A new macro economic regime poses challenges for asset allocation
We all entered 2022 with hopes for a successive return to a more normal world after the past two years characterised by the pandemic. Unfortunately, these hopes were abruptly taken away from us in February 2022 with Russia’s full-scale invasion of Ukraine.
Owing to the war, the global economy was not able to begin a well-needed normalisation following the pandemic. On the contrary, we saw a deepening of several of the problems that the economy was already facing, such as bottlenecks in global production chains, more or less rampant inflation at the same time that economic growth is flattening.
The consequence is that many countries now have to deal with macroeconomic challenges of a kind that we have not experienced since the 1970s.
The market performance during 2022 was a reflection of what happened in the world, and the dramatic events in 2022 gave consequently rise to considerable financial turbulence, with an unusual combination of rapidly rising interest rates and sharply falling values for most asset classes. Thus, there were very few places “to hide”, and diversification did not provide the same level of protection as it normally does.
Consequently, 2022 will go down in history as one of the most troublesome years ever for broadly diversified pension funds.
Central banks’ important balancing act
The world economy is expected to slow further during 2023, and the likelihood of a recession is high. Inflation is expected to fall back, but remain higher than what we have grown accustomed to during the last ten years.
The combination of falling growth and inflation above target levels presents a major challenge for the world’s central banks, where the rapid interest rate hikes have not yet managed to bear full effect in the economy, at the same time as the central banks are trying to curb inflation.
The market’s development will be determined to a high degree by how well the central banks succeed in their work on bringing down inflation without causing a deep economic downturn. The risk of the central banks acting too harshly is high, but there is also a risk that the tightening will be insufficient, which would give inflation a broader foothold.
Long-term perspective still key in asset allocation
With the extraordinary and very uncertain markets that we experienced in 2022 and so far in 2023, it is important to have the determination and ability to maintain a long-term perspective.
Pension funds will continue to need a relatively high share of equities in its asset allocation to best fulfil its mission over the longer term. This means that pension funds will need to be prepared for the possibility of having comparatively large swings in the result from one year to another, and also to have an acceptance for significant negative results during individual years.
As always, in the long-term perspective, when it is uncertain times, it is key to work with the robustness of the portfolio and try to efficiently diversify to build a portfolio that has acceptable behaviour in several rather different scenarios.
With a long-term perspective, the current environment might perhaps also provide some kind of comfort. The higher level of interest rates combined with somewhat lower valuations in the stock markets mean that the starting point at least for the longer term has improved, since long-term return expectations for both government bonds and equities have improved.
Moreover, the higher level of interest rates means also that there is again potential for fixed income investments to once again serve as a diversification alternative in the event of larger declines in the stock market.
Maintaining flexibility to adapt the portfolio
It is equally important to uphold an organisation’s flexibility to be able to quickly adapt the portfolio’s risk to changing conditions.
For example, AP4 work extensively with long-term economic scenarios (10 year) as the foundation for our strategic allocation, and a normalisation of interest rates combined with a structurally elevated risk of inflation have all the way back to 2017 been part of most scenarios.
To reflect this view, AP4 has as consequence made significant adaptations of the investment portfolio over the last couple of years. The ambition has been to maintain the portfolio’s return potential as much as possible, while at the same time strengthen the protection against rising rates and a more problematic environment for inflation.
A part of the above mentioned adaptation of our portfolio is that we have significantly increased the allocation to real assets in our portfolio, with long-term reasonable, stable real cash flows.
Another example is that we have introduced Defensive Equities as a new asset class in AP4’s long-term allocation. This asset class is a category of equities that is specially designed to have comparatively favourable qualities in a somewhat tougher economic environment of the character that now exists in our main economic scenario.
In turbulent markets, and as described, it is important to maintain a readiness to, when appropriate, quickly change the risk profile of the portfolio. However, it is as important to be able to exploit the opportunities that always arise in stressed markets.
This can be exemplified by the very large swings in the relative pricing between various assets classes during 2022, which during several occasions presented interesting opportunities to work actively with equity allocation, currency positioning as well as with the duration of the fixed income portfolio.
Under the spotlight: Niklas Ekvall, CEO, AP4
Niklas Ekvall has extensive experience from managing both organisations and specialists in the financial sector and especially within asset management. He has held leading positions at, among others, Nordea, Carnegie and AP3 and has substantial experience of managing financial risks. Niklas has a solid academic background and has been active at the Stockholm School of Economics.
The AP-Funds have one of the most important and exciting roles in the Swedish financial sector.
Niklas Ekvall is part is a part of our incredible speaking faculty at IMpower 2023. Don't miss out on his session 'What will future asset allocation look like?' on the 27th of June.
Find out more about IMpower 2023 here>>