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Survey Report

Five-Year Capital Market Outlook — 2019 North America


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 North America. 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 funded ratios and defined contribution account values.
  • Lower bond yields could push projected benefit obligations and annuity costs higher, putting further pressure on funded ratios and DC savings’ adequacy.

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. 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 but in a way that reduces 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 below.

Most North American pension plans could benefit from reducing exposure to equities outright. Simple ways of selling equities while not sacrificing too much return 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 diversifying.
  • 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 and hedge funds: Skilled hedge fund managers can provide diversification benefit within a total portfolio context (see priority #4 Alpha). For clients with more of a focus on cost and simplicity, we have sought to strip away the complexity and fees of certain hedge fund strategies, which are really just novel forms of beta, and provide them to investors cheaply. These alternative beta 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 favor of non-US or EAFE mandates, although this is governance and price-dependent (see priority #3 Dynamism).

Finally, while diversity doesn’t always have to be complicated, sometimes complexity is the price to pay for attractive assets. The governance required to cope can be acquired through delegation.

2. Reduce unrewarded risks

Why? Because risk should only be taken if it is rewarded. From a corporate perspective, reducing risk means improving certainty while maintaining return – a win-win. However, once again, the perception and often the reality of doing so is costly, time consuming and complicated.

How? Again, reducing risk doesn't have to be burdensome. We encourage DB investors to think about their approach to Liability Driven Investing (LDI). In particular:

  • Increasing duration through STRIPS or a treasury overlay. Despite recent falls in yields and the possibility of near-term increases, we believe the balance of risks over the next few years is for lower yields. This could cause pain for some pension plans, which can be mitigated by increasing the duration of existing hedges. STRIPS are an easy way to do this.
  • Do you need so much long credit? Unless you are very well funded and have a low target return, there are likely better things to do with at least part of your capital allocation. Long credit takes up a lot of capital, for not much risk reduction/duration and low starting spreads deliver little return, with the likelihood of rising spread levels from here. We would consider reducing long credit in favor of more capital-efficient assets (see above, see below).
  • In our view, LDI is a total portfolio paradigm, not an allocation. Consider how other assets contribute to LDI as well as serving return-generation objectives (e.g., alternative credit can serve a return and LDI purpose but realizing this efficiency requires a close partnership between your actuarial and investment teams).

We also encourage investors to integrate scenario analysis into risk management. Investigating specific macro risks – such as the possibility of a Japan-style deflationary equilibrium – and what to do about them makes sense if we are close to an economic inflection point. The impact of key disruptive megatrends, such as demographics, technology or environmental risks, can also be assessed this way.

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. There is no disguising it: creating value through dynamism is a complicated, time- and resource-intensive process and should only be undertaken by those with rich governance budgets and appropriate beliefs. Whereas using dynamism to manage risk is more widely accessible.

How? Dynamic risk management in practice means implementing a journey plan. Where are you going and how you will get there? Surprisingly few plans have solid answers to these questions and, as a consequence, are likely running a sub-optimal strategy. This is more relevant now because funded ratios will have improved significantly over the past few years and our outlook suggests now might be an attractive time to de-risk.

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. Equities and long credit together are likely a dominant risk for many plans, so less equity in favor of less macro-sensitive assets (e.g., alternative credit, alternative beta, real assets or outright derisking to cash or through options should be considered) as should reducing credit risk in LDI portfolios.
  • Reduce exposure to tighter liquidity: 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.
  • 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.

4. Innovate through alpha

Why? The reality investors face is, in our view, one of generally low returns – due to low cash rates and 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? Again, we will not pretend finding skilled managers is easy. However, it is possible, as demonstrated by our track records. With alpha in your toolkit you can consider the following:

  • Reducing 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 10-20 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.
  • Differentiated, low beta hedge funds: In general, hedge fund performance disappointed during and after the Global Financial Crisis. However, we remain committed to our approach to hedge fund investment, which prioritizes differentiation, low beta and value for money as well as all-out skill. In our view, many portfolio would benefit from exposure to these managers.
  • 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 it is scarce and deploy it through skilled managers.

5. Innovate to find diversity: China

Why? The world economy can increasingly be simplified to three centers 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 centers 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 North American 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 cashflows. 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 – this 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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