IMCO's CEO on Weathering the Storm Ahead?

Martha Porado of Benefits Canada reports, What’s the investment outlook for pension funds in 2019?:
Following years of steady, globally synchronized growth, volatility is back. In the final weeks of 2018, North American stock markets were especially hectic, posting losses in December to round out a relatively challenging year.

Virtually every asset class, with the notable exception of commodities, has done well over the past decade, says Bert Clark, president and chief executive officer of the Investment Management Corp. of Ontario. “That’s a place that should make any investor nervous, because eventually things are going to return to normal.”

After double-digit gains in equity portfolios, institutional investors were expecting the return of more dramatic price action, says Clark, who also notes gradually rising interest rates are underpinning some of the market unease. “It’s not a bad thing to start 2019 with interest rates at more normal levels and with people making sure they’re more comfortable with their portfolios given more normal volatility.”

With all of that in mind, where are pension plans looking to put their energy in 2019?

Macro and micro

The persistence of a populist or nationalist narrative can be considered a risk on a macroeconomic scale, says Clark, noting the U.S. administration’s continual promotion of unilateralism is certainly a reason to be wary.

However, apart from ideological concerns, the practical results of protectionism have both macro and micro effects, says Benoît Durocher, executive vice-president and chief economic strategist at Addenda Capital Inc. “If you do run pro-cyclical or protectionist trade measures at a time when resource utilization is running up against capacity limits, then you run the risk of stoking inflation,” he says. “You run the risk of central banks, particularly the Fed in this instance, moving away from gradualism and tightening more than the economy can withstand in the short run to quell inflation bursts. And then you run into a classical recession.”

While this scenario would take time to roll out and may not be fully realized in 2019, it’s certainly a worry on the horizon, says Durocher.

At a more micro level, protectionism is already affecting some pockets of the global economy, says Richard Beaulieu, vice-president and senior economist at Addenda Capital. “Quite a few firms are already complaining about having to put in higher input costs,” he says, referring to automobile producers as one example. He notes these producers are confronting higher tariffs on steel and aluminum at a time when their profit margins are already under enough pressure from a still very high degree of overall competition, as well as labour costs that have been firming up lately. “So if you add pressures that come through the international trade channels because of these protectionist measures, you certainly have some more serious headwinds to confront than otherwise.”

Stability shift

Italy is one developed market where a shift away from a globalist mentality is creating instability, says Rahul Khasgiwale, head of Americas investment director at Aviva Investors. “The Italian saga continued to rattle the market throughout 2018. We saw . . . Italian markets and assets come under pressure on multiple occasions.”

The Eurosceptic sentiment surrounding the country’s recent election resuscitated the potential for a euro crisis, he says. In particular, Italian government and sovereign bonds came under major pressure, with Moody’s Corp. rating them one level above junk bonds, he adds.

“They could become ineligible for a number of world bond indices and even potentially from [European Central Bank] asset purchase programs, so if something like that were to come to fruition, that would cause questions on Italy’s sustainability,” says Khasgiwale.

“Generally, we think being long Italian assets at this point is a little premature, and we think the situation is likely to get worse before it gets better. Certainly, more credible political and structural reforms [are] needed to reduce some of the current vulnerability of the Italian economy.”

On the other hand, in a less developed market, the transfer of power to a more populist government isn’t necessarily going to have the same ill effects, says Matt Benkendorf, chief investment officer of Vontobel Quality Growth, a boutique of Vontobel Asset Management Inc. He notes sticking to investments in Brazil over the past year has been painful, with the turbulence boosted by a dramatic presidential campaign. But with conservative Jair Bolsonaro taking office on Jan. 1, 2019, Benkendorf anticipates an improvement in Brazil’s investment environment.

“Emerging markets elections do matter as they do in developed markets like the U.S., clearly,” he says. “Sometimes they matter a little bit more in emerging markets. But just the uncertainty of a choice or a big potential shift coming up really throws markets and currency into a tizzy there.”

The conclusion of the election removes a significant amount of uncertainty, says Benkendorf, noting Bolsonaro is already appearing more market-friendly than many predicted. “He’s doing all the right things. I think the market has vastly underestimated his potential. The market still does.”

Within any market, fundamentals reign supreme during asset analysis, especially in a potentially contentious and complicated investing space like Brazil, adds Benkendorf. Regardless of geography, the best way to approach potential investments, he says, is to take a bottom-up approach in analyzing the best companies with solid stories and a clear, strong business strategy. Companies that provide life’s staples, such as beer producers or fuel suppliers, are excellent choices, especially when their values are being pushed down by worries over political upheaval. “We own very resilient businesses, despite what I’m giving on the top-down and the politics,” says Benkendorf.

Security blanket

Even with 2018’s rising volatility, many pension plans experienced their greatest move towards fully funded status since the 2013 surge in U.S. Treasury yields, says Timothy Braude, managing director of global portfolio solutions at Goldman Sachs Asset Management. “As such, we expect to see some fairly reasonable movements in asset allocation, particularly away from equities and into long-duration investment grade fixed income. That means long-duration provincials, corporate bonds and long-duration government securities as well.”

With a broader move into fixed income on the horizon, the effects of economic events on this asset class will be integral to watch in the year to come, says Braude. “As accommodative central bank policy is gradually withdrawn, we also see many pension plans adding market-based triggers to de-risking glide paths.” he says. “So rather than merely focusing on funded status, [they’re] looking at where interest rates are, thinking about things like the 10-year Bank of Canada yield or the 10-year U.S. Treasury yield as ways to make sure they’re modulating the overall exposure based not only on funded status but also where the market is going.”

Braude says implementing a more active strategy like this will take nimbleness on the part of pension funds, and further diversifying from a dependence on equities will push them towards innovating with liquid alternatives. Since these assets have gained in popularity, the number of managers servicing them has also risen, he adds, noting the investment community may begin a culling of the less successful players in the space in 2019.

But plan sponsors will continue to focus on liquidity this year, says Braude. “In Canada, you’ve actually seen a record number of plan annuitizations and plan terminations, or partial lift outs or buy-ins with insurance companies,” he says. “In order to do that you have to have a liquid portfolio.”

At the same time, he notes, institutional investors are paying attention to private assets, seeking ways to balance their inclusion in portfolios with liquidity. As well, investors are looking for private assets that have already shown some growth over an outlined trajectory, says Braude.

“You are seeing a lot more interest in things like secondaries, so being able to invest in private assets when they are already along the J-curve, not having to worry about allocating money and figuring out when that’s going to be committed.”

Demand for other alternatives, such as real assets, isn’t going to abate in 2019, says Calum Mackenzie, partner and Canadian investment consulting leader at Aon. While many investors have already jumped on core markets like New York City, especially for real estate, he notes pension plans still looking to buy have to look in less obvious locales and focus on fundamentals. “[They’re] moving from places like downtown Manhattan and putting more of an emphasis on an Austin or a Nashville.”

Available assets for infrastructure are also limited, adds Mackenzie, so plans will have to seek out holdings that require more effort to become completely healthy income generators. “The very core assets have been heavy targets from all global investors, so we’re encouraging plans to look at the assets that require a little more value add, assets that need a little more of that manager focus, so you’re buying a little more of that manager skill,” he says.

“Rather than going into simple public/private partnership assets, which might have been oversold, perhaps look at transport assets, for example. Take an airport that needs some asset management, so it’s not ready just to be taken on. You can’t just buy it and use it as a yield play. You’ve got to buy it and use it as a refurbishment. You’ve got to change some of the layout, deal with logistics with the building. You’ve got to put some work into it.”

However, when moving out of equities into any alternative, Mackenzie notes it’s important not to expect a true proxy from assets that simply don’t behave the same way as stock markets.

Allocation, allocation, allocation

In seeking diversification, equities have offered a less varied exposure, says Clark, and the traditional advantage of investing internationally has been weaker due to the tight-knit global synchronicity between stock markets.

As well, spreading out geographically by establishing positions in Canadian, U.S., European, international and emerging market stocks doesn’t guarantee the same true diversification it did in the past, he says. This is just one of many reasons he believes the most important investing choice a pension fund can make is the asset mix. “The biggest thing that we’re going to be doing in 2019 is working with our two initial clients to revisit their strategic asset mixes. For most investors . . . it dwarfs any other individual decision.”

Establishing an asset mix is the ultimate in getting back to basics for institutional investors. For Clark, a key rule to follow is diversification, not allowing a single choice to dominate the outcome of the portfolio’s return as a complete entity.

“You don’t want to take a position that dominates everything you do. If you have an outsized weighting to any of those things, you can find that, if the world plays out how you hope it will, things are great. But if it doesn’t, all of the other investment activities are overshadowed by that one decision.”
This is a great article, kudos to Martha Porado, the associate editor at Benefits Canada for putting it together.

There are lots of great insights from various people in this article but I want to primarily focus on what IMCO's CEO Bert Clark stated above.

First, just like CPPIB's CEO Mark Machin who recently came out warning to prepare for lower returns ahead, Bert Clark is right about this:
Virtually every asset class, with the notable exception of commodities, has done well over the past decade, says Bert Clark, president and chief executive officer of the Investment Management Corp. of Ontario. “That’s a place that should make any investor nervous, because eventually things are going to return to normal.”
So why aren't investors more nervous? I think it has something to do with the Fed put, now aptly called the "Powell put" after Fed Chair Jerome Powell, and the idea that no matter how bad things get, the Fed will be there to backstop risk assets and if needed, you will see the Fed's balance sheet mushroom to unprecedented levels the next time a crisis occurs.

All this to say, if you're just relying on mean reversion to make your asset allocation decisions, you might be making a serious mistake.

What about those making the argument for inflation in the article above? I like Addenda Capital's Richard Beaulieu, worked with him years ago at BCA Research, he's a smart macro economist and if he's right and inflation pressures continue, you will see rising rates and commodities rally (ie. mean reversion argument, the opposite of what happened over the last ten years).

I'm not so sure. I feel global deflationary pressures will persist and cyclical inflation can arise due to currency depreciation, fiscal policy (tax cuts or infrastructure spending), but ultimately there are too many structural headwinds weighing down inflation expectations all over the world (like aging demographics, looming retirement crisis, rising wealth/ income inequality, rise of artificial intelligence, and too much public and private debt).

Today, a tweet from Blomberg's Lisa Abramowicz caught my attention and I had to reply:

I just don't think the US or global economy can withstand a sustained increase in rates. And I see a US and global slowdown ahead whcih is why my forecast remains we have yet to see the secular lows on US long bond yields (which isn't good news for chronically underfunded US pensions, they're cooked).

I'm not the only one, HOOPP's CEO Jim Keohane told me that the economy cannot sustain a big increase in rates a few times in our conversations.

Inflationistas might be right over a year or two but a sustained rise in rates will decimate the economy, that's where we are right now.

The future I see is a Japanification of the US and global economy, central banks will continue to backstop risk assets but returns will be lackluster at best, there's too much money chasing the same assets and too much debt hampering economic growth.

Sure, maybe if Michael Sabia's new paradigm for growth takes off we can escape a long period of economic morass but count me as a perennial skeptic on this front.

That brings me to something else Bert Clark said which I completely agree with, you need to get your asset mix right and keep in mind that traditional diversification like geographic diversification in public equities isn't going to work.

I'm going to even take it a step further. I'm willing to bet anyone out there that traditional diversication and even diversifying into private markets won't work unless you implement a value creation plan prior to making an acquisition and being able to stick to it through thick and thin.

What do I mean by that? Long gone are the days where you can shove more money into private equity, real estate and infrastructure, even if it's in emerging markets. Pensions which are not implementing a value creation plan in these private markets will severely underperform their peers that do, especially peers that are increasingly co-investing alongside their partners to scale into these assets.

You need a value creation plan. I don't care if it's private equity, real estate, infrastructure, or even more liquid alternatives like hedge funds, you need a plan to make money in these markets over the long run and Bert Clark is right, you need to get your asset mix right.

In order to get your asset mix right, you need to get your macro calls right and that's not easy, especially over any given year.

I applaud IMCO for sitting down with its two primary clients to go over strategic asset allocation, Bert is right, it dwarfs everything else, but once you set it, you also need to approach public and private markets in an intelligent way.

That's going to be Jean Michel's job, IMCO's CIO:

He has a great team helping him, including Nicole Musicco who joined IMCO from Ontario Teachers' to head up private markets:

She has a huge job ahead of her and she knows what I know and what everyone else knows, if you're going to do what everyone else is doing in private markets, you're not going to create great long-term value unless you have a great value plan and great partners all over the world to co-invest alongside with, lowering fees and scaling into private markets.

My recent comment on the public versus private markets battle garnered a lot of attention and some of my readers are very skeptical about private markets, writing me that low volatility is all due to stale pricing because these assets aren't marked-to-market.

True but over the long run, Canada's large pensions have done extremely well investing in private markets because a) they have the right partners and b) they have the right governance and approach with these assets.

Private markets are critically important and there's a reason why Canada's large pensions are all fully-funded or close to it, because they invested in privates early on and had the right approach (HOOPP is a bit of the exception but as it grows, it will necessarily grow its private markets over the next decade).

People get very emotional with me when I discuss public versus private markets. Don't get angry at me, don't shoot the messenger, I call it as I see it and if you have a different opinion, feel free to email me and lay out your arguments in a concise rational way.

Lastly, I apologize for not posting a comment yesterday, was in and out of Toronto the last couple of days, had a lot of meetings for a new project I'm trying ot get off the ground. I also apologize to those of you who I didn't get to see because this was literally a last minute trip and I couldn't plan other meetings around it especially since it was Family Day in Ontario on Monday.

There are a lot of people I'd like to meet and profile on my blog in Toronto but I need to plan this way ahead of time and give these people the much-needed attention they deserve. That will have to be during another trip.

Below, Gary Shilling, president of A. Gary Shilling & Company, joins BNN Bloomberg for his global economic outlook (click here if it doesn't load below). Shilling still likes US nominal bonds and the US dollar. No surprise since he has been warning investors that deflation is coming and I agree with him, it's coming and when it hits us full force, it will be with us for a very long time.

On that note, listen to IMCO's CEO, you'd better get your asset mix right or else you're cooked!