Irish Pension Funds and Property: Where to next?

The ultimate “Safe Haven”? 

It’s how many see Property as an investment – it’s not true of course, but it does give us a sense of where it stands on the risk spectrum.   

Certainly in 2022, for Irish pension funds and investors generally, Irish commercial property has played this role in what has been an abysmal financial market environment. 

Most, though not all, Irish property funds are showing small positive returns in 2022 – while stocks are in a bear market and bond yields have surged. Other investments such as so-called Absolute Return funds available in Ireland are also deeply in the red.

Typically an Irish pension fund might hold 5% in commercial property – it’s been higher in the past. Some would hold higher – some none at all. This is in turn allocated to the Office, Retail and Logistics (Industrial) sectors. 

Today a confluence of factors sees all three sectors are in the midst of seismic shifts.

Office has always dominated commercial property portfolios and probably accounts for about 60% in a typical fund. Rents today point to the city centre still being sought after with rent levels over twice what’s being charged in any of the suburbs. We continue to see substantial activity here. And while issues such as global and domestic growth always play a role here, we are also facing the impact of new factors such as hybrid working and an institutional drive to sustainability. 

Some potential office occupiers are understandably delaying expansion and relocation decisions until we can see greater clarity on what the week  in the office will look like.

In other words –  do we need the space?

It’s simply too soon to say where the endgame is on hybrid working. There is a lot of flux between employee surveys, corporate intentions and the health environment. Throw the energy crisis into this and any forward looking view on the extent of hybrid working is unsure. Perhaps the most that can be said is that in Ireland today  about 31% of the workforce are not in the office five days a week. That number has come down and in all likelihood will fall further even if we’re not sure to where.

Return to office plans have been making headlines since mid 2020. Ultimately the issue will not just be about space. McKinsey say that executives should focus on making the workplace matter and measuring that success. There is a need to design and activate offices that truly foster human connection. It’s a complex issue; McKinsey highlight research which shows that work experience accounts for at least half of the average person’s human capital. That cannot be squandered in remote working.

Owned space can also be repurposed for other activity that can still meet corporate goals. A US insurance company has donated some space to third level education – creating a “triple bottom line” for the company, the local community and society. 

The other watchwords sweeping through the Irish office market are sustainability and resilience. Property is pivotal in the race to net zero.

The OECD recently noted  that buildings and construction account for nearly 40% of global energy-related CO2 emissions and, in larger cities, sometimes as much as 70%. 

Many occupiers and investors have made bold and public commitments around decarbonisation with goals of 2030 or sooner. 

This trend is irreversible. 

JLL estimate that zero carbon commitments are expected to double over the next two years from 43% to over 80%.

The good news is that huge strides have been made by builders and developers in pursuing this agenda.

IPUT, for example, which is the largest office owner in Dublin, has had ESG factors embedded in its DNA for decades now and its practice and processes reflect standards many still aspire to. Through new builds and refurbs to science-based targets and occupier engagement, a truly holistic approach has been shown to work. It is now working on its first net zero carbon build.

So there will be a supply of best in class office space but also a stock of secondary buildings with poor ESG metrics. The investor will need to choose wisely.

While office dominates portfolios and grabs headlines, other sectors are also undergoing fundamental and unprecedented change. 

As regards Industrial, the post covid obsession on supply chains, puts emphasis on “near shoring” and probably higher local inventory levels. Strong demand with little supply has seen rents rise and under-pins further advances. Corporates with a clear ESG mission will insist upon sustainability levels through the supply chain. Investors should do like-wise.

The Pandemic had a huge impact on trends in retail. During lockdowns, on-line sales in Ireland naturally rose to 15-20% of all retail sales based on CSO data. These levels, not surprisingly, fell back on re-opening, but settled at higher than pre-pandemic levels. The issue for investors looking at the Retail property sector is that some, such as consultants Oliver Wyman, see the on-line proportion moving to 25% over the next 5 years. Even for those who don’t avail of on-line, frequency of trips may have reduced. 

