Hand flipping wooden blocks from 2023 to 2024, text on table.

The start of 2023 was marked by caution, largely influenced by the prior year’s market environment that witnessed several firsts. 2022 was the first time investors faced double-digit negative returns from both equity and traditional fixed income investments in a calendar year. Many defined benefit (DB) pension plans also experienced a rapid change in their financial health, moving from deficits to meaningful surpluses despite the challenging markets. Returns in 2023 have bounced back strongly, though not without many twists and turns. This article reflects on 2023 and offers insights for the year ahead.

Interest rate surprise

The rapid rise in interest rates surprised many investors and the impact varied among investor types. Investors with a total-return goal, such as endowments, foundations and Indigenous trusts, saw portfolio market values drop in 2022 due to negative returns in both equities and fixed income. In contrast, despite negative asset returns, many DB pension plans saw their deficits replaced by surpluses as the decrease in liabilities outpaced asset declines.

Higher yields implied more favourable longer-term returns for fixed income, and discussions in 2023 shifted from the past focus of reducing fixed income allocations towards assessing the merits of increasing allocations for all investor types.

Balancing act

For total return-oriented entities like endowments, foundations and Indigenous trusts, an improved fixed income outlook was welcome. However, historical data suggests that higher fixed income yields can indicate lower equity market returns (see “crystal ball challenge” below).

Registered charities are dealing with the added impact of an increase in the minimum annual distribution quota (DQ) requirement from 3.5% to 5.0% introduced in 2023. This change could lead charities to target higher returns or accept a lower margin of additional return to meet the higher DQ.

The prospect of higher fixed income returns and potentially lower equity returns provided an opportunity for investors to reassess their asset mix strategy to ensure alignment with their goals, particularly if their fixed income allocation has been historically low or well below target allocations.

Opportunity knocks

The start of 2023 brought significant improvement to the financial well-being of many DB plans, after decades of additional contributions to counteract the adverse effects of declining interest rates and subsequent stronger growth of the liabilities compared to the asset growth. The better financial position provided an opportunity to revisit long-term asset mix strategies and risk levels.

The specific actions of DB plans depend on the plan type (e.g., corporate, university or public), actuarial liability measures that drive risk assessments, and other factors such as whether the DB plan is open or closed to new members, and plan maturity (e.g., percentage of active members versus retiree and deferred members). At a minimum, for plans that found themselves in a healthier funded position, there was a strong case for discussing the merits and trade-offs of de-risking.

While it’s unclear to what extent DB plans took the opportunity to de-risk and shift towards higher fixed income allocations, there was an uptick in fixed income search activity in the latter part of 2023, possibly indicating a trend by committees towards reassessing their asset mix strategy. However, the market roller coaster ride in 2023 was evident in both fixed income and equities. Longer-term bond yields experienced further increases at the end of the third quarter and into the start of the fourth quarter, but then yields subsequently declined leading to longer-dated fixed income investments bouncing back very strongly and achieving returns higher than major equity markets. The higher fixed income returns are likely a reflection that liabilities over the fourth quarter increased more than the assets and reduced some of the previous improvement in DB plans’ funded position.

One form of risk management that has continued unabated is de-risking through annuity purchases, especially in corporate DB plans, where the transaction can reduce the impact of DB plans on a company’s balance sheets. Many companies that chose the annuity purchase route for de-risking did so when inflation was low. Depending on the extent of built-in inflation-related pension increases, these companies might face pressure from retirees for ad-hoc pension increases given the higher inflation environment. Under a buy-out annuity, the structure is such that post-transaction there’s no longer a dedicated pool of assets with the plan sponsor for members captured under the buy-out, implying the only source of funding for ad-hoc increases would be the company’s balance sheet.

Tech titans increase market concentration

In 2023, equity returns were dominated by U.S. mega-cap stocks, particularly in the information technology sector, which benefited from investor exuberance around artificial intelligence (AI) and added to the concentration challenges of the bellwether S&P 500 Index. As shown in Figure 1, the S&P 500 Index’s top-10 holdings represented almost a third of the Index at the end of 2023.

Figure 1: Weight of top-10 holdings in the S&P 500 Index

Source: Connor, Clark & Lunn Financial Group and S&P Global Market Intelligence.

U.S. equities typically represent the largest individual component of many investors’ portfolios. Upcoming committee meetings should include discussions on the increasing concentration in the U.S. equity market. This isn’t to say the U.S. technology sector won’t continue to perform well over the next decade. However, it’s prudent to consider the benefits of diversifying the portfolio and to evaluate options for managing potential downside risks should negative outcomes unfold.

While diversification within equity markets is one option, such as leveraging the lower correlation merits of emerging markets compared to developed markets or pairing a value investment style with a growth portfolio, diversifying through fixed income and private market investments may be more advantageous. Therefore, any diversification strategy should include a broad set of investment opportunities and extend beyond equities.

Mixed experience from private markets

Over the past 10 years or so, private markets have experienced significant inflows from institutional investors. In 2023, the returns across various private markets have been mixed. Commercial real estate made most of the headlines for two reasons. First, there was the lingering impact from the COVID-19 pandemic on the office sector, leading to decreased market valuations. Secondly, some commercial real estate managers had liquidity issues, delaying divestiture requests. Other real estate sectors performed well, helping to offset office sector declines in diversified portfolios and contributing to a more optimistic market outlook for 2024 and longer term.

Private equity markets were also challenged in 2022/2023, but the forecast for 2024 and beyond is much more positive. In contrast, the infrastructure market was a standout performer in 2023 and appears well-positioned for the future. Infrastructure is increasingly seen as crucial for supporting clean energy projects and reducing reliance on carbon-intensive assets as part of global efforts to address climate risk. A successful energy transition will require extensive new infrastructure globally, focused on renewable energy sources.

The crystal ball challenge

Forecasting returns is no easy task. For example, a Horizon Actuarial Services survey of U.S. investment managers and consultants found that they significantly underestimated the strength of the U.S. equity market for the 10-year period ending December 31, 2022, and overestimated the weaker returns of emerging markets. The average annualized U.S. equity return projection was 5.9%, compared to the actual return of 12.6%. Emerging market equities were expected to return 7.5% but delivered just 1.8% (all returns in U.S. dollars).

There is, however, a historical correlation between yield levels and the outlook for equity market returns. Figure 2 illustrates the distribution of 10-year historical returns for the S&P 500. The green bars represent periods where U.S. government 10-year bond yields at the start of the 10-year period were below 3.5%, while the gold bars show returns when starting yields were between 3.5% to 5%. For example, when the yields were below 3.5%, around 20% of returns were around 17.5%. The overall average annualized S&P 500 return when yields were below 3.5% was 10.8%. Conversely, when yields were higher, such as the end of 2023, the average annualized Index return was 6.7%.

Figure 2: U.S. equity returns depending on the level of fixed income yields

Source: Connor, Clark & Lunn Financial Group.

Despite the recent decline in yields, longer-term return expectations for fixed income remain higher than what we’ve seen in a while. The level of yield at the time of writing also indicates the potential for lower long-term equity returns compared to previous strong performance.

For private markets, it is difficult to generalize since the outlook is heavily influenced by the specific strategy in which you’re invested. It’s therefore important to engage with your private market managers to understand their return expectations and assess the risk of liquidity constraints, like those recently seen in some commercial real estate strategies.

In other private markets, such as private debt, the current environment has likely enhanced its relative return potential, possibly attracting increased interest from all investor types. As noted earlier, the emphasis on energy transition to address climate risk will likely boost interest in specialized energy infrastructure strategies. Present conditions also provide an opportunity to consider more liquid, higher-yielding assets, such as commercial mortgages, that can take advantage of current higher rates.

2024: Steering through uncertainty

As your committee reviews 2023 performance, there should be welcome relief from strong positive total portfolio returns. For DB plans considering a de-risking strategy, the fourth quarter was a reminder that the opportunity to take advantage of a healthier financial position was not timeless and that there are scenarios where lower yields (and subsequent increases in liabilities) could prevail.

The top-performing market in 2023 was the U.S. equity large-cap market that was a beneficiary from the enthusiasm around AI. While the positive impact of technological innovation may persist, it’s up against a challenging economic, social and political backdrop, along with associated uncertainties. Geopolitical risks, including the U.S. election, conflicts in the Middle East and Europe, and the U.S.-China rivalry could significantly affect shorter-term market outlooks in 2024.

Given the various dynamics highlighted, ensure that committee meeting discussions focus on confirming whether your risk-return profile aligns with your objectives.

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Blocks showing transition from year 2022 to 2023

The market turbulence experienced over the last several years culminated with a major downturn for both public equities and fixed income in 2022. However, the journey along the way did provide useful insights and lessons, particularly from the experiences during the height of the pandemic in 2020. This article considers the extent to which investors heeded the warning signs, or whether they were desensitized to the ensuing risks.

The international risk consultant, David Hillson, defines risk as “uncertainties that matter”. In other words, when reviewing various investment uncertainties, the key is to understand how material the consequences could be if things do not go as expected. The assessment and acceptance of risk varies among investors. This is because different investors have varying levels of risk appetite and risk tolerance.

The practical implications for investors from Hillson’s definition is to prioritize risks when deciding how to respond to them. For example, if a particular risk has a minimal impact and low probability, then you may choose to accept the risk. However, for risks identified as material and with a higher probability of occurring, you will want to act. This may include controlling the risk exposure through better portfolio diversification, or avoiding the risk altogether, if possible.

Insights from the global pandemic

In the recent market environment, the global pandemic surfaced insights and warning signs, including:

  • Further concentration of equity markets, particularly towards technology companies;
  • Increased risk of rising interest rates and potential for negative fixed income returns;
  • Governments around the world working together to manage important global issues.

Equity market concentration

There was no surprise when equity markets declined in reaction to the spread of the pandemic in the first quarter of 2020 as investors responded to the implications for the economy and the fate of individual companies, particularly those in the travel and tourism industry as the world entered various stages of lockdown. However, the speed of recovery was a surprise to most.

Aided by extensive quantitative easing, equity markets bounced back robustly, with several delivering double-digit positive returns for calendar year 2020. Some of the strongest performing stocks globally in 2020 were technology companies that benefitted from the increased reliance on e-commerce during the pandemic. However, the strong performance also led to further concentration in the major equity indices. For example, Apple, Microsoft, Amazon, Facebook and Alphabet Inc. comprised over 20% of the S&P 500 Index at the end of 2020. The impressive performance also desensitized investors to concentration risk.

US equities are typically the largest equity component in most investors’ portfolios, so the increased concentration suggested a review of overall equity portfolio construction was appropriate. For those with a bias to global large capitalization developed equity markets, where the US dominates the overall market capitalization, potential considerations included the introduction of global small cap and emerging market equity allocations.

However, diversifying the overall equity allocation to reduce US stock specific risk did not address the information technology bias, since technology stocks globally benefitted hugely from the reliance on e-commerce during the pandemic. Therefore, an assessment of the overall equity style bias was also in order. For example, value style managers are less inclined to invest in technology stocks, thereby offering a source of sector diversification.

Reducing any bias to technology and growth stocks in general would have been a benefit in 2022, since technology stocks suffered the most for the calendar year. The ups and downs of specific stocks and sectors highlights the importance of having a formal risk assessment process to discuss and address uncertainties that arise, such as concentration risk.

Risk from rising interest rates

Fixed income yields have been in decline for decades, during which time governments and companies took the opportunity to significantly lengthen their bond maturities when issuing new debt. In doing so they contributed to an increased sensitivity to changes in interest rates (duration) for fixed income indices, such as the FTSE Canada Universe Bond Index, and the associated risk of low yields combined with high duration in a rising rate environment. For years “experts” predicted rising interest rates that did not unfold, leading to investors dropping their guard with respect to the ensuing risk.

Moreover, the fixed income market experience during the pandemic simply fueled investor desensitization. In times of equity market stress, a quality fixed income portfolio with high duration can provide an important source of diversification due to an increased demand for safe-haven assets and declining rates, which has seen fixed income markets deliver positive returns when equity markets experience significant declines. The defensive nature of fixed income came through in 2020 with the FTSE Canada Universe Bond Index returning 8.7% for the year, despite the low prevailing yield.

However, the risk associated with low yields and high duration in a rising rate environment reared its ugly head in full force in 2022 with the FTSE Canada Universe Bond Index declining over 11% and the FTSE Canada Long Term Overall Bond Index declining over 21% for the calendar year.

Actions taken by investors with an absolute return goal that heeded the low yield and high duration warning signs included:

  • Adopting fixed income strategies with a capital preservation focus and less sensitivity to interest rates;
  • Relaxing the constraints on fixed income managers with the goal of generating higher added value versus traditional fixed income strategies;
  • Increasing the yield through other fixed income assets, such as commercial mortgages;
  • Investing in higher yielding non-fixed income assets, including direct infrastructure and commercial real estate.

