The Markets January 4, 2022

Basic Market Lessons Reinforced by 2021

Among the takeaways one investment expert has from the year is that structural forces have a large influence on interest rates and may keep them relatively low despite the efforts of policymakers.

Reported by

As is par for the course at the start of a new year, PLANADVISER Magazine has received a number of equity and bond market analyses from a host of investment managers and advisory firms.

Among these is an analysis penned by Barry Gilbert, asset allocation strategist for LPL Financial, which stands out for the simple reason that it takes time to look back at key lessons learned during 2021. According to Gilbert, in many ways, 2021 was a typical year for markets, but it also reinforced some basic market facts that are hard to learn, even if they are not new.

Never miss a story — sign up for PLANADVISER newsletters to keep up on the latest retirement plan adviser news.

“As we launch into the new year, we’re highlighting three 2021 market lessons that we think may matter for 2022,” Gilbert writes. “These are as follows: 1) equity valuations are a poor timing mechanism; 2) structural forces have a large influence on interest rates and may keep them relatively low; and 3) politics and markets don’t mix.”

As Gilbert recalls, at the start of 2021, investors heard concerns that broad U.S. markets were overvalued using many traditional valuation metrics, such as the price-to-earnings ratio (PE). It was also commonly asserted that, compared with the U.S., international stocks looked relatively cheap. Despite these suggestions, the S&P 500 in fact surged higher in 2021, performing well above its historical average, while international equities lagged behind the U.S.

This basic dynamic underpins Gilbert’s first lesson re-learned: Valuations are a weak short-term timing mechanism.

“At the start of 2021, the PE for the S&P 500 was historically elevated at almost 22.5 on forward earnings, according to FactSet data,” he writes. “At the same time, interest rates were extraordinarily low, which makes stocks attractive relative to bonds and increases the present value of future earnings. On top of that, an extraordinarily strong year for corporate earnings helped stocks ‘grow into’ their valuations, with the PE actually falling to nearly 21 by the end of the year despite strong stock market gains. … The underperformance by international equities this year, which may have surprised some, also reminds us that valuations are not a timing tool. International stocks have been more attractively valued than U.S. stocks for quite some time and, yet, they’ve underperformed consistently for over a decade.”

Turning to interest rate considerations, Gilbert says the situation is complex and, in some ways, counterintuitive.

“If someone had told you at the start of 2021 that inflation (as measured by the Consumer Price Index [CPI]) would be up close to 7% over the year while real gross domestic product [GDP] would grow near 5.5% and asked you where the 10-year Treasury yield would be at the end of the year, most market experts would likely guess well above the approximately 1.50% where we ended the year,” he suggests.

Gilbert argues that one of the main reasons interest rates have stayed as low as they have was the amount of foreign interest into U.S. markets. Despite relatively low yields in the U.S., many foreign investors are still better off investing in U.S. fixed-income markets, he explains.

“With approximately $13 trillion in negative-yielding debt globally—it’s still crazy to think that you have to pay a country/company to own its debt—even modestly positive-yielding debt is an attractive option,” he writes. “So what is the key takeaway from 2021? Despite increased inflationary pressures not seen since the 1980s, there is still a huge global demand for safety, income and liquidity in portfolios and that has kept interest rates (and spreads) from moving much higher.”

Gilbert’s final lesson learned is that, at least in the short term, the goals and ambitions of political leaders do not necessarily lead to immediate changes in market performance.

“For example, when President [Joe] Biden was elected, one of the sectors most expected to suffer was traditional energy,” he says. “The bear case for energy was that Democratic policies toward fracking and the fossil fuels industry would further harm one of the worst-performing sectors over the past decade. In contrast, the solar industry was expected to benefit from an acceleration toward renewable and clean energy sources. Well, what happened? The complete opposite.”

Similarly, Gilbert explains, when President Donald Trump was elected back in 2016, the two consensus sector winners from his presidency were expected to be energy and financials, due to deregulation.

“However, from the date of the 2016 presidential election to the 2020 election, energy stocks were cut in half, while the financial sector returned less than half that of the broader market,” Gilbert observes. “Forecasters had the policy right and the business impact was generally as expected, but nevertheless it seemed small from a pure market perspective compared to other drivers influencing sector returns.”