Transaction activity in the sector is recovering from almost nothing in 2021 but investors need to think long and hard about how consumer habits may have changed for good.

An investor in Irish commercial property needs to consider (as they always have) risk of tightening financial conditions, level of supply, level and breadth of demand, valuations etc. Liquidity and vagaries in pricing are also ever present factors.

Current yields, at around 4%, stack up quite well in European comparisons.

Investors need to consider what sector offers the best risk return profile.

But perhaps today there is an imperative to drill deeper into those sectors and identify the winners and losers in a world of decarbonisation, hybrid working supply chain rebuilding and changed consumer habits.

For the investor, this may present more challenges – but also more opportunities.

Should Investors just forget about Emerging Markets?

It is one of the key tenets in investment.

If you take on more risk, you expect more reward.

It underlies why we invest in start-up businesses, new technologies, illiquid assets and much, much more. And it explains why individuals and institutions have ploughed vast sums into Emerging Markets.
Emerging Markets, now taken as a given asset class, really came to the fore in the 1980’s as investors looked to enhance what they assumed would be moderate returns from developed markets. An Emerging Market (EM) was usually smaller with lower per capita income, had some characteristics of a developed market, but did not fully meet its standards in terms of liquidity, transparency, regulation etc. Think Indonesia, Ecuador and others.
The asset class exploded in terms of investor interest and assets invested. The main components within EM were Asia, Latin and South America, and Central and Eastern Europe.

So has EM delivered for investors in the past 15 years or so?

In terms of risk, the answer is yes. The standard deviation of returns has been higher in EM than Developed Markets. For Latin America, risk levels have been almost double. Drawdowns in EM have also been more severe.

It’s a different picture when it comes to investment returns. In the past 15 years, EM equities as measured by MSCI have delivered cumulative returns of about 130%. Developed markets for the same period are up 220%! There have been blowout years such as 2009 when EM stocks rose 80% compared to mainstream returns of 30%, but these were often catch-up years. Over the longer period EM has failed to deliver.

We have also seen performance diverge within the EM universe. We have for example seen Latin American stocks in negative territory when the overall EM outcome was positive.

So how does EM stack up today?

In the past 5 years, EM trailed Developed Markets by about 5% per year in investment returns. This is probably not surprising – EM economies had a tough Covid. Delayed vaccination and less fiscal ability to support the economy meant low growth and weakened government finances. It also means any rebound will be constrained. Within EM, Latin America endured an especially high level of suffering. Brazil, for example, experienced 34 million cases and nearly 700,000 deaths. This poor social and economic picture is reflected in financial market outcomes. In 2020 when EM overall posted a positive return of close to 20%, Latin America was down by nearly 15%. This divergence in performance continued into 2021.

But in 2022, we have seen a closing of this gap. EM markets are off 17%, In common with global equities.

But Latin American stocks are up by 7%.

This difference has nothing to do with business models, corporate strategies, or any other micro issues. The gap is due to two global trends – surges in oil prices and other commodities notably copper. Chile is up close to 30% reflecting the improved price environment for copper – its signature export. Other countries such as Brazil are effectively petro-economies and record energy prices have boosted government finances.

This matters as investors need to be clear on market drivers, their sustainability and likely direction.

And it is important that such drivers, no matter how powerful don’t distract from what may be less positive undertows. Politics may well play a role in many Latam countries over the next 6 months. Argentina has a 100% inflation rate, a divided government and a recent assassination attempt on the vice president. Chile has a left leaning government which recently had its proposed new constitution voted down by the people. Brazil is facing into October elections, where a victory (claimed or otherwise) by Bolsonaro, a politician who makes Trump look like a beacon of integrity and gravitas, cannot be ruled out.

Investors need to take such issues on board, together with the issues of interest rates and inflation which EM is facing into in common with global markets.

How should investors look at EM now?

c The premise that higher returns will accompany higher risk has not be borne out

c EM is not a homogenous asset class but can display a wide range of returns.

c EM are still tightly linked into global, macro trends.

There is no shortcut. The golden age for EM started with absurdly low valuations.
Today this may apply to selected stocks – but not in aggregate.

