04 Dec Every silver lining has a cloud
Having witnessed one of the best months ever for stock markets in November, investors should be rejoicing. What has for the most part truly been an ‘annus horribilis’ could yet be signed off with a ‘Santa rally’. The impact of the US election result and positive news on a COVID vaccine, or several to be precise, have combined to send share prices skywards. Chinese equities have risen 6% in a little over a month, the S&P500 (US) by 11%, Europe 13% and the leader of the pack, the FTSE100 in the UK at a whopping 16%.
So does this mean everything is great in the investment world? Well, not if you happen to run a pension fund. According to research by Mercers, the US pension sector has combined liabilities to stakeholders of just under $3 trillion, but even allowing for the recent rally in stock prices, their combined wealth is just $2.2 trillion. In other words, there is not enough in the kitty to pay out all pension benefits. In the UK the situation is less acute thanks to the regulator insisting on ‘liability matching’ which effectively forced pension funds to hold more bonds.
Very broadly a typical pension fund might have say 60% of its assets in equities, which are the main engine of growth for the longer term. The remaining 40% will be invested in bonds which have historically served two functions. The first is to generate income for the pension fund and the second is to provide defensive characteristics so if equity markets fall like they did in March, theoretically the bond exposure will protect downside. Let’s look at both of these issues in turn, starting with income.
Whilst this is a simplification, as most pension funds will in reality contain a wide variety of assets, modern portfolio theory postulated by Harry Markowitz in the 1950s did ultimately kick off the quest for the optimum blend of assets. Many academic papers later, the received wisdom was that a 60:40 split between equities and bonds represents the optimum blend for a ‘balanced’ investor.
But herein lies the issue. The 60:40 split worked when bond yields were 4 or 5% but as we have said before in these pages, the yield on a 10 year government bond in the UK is now much lower than that, currently 0.4%. In the US it is 0.9%. In much of Europe it is negative. The hedge fund manager Man Group estimates that the average US pension fund needs to hit a performance benchmark of 7% per annum simply to continue meeting its obligations to retirees and that becomes extremely difficult when 40% of a portfolio is generating less than 1%.
The other function of bonds is to protect. Taking the UK as a proxy, the yield of 0.4% is a by-product of ultra-low interest rates and virtually no inflation. But what if this goes into reverse? A combination of low interest rates, huge amounts of liquidity being pumped into the system by central banks and a vaccine that should eventually see life return to something resembling normal, could see a return of inflation and ultimately higher interest rates. This is likely to be extremely painful for bondholders. All of a sudden the 40% of a portfolio selected for its defensive duties, becomes anything but.
So if the two primary functions of bonds are to produce an income and protect downside but both are potentially compromised, why have them in a portfolio at all, let alone 40%? This argument is not lost on the world’s most successful investor. Back in 2013, Warren Buffet, the billionaire investor and chief executive of the world’s largest financial services firm, Berkshire Hathaway, made waves. He said he was leaving instructions that upon his death, the trustees of the inheritance he leaves, put 90% of the money into stocks and only 10% into government bonds.
Pension funds are left with a dilemma. They can of course ask for more in the way of contributions to bolster their coffers, or reduce benefits. Or both. Another alternative is to raise the tax burden to syphon money into pensions but this would be political hari-kari as it effectively taxes the young to fund the old. The reality here is that these issues will unfold over the long term and this incentivises governments and regulators to ‘kick the can down the road’. It then becomes a riddle for successive governments to solve. Most likely, pension funds around the world will have to follow Mr Buffet and replace bonds with equities, and the regulators will have little alternative but to let them.
At CDC we have been grappling with this conundrum for a few years now. We have been underweight bonds for some time and within our ‘middle of the road’ Balanced strategy the weighting is only 15%, less for the more growth oriented portfolios. Having a full bond weighting makes us extremely nervous for all the reasons cited above. But simply removing bonds from portfolios has the potential to replace one problem with another because many alternatives to bonds either do not provide an income, are not scalable for use in portfolios or are themselves inherently volatile, meaning they lack the defensive characteristics to be a suitable complement to equities. In other words, we may as well shift to 100% equities!
Rest assured, this is not what we are proposing, but the paradox of low-risk assets having become the ones carrying much of the risk is real. We are ahead of the pack in reducing our commitment to bonds but the longer term answer lies not in one solution but a combination of them. Longer term we do see more widespread use of equities as the norm, but so too will be a broader range of assets classes.
The days of the classic 60:40 model construct are numbered but that is a cloud on the horizon. For now it is time for investors to enjoy the long awaited equity rally and bask in the warm glow that 2020 might end with a silver lining.
Dr Andrew Mann