commission was called into banking and financial services misconduct. There was some surprise that this review, which is still in progress, will include conduct within superannuation funds.
  • A consultation package from APRA was aimed at bolstering governance of superannuation funds. Trustees that are identified under the proposed prudential framework as being unable to consistently deliver sustainable member outcomes will be encouraged to lift their game or to exit the industry. Other potential responses by funds would include merging with other funds, or seeking to outsource certain functions such as administration and/or investment management.

Hong Kong

A $1.28 billion public annuity scheme to be provided by the government-owned Hong Kong Mortgage Corporation (HKMC) will be launched in mid-2018, and the scheme could be expanded if popular. Citizens aged 65 and above will receive monthly payouts for the rest of their lives immediately after making a lump-sum premium payment.

Tentatively, a cap and a floor on the premium amount are set at $1 million and $50,000 respectively. Based on an internal return rate of 4% per annum, the expected monthly payout for males at the entry age of 65 would be around 580 Hong Kong dollars per 100,000 Hong Kong dollars premium paid, while for females, the monthly payout would be around 530 Hong Kong dollars, due to longer life expectancy.

This new annuity scheme would complement the existing Mandatory Provident Fund (MPF), Hong Kong’s compulsory DC scheme that requires monthly contributions to fund one’s retirement. Under the MPF scheme, retirees can withdraw their accrued benefits in one lump sum or in installments once they reach age 65. Retirees might consider investing all or a certain portion of their MPF-accrued benefits into this lifetime-guaranteed annuity scheme in order to receive a stable stream of monthly income.

Japan

Japan continues to concentrate its efforts on corporate governance reform. Enhancing stewardship attitudes in the investment chain remains a key focus of these efforts.

In 2017, the Financial Services Agency released the first revised version of Japan’s Stewardship Code since the original version was formulated in 2014. There are some amendments from the original version to polish the effectiveness of the code, including i) improvement of investment managers’ governance structure to appropriately control any conflict of interest, ii) increase in transparency of proxy voting disclosure by investment managers, iii) clarification of the concept of collective engagement and iv) enhancement of effective investment manager monitoring by asset owners.

Along with the revision of the Stewardship Code, there has been significant progress in the attitudes of investment managers over recent periods.There has been a wide launch of independent committees to monitor proxy voting, but also to review disclosure policy on proxy voting so that it publicly reveals individual votes by investment managers. Some of this may further disclose rationales behind those individual votes. Another development that drew the industry’s attention was the establishment of an organization for collective engagement by some of the largest domestic investment managers including the Pension Fund Association, an owner of assets valued at 12 trillion yen. From the asset owners’ perspective, it is also recognized that public pension funds are starting to make an effort to strengthen their monitoring of stewardship activities by investment managers.

However, among pension funds sponsored by the private sector, there is a persistent hesitation towards the burden of engaging with stewardship activities. In fact, there has virtually been no increase in the number of signatories of the code in corporate pension funds since a handful of them opted in at the beginning. As a countermeasure, the Ministry of Health, Labour and Welfare recently revised its guidelines on the fiduciary duty of pension funds as a way of officially encouraging corporate pension funds to consider evaluating the stewardship activities of investment managers in their investment decisions. It is currently one of the most controversial topics in the industry and could be either a touchstone of success or failure of corporate governance reform in Japan. How can the wave of stewardship mentality be effectively extended to those conservative corporate pension funds?

Middle East

Middle Eastern economies have continued to be affected by the reduction of the oil price relative to pre-2014 levels, and this is likely to remain a concern throughout 2018. However, this is also likely to be offset by the continuation of production cuts, resilient global growth and accommodative financial conditions. Several countries in the region have adopted 2018 budgets which echo an expansionary theme made possible through a combination of increased debt issuance, reductions to subsidies and the imposition of taxes. Saudi Arabia has revealed its largest ever budget expenditure to date, while Dubai and Qatar are also focussing on higher expenditure ahead of the 2020 World Expo and the 2022 FIFA World Cup respectively. As a result of this sizable planned government spend, commentators are expecting Middle Eastern countries to remain regular issuers in sovereign bond markets during 2018. Saudi Arabia will additionally undertake a program of IPOs, potentially including Saudi Aramco, the world’s most valuable company.

We note that many institutional investors are working hard to respond positively to the new economic paradigm in the region. Assessing individual client context – particularly the objectives of an institution’s mandate – has been vital and has led to polarizing outcomes. For example, a number of funds have brought assets back onshore to bolster state balance sheets, whereas other investors have taken the opportunity to diversify their investment portfolios internationally in line with more advanced portfolio management. These changes are being made possible through investors undertaking programs to increase their governance capabilities and by making changes to the ’investment model’ they employ. Coupled to this, we are working with investors to identify areas where they can work their assets harder in order to access higher returns through alternative credit, private markets and direct investment. However, in these changing times we caution investors to take the time to determine their competitive advantages and fully assess the range of implementation options from building internal capabilities to using outsourced solutions.

Netherlands

For 2018, we foresee a continuation of the trends that emerged over recent years. An important one is the ongoing investment in governance of the Dutch pension sector, driven by both the regulator and pension funds themselves. The number of pension funds is ever decreasing, and the funds that are here to stay have become bigger and invest heavily in their in-house investment capabilities. There were more than 1,000 pension funds 20 years ago, but it is very likely that by the end of 2018 that number will be less than 200. This consolidation is happening through mergers with larger pension funds, the introduction of the so-called ‘General Pension Fund,’ an active insurance market and the rise of DC solutions. At the same time, the larger pension funds are looking to unbundle their activities with specialized, internal or external, solutions to optimize their governance and investment portfolios.