It is a different story for investors with liability-related goals, such as defined benefit (DB) pension plans, where in many cases, despite negative returns from the pension plan assets in 2022, the decline in the liabilities was greater, resulting in an improved funded position. However, for plans using leverage within their fixed income portfolio to increase the liability hedge, the market experience in 2022 may have worsened the funded position.

Due to the asset and liability dynamics of DB pension plans, upcoming risk assessments and related discussions will likely be focused on whether the experience in 2022 has created an opportunity to take advantage of an improved funded position. For example, where the goal is to manage the volatility associated with the funded position, increasing the allocation to fixed income assets could be one risk management consideration.

Governments working together

The global pandemic showed that governments around the world can work together to manage important global issues and created expectations for greater coordination on responsible investing in general, and specifically climate risk.

The current war in the Ukraine and associated impact to the energy supply and prices, saw resource-heavy markets, such as Canada, benefit from their higher energy allocation, which helped limit the extent of market declines in 2022 compared to markets with lower resource exposure. It also highlighted the challenges of adopting a position of no fossil fuel investments within a portfolio during a period when energy was the best performing equity sector.

However, it is crucial for governments and asset owners not to be desensitized to the importance and urgency of transitioning to renewable, cleaner energy, simply based on the recent investment return experience. While the world is still heavily reliant on traditional energy sources and there is still a long way to go to reducing our carbon footprint, a continued and orderly transition to cleaner energy is essential to manage the impact of climate risk.

Looking forward

Market turbulence of the last several years has contributed to desensitizing investors to ensuing risks. Risk management does not only have to rely on sophisticated modelling; it can take different forms including a simple discussion among trustees or committee members, drawing on the insights of investment managers and consultants, and fine tuning the asset strategy and portfolio diversification. In early 2023, take time to formally review your portfolio to identify any uncertainties which may elevate the risk of not delivering on your goals.

US broad money growth has normalised even as the numbers remain inflated by the tail end of the Fed’s QE programme.

The broad money measure calculated here – “M2+”, which adds large time deposits at commercial banks and money fund balances to the official M2 measure – rose at an annualised rate of 5.4% in the three months to February, only slightly higher than a 4.5% average over 2015-19, when the Fed’s core inflation measure was mostly below the 2% target.

Chart 1

Chart 1 showing US Broad Money Measures (% 3m annualised)

The Fed’s securities holdings rose by the equivalent of 3.8 pp of M2+ expressed at an annualised rate in the three months to February.

Current Fed signals suggest a mid-year start to QT. Broad money momentum could fall to a weak level in H2 unless bank lending grows strongly.

Commercial bank loan expansion was rapid in late 2021, partly reflecting high stockbuilding, but cooled in January / February, while demand for home loans could plunge in response to the recent surge in mortgage rates.

The monetary slowdown, as usual, will feed through to inflation with a “long and variable” lag but a reasonable expectation – assuming that current (or lower) growth is sustained – is that core price momentum would return to target during H2 2023.

The slowdown supports the message from the Wu-Xia shadow fed funds rate that there has already been a significant effective policy tightening via the withdrawal of “unconventional” support measures (QE, forward guidance, etc). The shadow rate uses information from the term structure of interest rates to quantify the impact of such measures when the policy rate is at the lower bound. The suggestion is that last week’s quarter-point hike was the ninth not first such move in the Fed’s tightening sequence – chart 2. (This casts doubt on market prognoses based on examining behaviour after previous first Fed hikes.)

Chart 2

Chart 2 showing US Fed Funds Target Rate & Wu-Xia Shadow Rate

The current conjuncture has some similarity to early 2016. The shadow rate had risen significantly during 2015 as the Fed wound down QE before its first hike in December. Subsequent US / global economic weakness caused policy-makers to defer the next hike for 12 months (i.e. until December 2016).

There are two key differences. The obvious one is inflation – core was below target during 2015-16, giving the Fed scope to execute a “dovish pivot” as economic news and markets weakened. In addition, the global stockbuilding cycle was nearing a low when the Fed hiked in December 2015. The current assessment here is that it is beginning a downswing, with a trough unlikely to be reached until 2023. Central banks lag the cycle and typically remain hawkish until well into the downswing (thereby magnifying the cycle).

Both considerations suggest a more sustained Fed tightening campaign – albeit increasingly questionable from a “monetarist” perspective – with a correspondingly much higher risk of a recessionary outcome than in 2016.