Pensions Ill-Prepared For a Rough Landing?
Pension funds' increased risk tolerance is "all but certain" to impact fund returns negatively, as some are ill-prepared for the problems posed by increasing interest rates, Allianz Global Investors (AGI) has predicted.You can download Allianz Global Investors' Annual Global RiskMonitor by registering here. You can also read all of Allianz Global Investors' market insights here, including a report on pension obligations in times of financial repression.
Publishing its annual RiskMonitor – for the first time surveying investors globally – the German asset manager said its nearly 400 respondents were concerned about price bubbles developing in fixed income.
Equal numbers of respondents, or 51%, were concerned about the bubble materialising in high-yield corporate debt and developed market sovereign bonds, and 44% also perceived emerging market property as a risky proposition.
Developed market real estate was only considered overpriced and at risk of an asset bubble by 24% of respondents, ahead of only commodities, which 23% identified of being at risk due to central banks' expansionist monetary policy.
The survey noted that the low-rate environment had led to "constrained" institutions – classed as those constructing cash-generating investment strategies such as pension funds – re-assessing the level of risk in individual portfolios.
"This open-mindedness among investors may well be necessary to meet performance objectives in this loose monetary policy environment," the survey said.
"But the recent shift in risk tolerance is all but certain to negatively affect fund performance if rates rise quickly and unexpectedly, or if investors are ill prepared for managing the dynamics of interest rates as they return to normalcy."
Of the 391 survey respondents, two-thirds said they saw an abnormal price distortion in fixed income markets developing over the last five years as a result of central bank intervention.
A further one-third said foreign exchange markets had been similarly affected, and 45% believed equity markets had been distorted.
The US Federal Reserve was singled out for its role by a number of respondents.
"Large institutional investors interviewed for this report pointed to multiple examples of emerging market economies, and even Japan, that have been negatively affected by the easy liquidity polices of the Fed and the coming tapering of that liquidity," the survey said.
AGI chief executive Elizabeth Corley cited the impact of the looser monetary policy initiated in the wake of the crisis as a concern.
"Five years on, we find that, despite sovereign debt [being] at historic levels, growth remains anaemic, and that what was envisaged as first aid has become an enduring support to keep growth afloat," she said.
"As we journey towards a world with less monetary stimulus, the question is, are we facing a bumpy landing or will policymakers be skilful enough to avoid unintended consequences?"
The survey of large institutional investors around the world finds broad support for central banks’ immediate response to the financial crisis, but also an increased sense of risk tied to the second order, long term effects of loose monetary policy.
Top-line findings from the first global RiskMonitor entitled “Prepare for Landing” include the following:
- A majority of investors see low rates from central banks as a source of near term GDP growth, but low rates also increase inflation and systemic risk in financial markets. They believe loose monetary policy poses risks to both the retirement savings systems and the long term economic health.
- Loose monetary policy is inflating asset prices to abnormal levels, especially in fixed income markets.
- Investors do not anticipate interest rates to return to long-term historical averages for several years. Thirty percent of survey respondents foresee rates starting to normalize at some point in 2015, while 42% do not expect rates to move before 2016.
- Tail risk and rising interest rates are seen as the most acute risks to fund performance over the next three years.
- In response to their most pressing risks, investors are most likely to have embraced duration management, dynamic asset allocation, asset diversification, and risk-driven investment strategies.
- More than 9 out of 10 investors see equities as a source of positive returns and two thirds say that equity risk will pay off most in the medium term. Study participants anticipate average annual equity market returns of 6% over the next three years.
- Investors anticipate a less favourable regulatory environment in the years ahead, citing stricter regulation and new capital controls and investment requirements from national governments as the most pressing regulatory and governance risks.
In terms of asset allocation, the basic theme remains the same. Lower fixed income exposure and increase public and especially exposure to private equity, real estate, infrastructure and hedge funds. But the perverse effects of quantitative easing are hitting all asset classes, including alternative investments. When you see a top global macro hedge fund like Brevan Howard struggling, you know this is a killer environment and investors are right to be concerned.
And while the whole world is short bonds, think the big surprise contrarian trade over the next decade(s) will once again be going long bonds, especially if policymakers are unable to avert a long period of debt deflation. This might sound crazy given historic low bond yields and all the quantitative easing going on all over the world, but there remain major deflationary headwinds that threaten long-term growth. Ironically, quantitative easing might actually usher in a long period of debt deflation because when all these bubbles in risk assets pop, the effects will disproportionately hurt the real economy once more (read Hoisington's second quarter outlook and Lacy Hunt's speech on Unintended Consequences of Well-Intended Policies which focuses on the negative effects of activist fiscal policy).
Of course, it's not all doom and gloom. We might be entering a period of low growth, low inflation and see the renaissance of U.S. manufacturing as lower energy prices push companies to bring their manufacturing operations back home. Lower energy prices will also boost consumption. If such a benign regime is what's in store over the next decade, then equities will outperform bonds and alternative investments will do just fine, with top funds continuing to deliver strong gains.
But I'm nervous knowing full well the starting point is different this time around. All these pensions, sovereign wealth funds, insurance companies, endowments and other institutional investors chasing higher yields in riskier assets are all dancing to the same tune, with the Fed being the conductor. All is well for now but as Leo de Bever warned a while back, when the music stops, watch out below (note: Leo is bearish on bonds but he doesn't dismiss the possibility of deflation in the future).
Nonetheless, when discussing bubbles and risks, keep reminding myself of Keynes' famous quote, markets can stay irrational longer than you can stay solvent. And the Fed might indeed be the last great bubble which lasts longer than anyone expects. At least those betting on the 'Fed put' hope so.
Below, Morgan Stanley's Adam Parker Pension Partners' Michael Gayed and Bianco Research's James Bianco discuss the possibility of a U.S. default with Trish Regan on Bloomberg Television's "Street Smart." Make sure you read Michael's latest comments, Is Market Correction Over or Just Beginning? and Is it time to go risk off rather than risk on?.
Also embedded a Max Keiser interview with Michael Hudson on the global property Ponzi policy (fast forward to minute 12 if you want to skip Max Keiser's rant). Michael is a rare economist and even if you don't agree with him, you'd better pay attention to what he says. He knows exactly what is going on between capital and labor, exposing harsh truths mainstream media never discusses.
Institutional investors looking to bolster their risk management, including that of illiquid investments like real estate, should contact the folks at Northfield. My institutional contacts tell me they are a top-notch firm when it comes to modeling financial risks (love their comment on The Ten Fundamentals of Pension Fund Risk Management).
Finally, it's Thanksgiving weekend here in Canada and wanted to remind you to please remember to click on the ads every time you visit my blog and to contribute via PayPal by going to the links on the upper right-hand corner. Just because it's free, doesn't mean you can't show your appreciation. I thank the few well-known institutions that are supporting my efforts and hope more will join them. Watch the clips below, will be back on Tuesday.