The Markets April 17, 2018

Guide to the Markets Forecasts Inflation Pressure, Yield Curve Questions

The latest J.P. Morgan Asset Management Guide to the Markets publication asks the complex but crucial question, at what level of U.S. interest rates should we start to worry about a recession?

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Recent market volatility demonstrated that institutional investors are fully alert to the risks posed by higher inflation, according to the latest Guide to the Markets report from J.P. Morgan Asset Management (JPAM).

“One strong wage print in the U.S. jobs report for January sent equity and bond investors running for cover—and the sensitivity is understandable,” researchers observe. “Higher U.S. wage inflation would cause the Federal Reserve to tighten monetary policy faster than expected, having implications for the wider economy and equity markets. However, we expect wage acceleration to be moderate, leading the Fed to raise interest rates another three times this year, only once more than the market expects.”

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Mike Bell, global market strategist for JPAM, hastens to add that interest rates aren’t anticipated to pose a problem for the economy or equity markets this year. “Instead, financial stocks should benefit,” Bell says.

Historically, JPAM finds, equities have not come under pressure until the U.S. two-year Treasury rate reaches above 3.5%.

“U.S. household debt-to-GDP has reduced significantly since the financial crisis. However, U.S. corporate leverage has been rising again,” the analysis suggests. “While currently manageable, we think it will be important to monitor the risk of higher interest rates feeding through into higher corporate debt service ratios.”

The research goes on to suggest the “flattening of the yield curve” is one trend to continue to watch for in 2018. Related to this, historically, the two-year Treasury yield has risen above the 10-year Treasury yield prior to recessions, JPAM researchers observe.

“While the curve has flattened in recent years, it hasn’t inverted yet,” Bell notes. “Importantly, equity markets have historically only peaked after the curve has inverted and often quite some time after.”

JPAM pins the first sell off 2018 to fears of higher inflation and interest rates, and the more recent sell off has been driven by fears of a trade war.

“Concerns around a trade war are currently overblown,” Bell suggests. “Even if tariffs do end up being imposed, it is important to put them in perspective. The U.S. economy is nearly $20 trillion, China’s is close to $13 trillion and annual global GDP is about $80 trillion. So, while a full blown global trade war would be an unfavorable scenario for the global economy, even if the measures that have currently been threatened were actually imposed, the tariffs would be equivalent to only 0.2% of U.S. GDP and 0.3% of Chinese GDP.”

Bell concludes by pointing out that, last year, the U.S. economy grew by 4.5% in nominal terms and the Chinese economy grew by 9.7%.

“That’s not to say that trade concerns aren’t worth monitoring, but it does suggest they’re not yet worth panicking about,” Bell says.

Client Service April 17, 2018

Corporate and Public DB Plans Focusing on Different Outcomes

A study finds most corporate pensions are winding down, while public defined benefit plans are trying to get stronger—paths that will require some common and some different strategies.

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A global survey of 300 pension funds explores the commonalities and differences between corporate and public-sector defined benefit (DB) plans and finds corporate plans are winding down as public plans are strengthening themselves for the long run.

The survey, which was conducted for BlackRock by the Economist Intelligence Unit, reveals nine out of ten public DB plans in the study are open to new members, but only about one in ten corporate plans is.

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In addition, nearly three-quarters of corporate plans overall say they are de-risking, but the proportion rises above 80% for U.S. plans. Among public DB plans, size is correlated with change on several important fronts, with larger plans (those with more than $25 billion in AUM) more likely to have added staff and revised board and staff roles than plans with less than $10 billion in assets under management (AUM).

Commonalities

According to the survey report, change is a major focus as both types of pension funds strengthen governance and investment policies. Nearly three-quarters of the pension funds have created or revised risk appetite and investment belief statements in the last three years, and while these best-practice tools are not new, their prevalence and prominence appear to have increased. More than 70% of respondents say they have enhanced risk analytics, and nearly as many have sought to improve their measurement of investment performance.

Monitoring fees is another major focus. The study finds many plans would take more such steps if they could, but the biggest barrier to governance and investment policy improvements, especially on the public side, is a lack of financial resources, cited by 69% of public plan respondents.

Both types of pensions are rethinking the respective roles of index-based, factor-based and alpha-seeking strategies. According to the survey results, use of factor-based strategies is cited by about three-quarters of respondents, while use of index strategies is also widespread and continuing to increase. Alpha-seeking strategies are still valued but are being applied with greater selectivity and attention to where they may be most effective.

Both types of pensions expect a greater role for hybrid approaches that combine DB and defined contribution (DC) elements. Already adopted by 20 U.S. state plans, hybrids look likely to spread. Around three-quarters of global public DB plans expect to offer a DC plan to beneficiaries in the medium term. A slightly smaller proportion of corporate plan respondents expect that over the medium term, their DC plans will be able to employ more of the strategies available to their DB plans.

Differences

The majority of corporate DB plans are de-risking, and runoff on the balance sheet is the likeliest endgame, according to the survey. Nearly three-quarters overall say they are de-risking, with respondents in the UK and U.S. most likely to be doing so. Of the de-risking corporate plans, 51% see immunization and runoff on the balance sheet as the likeliest endgame and 41% anticipate a pension risk transfer (PRT).

Public plans are relying more on private assets and enhancing their ability to invest in them. Nearly three-quarters say they have improved risk analytics to facilitate investments in private assets. More than half say they have added investment professionals to focus on such assets and support their pursuit of potential premiums for bearing illiquidity and complexity risk.

Multinational corporate DB plans are coordinating national plans—and in some cases pooling assets—to benefit from scale. Among corporates, nearly 40% are employing common investment strategies and/or managers for different national schemes, with 26% reporting a common strategic asset allocation and 11% saying they have consolidated some assets.

However, only a small number of the public plans have completed a consolidation, and fewer than one-fifth are currently consolidating or have plans to do so. At the same time, large funds are doing more than small ones to strengthen their organizations and add the resources needed in a more challenging climate.

“Drivers of change have been building since the turn of the century. From the setbacks dealt by the post-2000 and post-2007 downturns to the current swirl of demographic, financial and political challenges, the need for funds to adapt and adjust has steadily grown,” says Edwin Conway, global head of BlackRock’s Institutional Client Business. “These forces have pushed DB pensions down two diverging paths. More and more corporate DB sponsors have chosen to wind down their DB plans, while many non-corporate plans are shoring up their models to better serve their participants over the long haul. These basic storylines are playing out around the world, albeit with plenty of local variation resulting from regulatory, cultural and other factors.”

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