Written By: Emma Powell
Emma Powell discusses the efforts pension schemes are putting into learning lessons from the events of 2020 and the possibilities offered by investment in different regions and asset classes
Against sharply volatile investment markets and a still uncertain economic outlook, pension schemes are unsurprisingly attempting to learn lessons from 2020. “There is a definite move towards being more cautious about your risk profile,” says Jude Bennett, principal in Barnett Waddingham’s investment consulting practice, “looking for assets that deliver stable income to meet cashflows and not being overly reliant on equities.” The downturn in global equities that followed the acceleration in Covid-19 infections and the imposition of lockdown measures in March, was followed by a rapid rebound due to central bank stimulus and the rollout of vaccination programmes at the end of last year. That meant that most schemes ended 2020 with level, or even improved, funding positions, Bennett says.
Yet while global equities more broadly rebounded from the March crash, some geographies fared better than others. US equities led the recovery, thanks to the surge in inflows into major tech stocks, such as Tesla and Apple, while UK indices have been held back by their weighting towards energy and financial services companies. The FTSE 350 ended 2020 down 14% on the start of the year, compared with a rise of the same proportion recorded by the S&P 500.
That geographical divergence in performance is a symptom of the difference in sentiment towards growth companies and those with beaten-up valuations. Indeed, since the end of March, value stocks have rebounded markedly but to a much lesser degree than growth companies.
That is a continuation of a prolonged period of underperformance. Value stocks have consistently lagged growth stocks over the past decade. The MSCI World Growth index has returned 170% since 2010, far outstripping the 36% in gains generated by the MSCI World Value index.
Yet the tech-led rally in US equities has sparked fears of a stock market bubble, reminiscent of the “dot com” era of the early 2000s. The S&P 500 index stands at a near all-time high and is valued at an enterprise value/forecast adjusted cash profits multiple of 14, according to market consensus figures, a substantial premium to the five-year average.
Fears of a market bubble could be overblown, says Lewis Grant, global equities senior portfolio manager, international at Federated Hermes. “The difference this time is we have more established technology companies, which for the last four to five years have proven their ability to deliver not just incredible shareholder returns, but incredible revenue growth,” says Grant. However, he adds: “That’s not to say the valuations haven’t got a little bit toppy.”
Whether those valuations are justified will depend on the improvement in earnings, which is expected by analysts in 2021, materialising and continuing over the medium term. The consensus forecast is for the S&P 500 to deliver an annual rise in earnings per share of almost a quarter this year, but that slows to 16% in 2022 and 12% the following year. What’s more, expectations of a sharp recovery this year could still be upset by a slower-than-anticipated roll-out of vaccines and a weaker economic recovery.
Value investors betting on an economic recovery could also be disappointed. Yet Grant believes there is merit in looking for economically-sensitive stocks, which have perhaps been overly-penalised during the Covid-19 crisis. That includes those in the financial, industrial and energy sectors.
However, investors looking to identify opportunities within the energy sector need to be cognisant of the drive towards sustainable investing, Grant caveats. “It’s not just about finding wind farms and solar farms, which aren’t particularly difficult to identify, but looking at how a business is run and asking is this company working sustainably and identifying its weaknesses and taking active steps to improve,” he says.
The clamour for yield
Yet while the quantitative easing programmes unleashed by central banks globally may have boosted equity markets, it has also driven government bond yields even lower, with the yield on two- and five-year Gilts entering negative territory for the first time in history last year.
This has naturally exacerbated the inflows into both alternative assets and higher yielding fixed income instruments. The former includes infrastructure, real estate and private debt. A July survey by Aviva Investors revealed that 37% of pension funds planned to increase their exposure to real assets over the next year, while 20% of those surveyed intended to decrease their bond allocation.
Respondents cited the relative resilience of real assets and the ESG credentials of some asset types as core attractions. The pandemic has added an additional pull factor: around 94% of pension funds and insurance groups surveyed by Aviva said real asset investments could play a role in recovery from the crisis.
Even prior to the pandemic, a report by PwC found that the UK would need to increase infrastructure spending to £40 billion a year, double the current level, in order to reach its climate target of net zero by 2050.
Pension funds are aware of the asset classes’ attractions. For instance, in November, Brunel Pension Partnership committed £840 million of pooled capital to two infrastructure vehicles, one of which was allocated to renewable energy projects.
Staying within the bond market, investors are increasingly looking to alternative credit for higher yields. That includes investment grade debt, says Insight Investment’s fixed income specialist Serena Galestian, despite it looking more expensive than it did prior to the pandemic.
“Investment grade valuations have come in quite a lot, spreads have tightened pretty meaningfully [but] you’re still getting a relatively good yield compared with government bonds,” she says.
Within the investment grade market, investors are largely getting compensated for the historically higher level of default, she adds.
However, investors may find better returns in other forms of debt such as asset-backed securities, Galestian argues. “That’s because asset-backed securities lagged the recovery that we’ve seen in investment-grade credit,” she says.
Another benefit is that asset-backed finance is a more complex asset class so investors are rewarded with a “complexity premium”, she says, adding: “If you’re willing to give up some liquidity then you get an illiquidity premium as well.”
Emerging markets could also prove worthy of investor attention. J.P. Morgan Asset Management forecasts that emerging market growth, led by China, could reach 6.7% this year and a backdrop of easy global monetary policy will further support the case for emerging market assets broadly.
The asset manager argues that local currency assets present the best opportunity for investors thanks to attractive valuations, sensitivity to emerging market currencies and historically wide yield premiums over US Gilts. The outlook for emerging market local currency “is only very rarely this appealing”, it says.
That is a sentiment echoed by Galestian. Insight forecasts that local currency debt will generate a return of 6.5% in 2021 and Galestian believes that emerging market local currency government debt will benefit from existing weakness in the US dollar. “The local currency sovereign market we think will weather recovery well this year as well, and that’s predominantly going to be driven by exchange rates,” she says.
“It’s very much this year about country selection and getting that right,” she adds. That means identifying countries with steep yield curves, which are pricing in interest rate hikes. Those markets include Brazil, where the asset manager believes the central bank will not hike rates as much as expected by the market, and Mexico and Romania, where it believes there is even room to cut rates.
Yet the pandemic has also increased interest in another corner of the fixed income market – sustainable bonds. Issuance of social and green bonds rose to a record of more than $500 billion last year and took total issuance past the $1 trillion-mark. “I think there’s just more focus on inequality and the social impact of the pandemic,” says Yvette Klevan, portfolio manager and analyst in Lazard Asset Management’s global fixed income team. Despite the increased issuance in debt to finance green or socially responsible initiatives, sustainable bonds benefit from being more limited in supply than other forms of debt, she argues. “When we had extreme volatility related to the pandemic… I would argue that a lot of the social and green labelled bonds held-in and defended pretty well because I think if you’re managing a portfolio and you need to make changes you would want to hold onto them because of their scarcity value,” asserts Klevan.
The debt burden of global government and corporates coming out of the pandemic means interest rates and asset purchases are likely to continue for some time yet. While that should buoy asset prices, there is still the risk of a correction in equity markets, should the vaccine rollout not progress according to the timetables provided by governments. It also means investors will need to work harder to identify the assets and geographies that will generate the returns they need. Further inflows into alternatives such as infrastructure and private debt seem likely.