In the wake of the Lehman collapse in September 2008, the global economy and banking system faced meltdown. Many feared a re-run of the great depression. This view failed to reckon with the powerful tools available to policymakers. More recently, the policy responses to the pandemic have seen these tools deployed with renewed and expanded aggression.
For example, negative official interest rates are the new normal in Europe and bond investors at every maturity out to 30 years are paying for the privilege of loaning money to many Eurozone governments. More generally, negative real long-term interest rates are now embedded globally.
For long-term investors, this is creating a difficult double challenge: the rising cost of meeting liabilities combined with the falling return on fixed income assets.
This is especially acute for Pension Funds and Insurance Companies who traditionally have a very high exposure to fixed income assets for ‘risk’, regulatory and ‘liability matching’ purposes.
According to data from Willis Towers Watson, global pension fund assets totalled over $50tn at the end of 2020. The ongoing exposure to negligibly returning cash and fixed income assets is a growing challenge for these funds. Meanwhile, ‘general account’ (GA) insurance assets are estimated at around $30tn. Once again, the exposure to negligibly returning cash and fixed income assets is a clear and growing challenge. The allocation to such shrinking returns in Europe is especially striking.
The price to earnings ratio is a relationship normally cited for equities. But as a tool for comparing the earnings of any asset, with the price of that asset, it can be usefully employed elsewhere. It is after all just the earnings yield inverted.
So, for example, a yield of 1% on a bond is a price to earnings ratio of 100 i.e., a ratio roughly that of the Japanese and Nasdaq stock-markets at their peaks in 1989 and 2000, respectively. Described this way, the large and continuing exposure of long-term pension and insurance investors to fixed income is troubling. The argument that it reduces ‘risk’ seems especially misplaced.
In a 2006 memo simply called ‘Risk’, Howard Marks of Oaktree Capital sought to broaden the debate about investment risk from the actuarial and the conventional. In an updated memo in 2018, ‘Risk Revisited’, he returned to the fray with the crucial insight that:
‘Investors face two major risks: the risk of losing money and the risk of missing opportunities. Either can be eliminated but not both. And leaning too far to avoid one can set you up to be victimized by the other.’
For pension scheme members, trustees, actuaries, regulators, and investors it’s time to stop sleepwalking mechanically into such an outcome. The author and economist, John Kay, has summarised the issue with a typically apt analogy:
‘Do not confuse security with certainty. The man who knows he will be hanged tomorrow has certainty, but not security. His fate is not much more comfortable than that of the saver who today plans to use bonds as a vehicle for retirement saving — the certainty such a saver will achieve is the certainty of a low standard of living in old age.’
Author: John Looby is a Senior Portfolio Manager on the global equity team at KBI Global Investors. The views expressed are his own.
His new book, ‘In Search of Returns: Making Sense of Financial Markets’, has just been published by Oak Tree Press. In grappling with the challenge of investing, it will help the reader to:
- Evaluate the relationship between ‘expected’ risk and return in financial decision-making.
- Understand different asset classes and investment strategies.
- Appreciate the influences of cognitive biases in asset pricing and investment behaviour.
It’s a timely guide to making sense of financial markets, covering active investing and value investing, the ‘dumb money’ effect, why banks are different, and managing foreign exchange rates and exposure, as well as the key challenges ahead for investors. And in stark contrast to the frenzy that currently – and too often – grips the market, the final chapter references the Latin maxim: festina lente – hasten slowly.
The book is available in hard copy, ebook and ebook pdf formats at the links below: