How should investors integrate the prospect of an economic recovery into their investment strategy and what challenges could they face in the year ahead?
In the early 1990s the UK was living in interesting times. It was facing recession. Unemployment was rising and it endured a challenging exit from the European Exchange Rate Mechanism. The sentiment of the period was perfectly articulated in the title of a number one song at the time by Northern Irish pop group D:Ream, Things can only get better.
Fast forward 30 years and the UK is in a similar predicament. It is facing a challenging economic climate, the number of people looking for work has jumped sharply following the onset of the Covid pandemic and it is having a difficult departure from the European Union. But as 2020 drew to a close, news of a Covid vaccine roll-out sparked hope. Again, there is a widespread sentiment that things can only get better. But will they?
The macro context: A difficult ascent
Throughout the summer, the world started getting a glimpse of normality as parts of Asia and Oceania succeeded in controlling the virus and regional lockdowns across Europe and the US were partially lifted. Nevertheless, the International Monetary Fund (IMF) warned that the global economy was on the brink of a “difficult ascent” and that until the health risks of the pandemic had been fully brought under control, the world’s economy would continue to struggle. In its growth outlook published in October, the IMF predicted that the UK economy was on track to shrink by 9.8%, nearly double the average level of advanced economies.
But in December, as the Covid vaccine was being rolled out in the UK, the Bank of England struck a more optimistic tone. Andy Haldane, its chief economist, predicted that progress with the vaccine would lead to a boost in business confidence. But even within the Bank of England’s Monetary Policy Committee this view is disputed. Michael Saunders, an external member of the committee, warns that the central bank has used up much of its firepower and that the potential beneficial effects of the vaccine had already been priced in.
This more cautious outlook is backed by news that less than a quarter of the 40 million doses of the Pfizer/BioNTech vaccine ordered by the UK government is likely to have arrived before the end of the year, due to manufacturing delays. Production of AstraZeneca’s vaccine also faces delays, with only 4 million doses due to have arrived here in 2020. Even if the government managed to vaccinate an average of 2.5 million people a week, the NHS predicts that it would take until the second half of 2021 to vaccinate everyone aged over 50.
Mark Fawcett, Nest’s chief investment officer, is just one investor adopting a cautious stance. A vaccine may have been developed, but he still sees Covid as a risk until the drug has been widely distributed.
And the pandemic is by no means the only challenge facing the UK economy which now grapples with the effects of its formal exit from the European union based on a last-minute trade deal.
For Fawcett, investors are likely to see more volatility, bringing the issue of currency risk back on the agenda. This view is also embraced by Nico Aspinall, chief investment officer of BC&E and The People’s Pension. While he remains agnostic on whether advanced economies might be entering the stages of competitive devaluation, managing the adverse effects of currency volatility through hedging strategies will be high on The People’s Pension’s agenda.
Doug Heron, chief executive of Lothian Pension Fund, worries that an unintended side effect of ultra-loose monetary policy could see prices rise. “The key risk for us is that we will see higher levels of inflation which is usually a natural outcome of such a public finance response. So, we might be in for a period of lower returns across all asset classes,” he says. Nevertheless, as a defined benefit (DB) scheme with a relatively higher exposure to equities, Heron also sees opportunities to capitalise on the long-term innovation created in response to the adversities Covid has accelerated, from the trend for home working to delivery services and online exercise apps.
Equities: Year of the bull?
The desire for things to get better is reflected in the outlook of most asset managers, who have positioned themselves as bullish for a further surge in equity markets. At the end of 2020, fuelled by monetary policy, global equity markets grew 12%, despite widespread economic damage across the real economy.
As it happens, according to the Chinese zodiac, 2021 will be the year of the ox. This might sound better than 2020’s year of the rat, but investors might want to be cautious not to assess the merits of these animals through a Western lens. While the year of the rat, according to the Chinese zodiac, stands for new beginnings, the ox tends to be associated with hard work, diligence and persistence.