Looking ahead, Gilbert says 2022 likely will not be a simple repeat of 2021, for a number of reasons.

“We’ve moved further toward the middle of the economic cycle, inflation is likely to decrease rather than increase, and economic momentum will probably slow,” he proposes. “But perhaps most importantly, the policy support from central banks and governments that have helped global economies bridge the economic fissures left by COVID-19 will likely begin to fade, leaving the economy to stand increasingly on its own two feet while putting more emphasis on the aggregate decisions of businesses and households.”

The Markets January 3, 2022

DB Plans Should Invest to Achieve Set Objectives in 2022

Protecting funded status, addressing inflation risk, adding value, and more are among suggestions from consultants and asset managers.

Reported by

Plan sponsors should think about their purpose and key objectives when managing investment portfolios, says a paper from Willis Towers Watson.

For more stories like this, sign up for the PLANADVISERdash daily newsletter.

While the paper addresses investment considerations for both defined benefit (DB) and defined contribution (DC) plans, it says DB plan sponsors should understand what their return needs are relative to their desired objectives. “For example, we have seen some plans de-risk too quickly with a capital allocation glide path, leaving the plan with insufficient returns necessary to reach its goals,” the report says.

Sweta Vaidya, North American head of solution design at Insight Investment in New York City, says what DB plans should do in 2022 will depend on what happened to the specific plan in 2021. “Many plans have seen a funded status improvement,” she says. “Regardless of whether a plan is open, closed or frozen, any gains earned should be protected.”

Vaidya says open plans can probably continue to hold some risk because they will need growth to meet obligations that are continuing to accrue. Still, they have an incentive to take some risk off the table to protect funded status.

The funded status means something different for frozen plans than it does for open plans, says Vaidya. For example, because an open plan will continue to accrue benefits, even if it is 100% funded, it will need to hold some risk. However, fiduciaries of a frozen plan could probably decide the plan only needs a 5% buffer over full funding to protect against volatility. “It would depend on the objectives of the plan sponsor plus any constraints on cash,” she says.

Willis Towers Watson says it believes investors require an expanded return-seeking opportunity set to make portfolios more resilient in the face of an inflationary environment. “Specifically, the uncertain policy environment associated with stimulus being withdrawn, corresponding rate rises and inflation risk will require traditional portfolios of equities and investment-grade credit to be scrutinized under these scenarios,” the firm says.

For DB plans, the volatility of rates is expected to impact both liabilities and assets, “with credit and Treasury bonds expected to perform poorly due to rising inflation risk premia and secularly low-starting yields,” Willis Towers Watson says. Plan sponsors need to understand how their existing portfolios will respond to different inflation scenarios and identify new sources of income that are typically more resilient to inflation.

In 2022, Vaidya says, it will be important for DB plan sponsors to de-risk in both fixed income and equity.

“For growth assets, diversify out of equities, because we feel like they are overvalued and we expect a correction,” she says. “Plan sponsors should consider real assets, private equity, infrastructure, hedge funds or multi-asset class strategies, as well as private credit. Over the years, we’ve seen plan sponsors start to gravitate toward these.”

On the fixed-income side of the portfolio, yields are low, and credit migration risk will add a wrinkle if defaults or downgrades affect assets differently than liabilities, Vaidya says. “It’s difficult to perfectly hedge liabilities, but plan sponsors are looking into emerging market debt, structured debt, private debt, fallen angels and bank loans,” she says.

While inflation could be a good thing for corporate DB plans in the U.S. because it might decrease costs, the Federal Reserve’s reaction to it could have an effect on how DB plans should invest, says Vaidya.

“All else being equal, it’s probably not a big issue,” she says. “Corporate DB plans don’t usually offer COLAs [cost of living adjustments] for retirees, and some plans are holding real estate and infrastructure investments, which will keep assets growing. But plan sponsors are concerned that the Fed might quickly raises rates, dampening returns on fixed-income portfolios. Sponsors will need to look at their strategies for managing interest rate risk.”

Addressing Inflation

Willis Towers Watson says private assets, particularly private loans with floating rate coupons, as well as real assets, which have a natural inflationary component, may become more relevant tools for plan sponsors to weather future inflationary pressures.

With a more than 5% annualized inflation rate through the end of May in the U.S. and increasing inflation fears, Morningstar Indexes studied 2021 year-to-date index returns. The results suggest that value stocks, commodities, real estate and Treasury inflation-protected securities (TIPS) can be inflation buffers.

“The past few months have presented a unique opportunity to test the performance of various asset classes in an environment of rising inflation and inflation expectations,” says Dan Lefkovitz, strategist, Morningstar Indexes, in Chicago. “Notably, value-oriented stocks have responded well to economic growth and a concurrent rise in interest rates. And ‘real assets’ such as commodities and real estate—traditional inflation hedges—have been true to form. And, on the fixed-income side, TIPS are a great hedge to inflation, as returns are tied to the U.S. Consumer Price Index [CPI].”

“Inflation has a devastatingly corrosive impact on purchasing power and the current bout of higher prices is a real-time reminder for investors to remain ever vigilant,” says Mark Carlson, senior investment strategist- FlexShares at Northern Trust Asset Management in Chicago. “Maintaining a strategic allocation to real assets such as a broad selection of natural resources, real estate and infrastructure assets has the ability to provide durable long-term inflation protection for portfolios.”

Other Investment Considerations

Willis Towers Watson says the expansion and extension of funding relief for DB plans via the American Rescue Plan Act (APRA) has provided plan sponsors with increased flexibility in pursuing their objectives, as the potential for higher contributions has been reduced. It says this could allow some plan sponsors to pursue a more aggressive investment strategy that can ignore some of the bumps in the road that might have previously triggered a cash contribution. Alternatively, plan sponsors that are looking to take on less risk might be content with a longer time horizon on their path to achieving their goal.

But, Vaidya warns, the funding relief might give plan sponsors the urge to re-risk. “I can see that happening with poorly funded plans, which could create a lower likelihood of achieving fully funded status,” she says.

Willis Towers Watson also suggests that plan sponsors consider active management and more high-conviction portfolios that can add value. “The individual manager volatility can be offset with a multi-manager structure, with monitoring relative to objectives and/or a benchmark occurring at the aggregate or total structure level,” it says.

More specifically, Willis Towers Watson says DB plan sponsors should consider extending their high-conviction investment strategies into potential return-generative ideas—for example, credit and real assets—other than equities. And the consultant warns plan sponsors not to “lend where it’s crowded. Instead, evaluate where you lend and aim to reduce corporate lending risk, given overlap with your equity portfolio.”

In addition, Willis Towers Watson suggests that DB plan sponsors consider integrating investment themes into portfolios, such as environmental, social and governance (ESG) investing. “An area of focus that investors will likely need to embed within their programs is management of climate risk and its potential impact on asset returns,” the report says. “Having a more explicit focus on climate risk throughout your portfolio could lead to alpha opportunities and/or more sustainable cash flows.”

On a similar note, the consultant says diversity, equity and inclusion (DE&I) has never been more top-of-mind for the asset management industry. According to the paper, DE&I evaluation “requires a holistic assessment that goes beyond simply looking at ownership. We believe that ownership is an easily attainable metric that fails to integrate diversity across different functions within an organization. We believe that the only way to have more diverse-owned investment firms is to first have diverse investment leaders and teams. By measuring diversity across these three levels, we believe the resulting evaluation helps provide a more robust and relevant picture of diversity.”

Willis Towers Watson says its beliefs are backed by its research, which shows that investment teams that are more diverse result in greater investment returns.

On a final note, Vaidya says there’s a risk of plan sponsors being unprepared. For some, the funded status improvement came quickly and they adjusted their glide paths, but others don’t have glide paths in place. “Teams in general should ask what their goals are and whether they are prepared as they get closer to their goals to take action and make changes to their portfolios,” she says.

The full list of issues Willis Towers Watson says retirement plan sponsors need to consider in 2022 is in its paper, “Investing With Purpose in 2022.”

«