Part of this optimization is an increased focus on diversification and effective management of their investment portfolios showing much more dynamism. Over recent years, very loose central bank policy and the subsequent search for yield has driven spreads down and practically all asset prices up. Despite continuing momentum across most markets, Dutch investors are increasingly risk aware. To mitigate downside risks, diversification across risk and return drivers is key. This will be illustrated by ongoing research into the unlisted alternative credit space, growing attention for secure income assets and reconsideration of both interest rate and inflation hedging. Given market dynamics and increasing complexity, we believe pension funds agree on the importance of efficient implementation and managing the different return drivers underlying these assets more dynamically.

Finally, Dutch pension funds will continue to take pride in their efforts in sustainable investing. Progression on ESG in The Netherlands, by both pension funds and Dutch asset managers, has been substantial over the recent years and inspired global discussions. As more and more implementable solutions are being offered, Dutch pension funds are able to execute their policies. Overall, this will prove to be a year of increased focus and professionalization to further optimize portfolios in this complex and dynamic environment.

U.K.

For DB investors, 2017 was similar to 2016. Investors continued to worry about economic uncertainty and the potential for equity market falls, or further reductions in gilt yields which might blow them off course as they seek to achieve their long-term objectives. This means there is a continued desire for diversification within growth assets and, as schemes look to de-risk, for a range of low-risk assets that help manage the risks associated with DB liabilities.

With liabilities maturing, there is an increasing focus on nailing down the long-term goals for DB schemes and constructing strategies aligned with these goals. DB investors are choosing between two long-term paths depending on their funding position, the ongoing strength of their covenant and the maturity of their liabilities. These are either buying out the liabilities with an insurance company or long-term runoff, effectively planning to continue to pay benefits as they fall due. This focus on the long-term path means DB pension trustees are starting to think more like an insurance company and structure strategies that aim to reduce the cash flow burden. There is increasing demand for assets that provide very long-term, inflation-linked cash flows that have very strong counterparties and/or are well-collateralized. In fact, the preference is for them to be over-collateralized. These type of assets include property-based strategies such as long lease and ground rent as well as social infrastructure and renewable energy. Additionally, buy-and-hold credit strategies are gaining popularity.

Pension scheme trustees are recognizing the need for good governance to ensure they are getting their fair share of the right assets, and that they are in a position to react quickly to market conditions and changing funding positions to capture opportunities. This is leading to trustees spending the bulk of their time determining the direction of travel and outsourcing a lot of the operational matters, such as manager selection and implementation. This trend is likely to continue far into 2018 and beyond.

Outsourcing is becoming more prevalent for DC benefit provision, and there has been significant growth in assets moving to Master Trusts, which is expected to continue throughout 2018. For DC plans that are continuing to be run under the traditional Trust structure, there is more interest in Target Date Funds which, up until now, have been widely used in the US. but are uncommon in the UK.

U.S.

The past year had some positive surprises. Upbeat market sentiments following the election of President Trump received further support from continued GDP and corporate earnings growth. Inflation remained muted despite tightening labor markets. Long bond yields ground lower despite the Federal Open Market Committee (FOMC) continuing its tightening cycle with three additional rate hikes. Monetary policy in Europe and Japan remained largely accommodative, and the populist specter looming over Europe appeared to recede with the election of establishment favorites in Germany and France.

However, it’s worth pausing and considering where this leaves us. Equity valuations are at or nearing historic highs across a variety of metrics. Credit spreads are similarly nearing historic lows. Investors are receiving very little compensation for bearing risk as the US. moves into the latter stages of the economic cycle. Inflation pressures build, China’s credit expansion remains unresolved, and significant geopolitical risks loom over the Korean peninsula, Eastern Europe and the Middle East. There is a low risk premium and major central banks are limited in their ability to provide any new large scale stimulus which leaves little in the way of a buffer against future market shocks.

Accommodative monetary policy and other cyclical trends may result in continued positive market surprises in the near-term. Looking forward, we continue to maintain our ‘new world’ outlook of historically low growth with growing downside risks over time. In this environment, it’s prudent for institutional investors to reflect on their current positioning and consider how much and what types of risk are worth bearing.

Market movements over the past year have allowed many institutional investors to make progress on their objectives. Policy changes over the coming year, including the recently passed Tax Cuts and Jobs Act of 2017 and FASB accounting changes concerning the recording of pension expense, provide incentives to reduce risk and diversify.

We feel this points toward the continued need for U.S. institutional investors to:

  • Assess critical resources and fiduciary risk. All investment committees must prioritize their activities. But not all investment committees are created the same: plans, staff, budgets and expertise vary drastically. Consider how your governance structure affects your ability to focus on high-impact decisions, and identify areas where you may require additional support.
  • For DB plan sponsors, have a purposeful approach to liability hedging, subject to your context.
  • Explore diversity and other risk management strategies (e.g., options, dynamic hedging) in portfolios seeking returns over bonds so that you can potentially reduce the impact of a downside market event on portfolios.
  • Use dynamic portfolio views where possible and appropriate, subject to your governance.
  • Keep a sharp focus on external costs and value for money, with expected returns and yields likely to stay historically low for years — recent and expected FOMC rate hikes notwithstanding.
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