It’s all relative (to liabilities)

04 November 2022

Relativity and predictability have a place in navigating financial market fluctuations. But never forget the words of physicist Leonard Susskind that 'unforeseen surprises are the rule of science, not the exception. Remember: stuff happens.' Focus needs to shift away from traditional asset allocation approaches towards those that are more liability driven. As investors tackle global recession fears as well as lingering inflation, Ashburton Investments can help plans maintain their desired objectives of meeting their liabilities when they become due.

Commonality of activities has evolved to the point where we all have time and money in common. This commonality has ensured that financial market participants engage in activities that give to some and take from others.

Some market cycles can lead to symmetrical effects, while others lead to asymmetrical effects. It’s the asymmetry that worries financial market participants.

Recession fears are a sign of asymmetrical behaviour in the markets. And, in a more global environment, this asymmetry tends to be inflated. As we saw with the Covid-19 pandemic, globalisation can be helpful, but it can also create chaos.

 

RECESSION CONCERNS

Currently, recession fears in the United States (US) have spilt into other parts of the world, both developed nations and emerging markets. As evidenced by recent market activity and performance, the asymmetrical nature of recessions is undeniable. The war between Russia and Ukraine has impacted various markets differently, with some feeling the lack of resource * See China Common Prosperity policy. supply more than others. Nonetheless, we must all still worry about time and money. Each consumer and saver worry about 'the enough' at their disposal: Is there enough time to build up? Or is the money they have sufficient to live comfortably?

Such concerns are naturally linked to questions of inflation. Not long ago, market commentators were debating the nature of inflation. Some arguments were that it's transitory while others were that it's enduring. However, if you fast forward to the present, there really is no more debate. Rather there is agreement that central banks are fighting to contain inflation as it continues to trend higher (see Figures 1 and 2).

The world is wrestling with the risk of underinvestment because uncontrolled inflation will lead to the erosion of monetary resources. Here, the real return or value of investments will be very low and, in most instances, negative. To play catch-up will be a daunting task which is out of reach for many investors. The world is wrestling with the risk of underinvestment because uncontrolled inflation will lead to the erosion of monetary resources. Here, the real return or value of investments will be very low and, in most instances, negative. To play catch-up will be a daunting task which is out of reach for many investors.

 

Figure 1: G-10 YOY CPI
Source: Bloomberg

 

Figure 2: BRICS YOY CPI Source: Bloomberg

 

AND THEN WE WENT HIKING...

The world now collectively agrees that the inflation call was all wrong. Unfortunately, the nature of globalisation means that those who arrived late to this realisation are left playing catch up. At the time of writing, the US Federal Reserve (Fed) had already delivered three consecutive 75-basis-point rate hikes. Combined, the central banks of the 11 member countries of the Group of 10 (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) had delivered 1 965bps of hikes. Those who have refused to do more, like Japan, were being punished to such an extent that it necessitated the intervention of authorities to protect the currency.

The point is that we can no longer rely on cheap liquidity, and when liquidity becomes expensive, markets tend to gyrate. We then witness a flight to quality, leading to a painful bear market which is characterised by a prolonged decline in prices. The figures below show how the markets have suffered year-to-date because of the hiking activity and the recession fears. The performance of the indices reflects behaviour normally observed in a bear market - namely a lack of or low confidence in financial markets, as well as pessimistic attitudes towards the future, which leads to persistent asset sales, as illustrated in the figures below (see Figures 3 and 4).

 

FIGURE 3: S&P 500 INDEX
Source: Bloomberg

 

FIGURE 4: NASDAQ COMPOSITE INDEX Source: Bloomberg

THOU SHOULD NOT DEVIATE FROM OBLIGATIONS

Traditional asset allocation has always placed emphasis on what happens to an investor's assets. However, when one has obligations that need to be met, it's important that they pay attention to these throughout market evolutions. For institutional investors like pension funds and insurers with future liabilities that must be met, this perspective becomes relative.

Traditional asset allocation can lead to devastating effects on the investor's obligations when markets turn bearish, leading to unwarranted balance sheet volatility. Predictability is important where liabilities are concerned. Inflation can be a big enemy for defined benefit pension obligations. Preserving the purchasing power of benefits is important for sponsors. To do this, focus needs to shift away from traditional asset allocation approaches towards those that are more liability driven.

Here, liability-driven investing (LDI) plays a major role in helping investors minimise the volatility of their liabilities. LDI as an investment approach focuses on managing the risks that affect liabilities, which are interest rate and inflation risks.

When implementing an LDI strategy, the focus shifts from measuring risk using standard deviation to using surplus volatility. The aim is to find a balance between growth and risk, i.e. surplus volatility. Due to the limiting impact of inflation on plan liabilities, hedging these through inflation-linked instruments while also allocating to growth assets can provide a solid strategy for a pension plan. Globally, the market for inflation linked debt has grown because of the increased demand for reliable inflation-hedging instruments. For LDI portfolios, inflation-linked bonds play an important role, mainly due to their diversifying ability – their low correlation with other asset classes – and capability to provide a risk-free hedge to liabilities.

 

GET THE RIGHT TOOLS AND GET THEM EARLY

Liability-driven investing is not limited to the consideration of a single asset class; the LDI framework can - and should - be applied across all asset classes to arrive at a holistic view of the volatility of all asset classes relative to the liabilities. It focuses on long-term goals while simultaneously ensuring that acceptable investment outcomes are achieved in the short term.

Ashburton Investments, through its capable and proven LDI capability, offers clients a broader set of tools that help investors implement a sustainable LDI framework. Through a combination of erudite portfolio construction and risk-management techniques, clients are exposed to excellent tools that provide access to different sources of return, including inflation-linked bonds, listed as well as unlisted investment grades and high yield credit.

The business' LDI capability and cutting-edge approaches, are customised to each investor's plan needs, helping institutional investors achieve their goals of minimising surplus volatility and reaching their desired funded status. As investors tackle global recession fears as well as lingering inflation, Ashburton Investments can help plans maintain their desired objectives of meeting their liabilities when they become due. Our approach focuses on each investor's objectives by managing their assets relative to their liabilities, helping to achieve predictability.

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