What’s Moving Markets?

    

Just what is driving global stock-markets in 2022? 

A stuttering start to the year, based on fears around economic growth and rising energy prices, was followed by the Ukraine war induced decline into early March. Markets then rallied from about St. Patrick’s day to the end of March only to fall more substantially by about 20% on renewed and indeed reasonable inflation fears. This was the bear market many feared.

But stock-markets staged a strong recovery from mid-June to late August. Earnings season came and went with little market response, as previously reduced company earnings forecasts were easily met. Also most economic forecasts were being downgraded – so there was little positive for stock markets in that.

The strong Summer rally was really facilitated by comments from the US Central Bank that interest rates might not be that far off neutral, and markets took heart that future rate hikes could be more modest. 

But now the S&P index has lost over 7% from its recent high.

What is driving financial markets today?

 —– Central Banks. 

This last market fall can be traced to the comments of the US Federal Reserve Chair Jerome Powell who at the Jackson Hole symposium called for “forceful action to restore price stability”. This torpedoed any market confidence that US rate increases might moderate. Any improvement or stabilisation of inflation rates we have seen, falls far short of where the Central Bank wants to get to. The prospect of a further 0.75% increase in September was left firmly on the table.

In what was really a call to arms for Central Banks around the world, Jerome Powell said the responsibility to crush inflation was unconditional. He affirmed that the US Central Bank won’t stop until the job is done.

This was a more “hawkish” tone than the market had been expecting. Some commentators took too much comfort from mid-summer inflation statistics that showed headline numbers falling back as food and energy (both highly volatile) declined from higher levels earlier in the year. But Central Bankers look more at core inflation and inflation expectations. The issue here is that core inflation can be quite sticky. Some of its principal components include rents and services where prices, once higher, can be difficult to peg back. This requires a vigilant Central Bank and points to an interest rate profile that may be less market-friendly.

Will other Central Banks heed the call of the US to recognise unconditionally the need to be forceful in tackling price inflation?

The ECB is next up to take a swing with the interest rate bat. While the language and imagery from the Federal Reserve has shifted up substantially as we have seen, the forward guidance from the ECB is still, to a degree, “Emm….” 

ECB Chief Economist Philip Lane favours a gradual step by step, meeting by meeting, approach and typically smaller increments when it comes to upping rates. In fairness, this was also his view prior to the last hike which proved wide of the mark.

However many of the heavy hitters on the council – such as Schnabel, Muller and Knot –  are looking at rampant inflation and calling for more dramatic rate hikes – some for a 0.75% increase, similar to the US.

Communication from the ECB continues to be less than clear, and this further increases the market nervousness in what will be an uncertain regime of rising interest rates anyway.

Central bank policy has been at the centre of what’s driving global stock markets in this latter part of 2022.

Even though we may see bigger instalments of hikes than a typical cycle, it may still be quite a drawn-out reversal in inflation. Core inflation has a tendency to be more “sticky” and if Jay Powell’s vow to “keep at it until the job is done” holds up, interest rate levels and policy will continue to be  significant market drivers for some time to come and markets will be wary of any Central Bank errors.

Jerome Powell and his Federal Reserve say they are braced for more pain – but is the US economy? 

The Global Food Crisis and Pension Funds

We are in a global food crisis.

While food prices have eased somewhat from the highs of March April, they are still 43% higher than 2020 levels (as measured by the FAO index). Though the rise is widespread, grains have been to the fore in pushing higher. In lower income countries, where food makes up a large portion of consumer spending, it is hard to compensate. In Egypt, food accounts for over a third of household spending. In Ethiopia that figure is 38%; Mozambique 60%!

It has never been more expensive to be poor, according to Oxfam

But the statistics too readily bleed from the page to mind pictures of what this actually means – 770 million people went hungry in 2021. 

2022 will be higher

2023 will be higher again. 

A leaked UN email speaks of 60 countries struggling to afford food imports this year. This is all coming after a 6 year period of low and often falling foodstuff prices.

This doesn’t feel temporary. This is not just because of the war – there are multiple major causes behind it. Broken economies due to Covid, widespread droughts and dismantled supply chains are all part of the cause. Some analysts believe the true impact of this combination will only become apparent next year.

So, where do Pension funds come in?

Most major pension funds today invest across a wide range of assets and look for those assets which may perform at different times and so reduce the overall portfolio risk. Commodities have been one such “alternative” asset class that investors have looked to. While energy and metals were the mainstay of such exposures, many of the leading players in this field looked to include agri-products such as grains, oilseeds and other soft commodities from the early 1990’s. It’s been a target for investment funds generally. It is estimated that the number of investment funds backed by agriculture grew from fewer than 50 in 2005 to over 600 today. 

One possible question is does institutional investment in commodities push up prices, to the detriment of subsistence farmers in the Horn of Africa who requires seed for next year’s crop.

Some may argue that much of this investment is in swaps, ETFs or futures rather than direct, but ultimately upward pressure in derivatives can lead to arbitrage opportunities and actual buying of commodities. S&P noted a net long position of over $50 billion in agri-commodities in the middle of this year  – a huge amount of buying by investment funds. The corresponding figure in 2019 was a net “short” $13 billion. Analysts have shown that the degree of speculative as opposed to fundamental activity rises dramatically as commodity price rises. Oxfam continue to liaise with many of the sponsoring banks to control and curtail this investment behaviour. 

Standard & Poor view this institutional buying as a “contributing factor in pushing prices higher”.

Pension funds should also apply laser focus to any hedge fund holdings they may have in their “Alternatives” category . Many hedge funds have a “go anywhere” mandate and may look to generate returns as global food prices rocket. This can be less easy as exposures are often opaque but should emerge in pre-emptive due diligence

Pension funds need to drill down to fully assess the impact of all exposures.

The impacts of the global food crisis needs to be assessed in the round. There are knock-on effects which investors in Emerging or Frontier markets need to be aware of. Soaring inflation and the inability to feed a family have in many cases meant an increase in social unrest which has implications for  the risk assessment, investors should apply to any investment case for many of the “newer” emerging stock markets. Many such Emerging markets, still struggling to pay for Covid, have been beset by social and political unrest. The IMF Social Unrest Index has been rising steadily since 2021. Recent examples include Sri Lanka, Kenya and Nigeria.

By being diligent, Pension Funds can ensure they are not part of the problem, but there is also clear opportunity to be part of the solution. 

Improving farmlands, greater access to agronomists, increasing yields, tackling irrigation etc. are all long term projects and ideally suited to the time frame for pension funds. There is a clear role for public and private finance here which can be sustainable into the future and produce financial returns. 

Pension funds can have serious impact in this area.

As Pension funds wrap themselves in the mantle of Environmental , Social and Governance concerns, they should ensure that the reach of that impact is global and not just parochial.

Forget the economists – what they are saying on the Street?

As the second quarter company earnings season closes out, it provides a good window on to what’s actually happening on the ground in the US economy.Rather than listen to the economists and analysts, we can hear what the women and men who actually run companies, and have to report to shareholders, think where we are in this business cycle.

The numbers are less important than what forward guidance is given by management, and what answers are given in post announcement briefings. The earnings numbers themselves are part of a highly choreographed exercise to make sure market expectations are not out of synch with economic reality. 

So, what can we tell from what CEOs are saying?

Profit margins are under pressure. 

This is the second quarter when year on year margin comparisons are negative for most sectors – Energy being a major exception.  

Higher material costs, higher transport  and labour costs are quite a common feature in what executives managers have to say.

Domino’s Pizza, for example, faced with higher energy prices, higher flour costs, and shortage of drivers have actually had to discount to retain demand. Naturally this hits margins  – for the pizza maker gross margins fell this quarter from 40% to 36%.

Can anyone pass on cost increases to customer prices and preserve margins?  Pepsico, maker of Quaker Oats and Frito-Lay, one of the earlier companies to announce, pointed to their core business where price increases were having no negative impact on demand. They have increased prices twice already and see more room to go further if required. There is a similar story over at Coca Cola where CEO James Quincey spoke about their ability to push price increases through to offset the rise in fructose, aluminium and transport costs, but he cautioned that there will be limits to doing this continuously. Unilever also spoke about being able to pass price increases through on a lot of their premium brands. 

Despite what may be near term recessionary fears, companies continue to invest – especially in technology and especially in the “Cloud”. We can see this in the numbers from some of the companies which often facilitate that investment.  IBM. In this quarter, saw robust demand growth, making for double digit performance from its consulting side. This cloud migration theme was backed up by very  strong numbers from Microsoft coupled with a very positive outcome.

What about the health of the economy overall? Most companies refer to macro-economic challenges. But is the US entering a full-blown recession?

Well a lot depends who you listen to. Many companies are cautious. Apple for example, well in advance of their announcement, surprised the market, saying they would look to slow-down hiring and spending  in 2023 to cope with potential economic down-turn. It wouldn’t however be company-wide but in selected teams.

But it’s not universal and many CEOs speak of resilience in the economy and notably the consumer. General Motors, historically a bellwether stock for the US economy, speaks of robust demand and a strong pricing environment and in fact didn’t have enough vehicles to meet demand. This positive view on the all-important US consumer was repeated by many of the main street banks. Looking through what was said at press conferences, the message was not to jump on the recession bandwagon just yet – at least not a consumer-led one. 

Citigroup CEO Jane Fraser said little of the data she sees suggests a US economy on the brink of a recession, with strong household savings providing a “cushion for future stress”. Jamie Dimon, CEO of JP Morgan, thinks the consumer is in great shape. Even low income households have cash balances 70% higher than in 2019. And as for business credit, Dimon thinks it has never been better “in our lifetimes”.

So what’s the picture from what managers are saying in this US earnings quarter.

Some companies are able to pass on price increases to their customers and thereby ease some margin concerns. Others are less well positioned.

But the most important thing seems to be this – the consumer appears to be in good shape – certainly much better than when the economy flirted with downturns on previous occasions. 

This may well be the vital difference that means any US economic downturn could be shallow.

Beyond the Beaches

Every evening, as the blue of the night darkens, the Paseo Maritimo, which winds its way  from Marbella to Puerto Banus along the Spanish coastline, is once again thronged with locals and tourists, Spanish and international, as they stroll before or after dinner, incessantly chatting, catching up on the news of the day.

The ambience is positive and relaxed as many are happy to get back to what was taken for granted in pre-Covid times. Indeed there are quite a few reasons for positivity in this area of Andalusia.

Tourist numbers are up of course, which is perhaps the single biggest driver of a positive economic outcome, but the spill-over effects are now seeing the Costa del Sol progress at a faster pace than the rest of Spain.

Andalusia now has higher economic activity, exports and property sales than prior to the Pandemic and has outpaced the national averages. But where the Costa economy has done especially well has been in the growth of the official workforce. This is now higher than pre-pandemic. One of the unforeseen side-effects of Covid was to nudge many Spaniards out of the informal economy, and into regular employment. Income tax collections from workers have been outpacing GDP. The desire for social protection, decreased use of cash (for hygiene reasons) as well as government action has reduced the use of cash filled envelopes or “sobres” as worker compensation is now based on legal contracts and tax compliance has become the norm.

The near term picture for the Costas looks bright. Tourism numbers, barring any Covid resurgence, are holding up really well. Sentiment surveys show Irish consumers determined to have a holiday and CSO data suggest that in 2022, the number of Irish visitors to Spain will be a lot closer to pre-pandemic levels. Before Covid about 2 million Irish tourists visited Spain.

Spain’s Industry Minister Reyes Maroto sees tourism business in 2022  surpassing pre-pandemic levels.

But beyond the Costas, the picture is less rosy. Spain probably suffered the most economically from the Pandemic. In the second quarter of 2020, Spain’s GDP (PIB) declined  by 18% and has yet to make it back. Spain is experiencing what the Spanish Central Bank has labelled “an incomplete recovery in an uncertain environment”.

Business and consumer confidence across Spain has imploded. The last reading on sales of household goods was negative. Spending on big ticket items is under pressure. Spanish car sales are forecast to be down on the year by about 3%.

Q1 this year posted a growth rate of just 0.2%

Even where we will see growth and investment, it comes with caveats.

One of the larger employers in Spain is  auto manufacture (accounts for 10% of GDP), which has been under pressure now for a number of years. Chip shortages in 2021 caused many plants to be idled and production lines cut. There is little sign of the industry returning to robust health in the next 6 months. Looking ahead, we will see substantial investment in electric  vehicle manufacture – but even that is bittersweet. 

SEAT are looking to expand in EV at both Pamplona and Martorell, but as such manufacture is less labour intensive, SEAT are forecasting a loss of 8000 jobs. Ford in Valencia is also looking at future job losses as they invest in EV plants.

A 10% inflation rate dominates newspaper headlines. The Head of government statistics resigned rather than continue to bring bad news! Despite surging public deficits, the government is pushing ahead with its emergency Stability Programme, which aims at adding 1.5 million new jobs. Social welfare payments like pensions for the most vulnerable are being increased by 15%. Energy bills are being reduced and public transport subsidies extended.

Many Irish visitors to Spain this summer, will see a vibrant local economy, with full restaurants, crowded beaches, and signs of re-commencement of building works.

But beyond the Costa economy, it’s a very different picture, with the rest of the country dancing to a different and more sombre beat.   

Fund Management: What’s working – what’s not

Markets have been unforgiving in 2022. Especially in the second quarter. 

A pincer movement between inflation and growth has compounded the concerns about the war in Ukraine to wreak havoc on many sectors in the world’s stock markets and in investor funds. Fund managers have had quite different experiences depending on how they have been positioned.

Looking at Irish Balanced Managed funds all with a risk rating of 4 (which might suggest we should be looking at reasonably similar outcomes), there is over a 10% range in returns delivered by managers in the last six months. For sectors like North America, the dispersion of returns can be over 20%.

So clearly fund managers have positioned portfolios differently.

For those who like labels, we can look at how value and growth styles have performed so far this year. Growth clearly has been in the ascendancy for decades with value making brief forays into the limelight. 2022 seems to be on the those episodes, and the numbers are startling – US Value is down by about 9% but US Growth is off 28%. So both styles have delivered negative returns

The catalyst for Growth’s decline is most likely higher interest rates which choke the present value of future income streams. But it’s also the case that there has been a negative business backdrop for many of the key names. The table below highlights the businesses which would feature in a US Growth index and how their prices have performed so far this year (correct at time of writing):

Amazon-38%
Apple-27%
Facebook-49%
eBay-35%
Google-26%
Netflix-70%

These stocks have been clear winners in recent years – even performed well in the pandemic economy – but have now torpedoed portfolio performance for many.

Higher yields and interest rates will continue to put pressure on growth stocks, but for some stocks that may already be in the price – especially if the view that the rate of inflation may have peaked in the US proves correct.

Did it make any sense diving deeper and maybe getting some “cover” from market conditions in the small cap arena? There has been little relative benefit from owning smaller stocks in 2022 so far. In the US, small cap indices have been as poor as their larger cousins, while in the UK small cap stocks also posted significant losses.

Even funds with the ability to go short (and benefit from falling asset prices), so called Absolute Return funds have found the conditions difficult to navigate. Over the last 6 months the two highest profile absolute return funds in Ireland on average are down 6 to 8%.

There seems to have been no hiding place for mainstream investors in 2022 to date. Obviously assets like property have performed well as rents are holding up and there is no “mark to market” risk. For a typical institutional property fund, we are looking at a 2-3% return over the last 6 months.

Even for a fund manager who had 20/20 vision and opted to overweight commodities, it wasn’t straightforward. Of course energy has done well. But in recent years many investors, wary of the geo-political risk or “ESG” risk in the energy sector, looked for indices which excluded energy but instead concentrated on the more economically sensitive industrial metals. The difference is stark. Broad commodity indices are up about 40% year to date; non-energy versions are up less than 11% and in fact have been in decline since March.