Characteristics that certainly chime more with the average outlook that most institutional investors have for the new year. Unlike asset managers, most institutional investors appear to be wary that the current pace of stock market growth can be sustained.
The vast majority (78%) of institutional investors believe that the current pace of stock market growth is unsustainable, according to a Natixis survey of 500 pension schemes, insurers and sovereign wealth funds. Insurers, in particular, have scaled back their return assumptions to 5.5% from 6.5%. At the same time, more than half of the respondents believe that an increase in volatility could provide more opportunities to generate alpha. For Nico Aspinall at The People’s Pension, which as a defined contribution (DC) scheme has a relatively young membership and consequently a long-term investment horizon, the return to “a more textbook investing environment” provides opportunities to capture value in equity markets.
Defined bearishness
In contrast, DB schemes across the UK are continuing their path towards de-risking, which is, of course, largely dictated by their lifecycle rather than any secular growth outlook. Among the schemes in the Pension Protection Fund’s (PPF) universe, only 11% remain open to new members and 46% are closed to new benefit accrual, according to the Purple Book.
In line with that, DB schemes continued to reduce their average equity allocation to 20.4% from 24%, year-on-year. But being underwritten by a corporate sponsor, final salary schemes, by definition, have one foot in the door of the real economy.
From travel to hospitality and retail, the economic fallout of multiple lockdowns has been a lot more tangible for final salary schemes. The strength of sponsor covenants will be a key priority, especially as two thirds of companies with a DB scheme issued a profit warning in the first nine months of 2020, according to Ernst & Young. DB schemes have also been hit by the adverse effects of falling gilt yields, with average pension deficits in the PPF universe ballooning to £229bn from £160bn, Purple Book data shows. The challenge for many DB schemes is how to address the funding shortfall in a low return environment, without moving unduly up the risk curve.
Fixed income – a riskier ride
But this risk curve has shifted significantly over the course of the past year as borrowing has surged across the globe. Global debt levels have increased by $15trn (£11.2trn) in the past year and are set to hit $277trn (£208.5trn), or 365% of global GDP, by the end of 2020, according to the Institute of International Finance.
Meanwhile, investors have attempted to navigate the low-yield environment by diversifying away from treasuries and into more exotic segments of the fixed income market, be it emerging market, frontier or private debt. This trend is likely to continue in 2021. In this context, the two main headaches fixed income investors might face in the year ahead are a potential increase in inflation and a rise in defaults.
The combination of a potential surge in consumer demand as lockdowns are easing, combined with a slowdown in globalisation and increased central bank tolerance towards rising price levels as a way to manage debt could become triggers for inflation, warns Evan Guppy, head of liability driven investing at the Pension Protection Fund. “The inflation outlook for the next 12 to 18 months is probably the most uncertain it’s been in my 15-year career of trading inflation-linked products,” he says.
Emerging markets appear to be one of the areas which benefited from investor buoyancy towards the end of the year. In November, $76.5bn (£57.7bn) flowed into debt and equities in the developing world, the strongest level for more than seven years. However, as the 2013 taper tantrum suggests, their fortunes can reverse swiftly, if the macro outlook changes.
For Mark Lyon, head of internal management at Border to Coast, default risks are on the rise, particularly in private credit. “Default rates were very low because we are at the top of the credit cycle. “I think default rates are going to increase,” he adds. “The headline numbers might not be as high as they have been in previous corrections partly because there is a lack of covenants in a lot of loan documents, which means you do not necessarily get the formal defaults. But there are certainly a lot of problem loans which managers are going to have to spend time dealing with.”
More ox than bull
After a more than challenging year, there are reasons for investors and households alike to be more upbeat. The news of a potentially successful rollout of a Covid vaccine being the most important. Nevertheless, given that a lot of this good news has already been priced into equity markets and fixed income has become a borrowers’ market, institutional investors might be better off not being overly bullish. The defining features of the ox in the Chinese zodiac, being a hard worker in the background, making intelligent and prudent decisions, might stand them in good stead.