In a world of tumbling bond and stock prices, it’s been hard to find a safe harbour, and tough to act in a timely fashion. Large institutional portfolios with their incremental decision-making processes bear a lot of market pain. Many of the broker strategists stick with (usually) higher equity contents even as stocks free-fall.

Even at a stock level, it can be hard to reverse opinion, even in the face of extreme performance. Last week, an analyst with a major Wall Street firm lowered their recommendation on Netflix – after the stock had declined 70%!

A Confluence of Calamities

It sounds like some medieval curse that the Wizard Wobegone called down upon the elves of Myrtle, in response to their kidnapping of the Princess Petrushka, but this is in fact how the IMF described the current global economic and financial market situation.

IMF Managing Director Kristalina Georgieva said the global economy faces its biggest test since WW2.
The war in Ukraine has compounded the Covid 19 pandemic – “a crisis upon a crisis” – devasting lives, dragging down growth and pushing up prices. The IMF is also concerned that all of this is happening at a time of tightening financial conditions and increased financial market volatility.

And the IMF feel our ability to respond to these calamities is hampered by what it labels “geoeconomic fragmentation”. By this, they effectively mean the rollback of the freeing up of flows of capital, goods, services and people which in the past three decades have transformed the world. This globalisation boosted productivity and living standards, tripled the size of the global economy, and lifted 1.3 billion people out of extreme poverty.

But now we run the risk of slipping into a world of higher tariffs, outright trade bans and less effective supply chains. The Fund believe that trade uncertainty alone reduced global GDP by 1% in 2019. Since the start of the war, around 30 countries have restricted trade in food energy and other key commodities.

The message from the IMF is to strengthen trade and to strengthen trust.

This is hard to see in the current environment and it points to a worse outcome that what consensus thinking is today. Currently the IMF are forecasting sub 4% growth for 2022 and 2023, which if we got them, I think would be more than acceptable. Given their newly expressed concerns, I could see those forecasts being revised and the prospect of recession looming larger.

The mood music in economic and market commentary has clearly shifted since the war began and many at Davos for example spoke about the risk of a global recession. In financial markets, while the talk in the first third of the year was more about inflation, there has been a clear shift to worrying about growth.
Several factors have driven this. Surging prices for energy and soft commodities could knock several percentage points off growth forecasts. Central Banks, notably the US Federal Reserve now seem to be in a catch up mode with much more aggressive hiking of rates, at times invoking the memory and spirit of Paul Volcker in the 1980’s, where US economic growth was choked off to solve the then inflation problem.
While there are some tentative signs that inflation may have peaked – core inflation in the US has been more or less unchanged in the past three months. The question will be how sticky it is to come down to allow Central Banks relax.
Those in the recession camp have also been boosted by signs from the US bond market, namely a fleeting inversion, that recession is on the way. Global economic activity is slowing and all forecasts are being revised lower.

What could push us into a recession?
Certainly in Europe double digit inflation, were it continue at length, would erode consumer confidence and divert resources from economic activity – and we have yet to see the full impact of food shortages were the war in Ukraine to continue.

Central bank policy would be another concern. There have been 60 individual rate hikes in the past three months by the world’s major central banks and some fear that in the race to ensure they are not “behind the curve”, overly aggressive action could impair growth.

Finally there is always the risk that we simply talk ourselves into a recession if we put spending plans on hold, hold off on big ticket items or businesses cut back on investment.

The IMF is right to stress the importance of improving trade and trust.

Irish Pension Funds and the War in Ukraine

As a world event, the Ukraine War is seismic, and has edged out most topics from the financial news cycle since February. The human horror and loss is evident and growing daily. It is also having a wide impact on global politics and finance. Given its role in financial markets,  it is worth seeing what has the impact of the war been on the €130 billion or so in Irish Pension Funds and what should pension investors do.

2022 didn’t get off to a great start for Irish pension funds anyway. Fears over run-away inflation and higher interest rates at the start of the year knocked market returns. The average Irish Pension Fund lost about 3% in January. February wasn’t much better and we saw the dip continue driven by the same reasons – surging cost of living, central banks rushing to catch up, and then – the early stages of the war. The average Irish Pension Fund was down about 2% in February.

Market response to the outbreak of war in Ukraine has been complex. Immediately on the invasion, global markets fell away until they found a level in early March. From that low, by the end of the month, world equites were up nearly 10%! As the war moved into a more static phase, global shares become less responsive. This is visible in stock market volatility, which, as measured by the VIX index, peaked on March 7th and has been broadly declining since then. So since early March, we have on-going conflict coupled with positive financial markets.

This market response has resulted in a much better March for Irish Pension funds. A standard managed fund returned between positive 2 and 3% – much better than either January or February. 

In the worst of the war, pension funds have moved ahead.

In fact looking at this first quarter, factors such as global interest rates have been much more dynamic and influential for pension fund investors than events in Ukraine. In the US, 10 year yields started the year at 1.4%, but are now close to 2.8%.  German 10 year bunds went from negative 0.2% to close to 0.8% today. These are significant moves and in fact improved the health of many defined benefit pension schemes in reducing the value of future liabilities. These moves in government bond markets point to the interest rate debate being a critical one for investors.

Initial strategy calls from large global investment houses were very much to hold positions. Some advised to “take some risk off the table” while essentially meant reducing equity holdings but staying overweight. 

Several commentators looked to what stock markets had done in recent outbreaks of conflict such as the Gulf Wars, Iraq, Vietnam. In these instances markets regained their poise in relatively short order. But in certain respects many of these events were quite contained. 

There is little that is contained about the Ukraine conflict. 

It’s clear that stock markets haven’t been following every ebb and flow of events in Ukraine – especially after the initial ‘shock and awe’ of the invasion. On occasion, markets have responded on days of dramatic news, such as constructive talks – often to lose it again. Rather than the direct progress of the war, it is the secondary effects of increased energy costs, possible food shortages, supply chain disruption, job losses where markets have rightly been focussed. 

There may well be a long way to go in this conflict. The risk of corporate defaults and the inability to sell Russian assets may increase the direct systemic impact from the war. Many corporates are closing Russian operations. Several funds investing in Russia have been forced to suspend dealing. Some UK pension funds are divesting of Russian assets. Russia has been removed from many market indices but we have yet to see any material impact on the world’s financial plumbing.

Even if events take a positive turn, we are unlikely to see a swift removal of sanctions or restoration of supply chains. Investors should adopt an equally careful approach and not react to events.

Markets find it very hard to price geo-political risk. Prepare rather than predict by ensuring diversification and eliminating  disproportionate exposure to at risk sectors and stocks. But attempting market timing in a potentially volatile landscape is a risky strategy.

But it may well be that looking back on 2022, it will be the usual suspects of interest rates, inflation, oil prices and a deteriorating company earnings outlook that were the real market drivers.

Ukraine War hits all key issues for Markets

The war in Ukraine, while above all a deeply sad humanitarian crisis, may impact practically every aspect of our future lives. 

Following on the heels of a pandemic that continues to take its toll, the war will cast a long shadow.

Financial markets are one barometer of the impact beyond Ukraine’s borders. But historically, markets have found it very hard to price geo-political risk. Moves may appear indiscriminate, but they are widespread and substantial with significant impact on general savings, pension funds, sovereign wealth funds and others.

Initial calls from investment houses were very much to hold positions. Some advised to reduce risk slightly while still being “risk-on”. Several large investors looked to what stock markets had done in recent outbreaks of conflict such as the Gulf Wars, Iraq, Vietnam. In these instances markets regained their poise in relatively short order. But in certain respects many of these events were quite contained.

There is little about this Ukraine War that is contained. One of the aspects of the current crisis is that it has seismic impacts on a wide range of issues. And these issues were  already “in motion” in financial markets and were top of mind for many investors. 

For example inflation. Inflation has been a hot topic in markets for the past year as Central Banks gave up on their view of price increases being only transitory. Annual price increases of over 7% have become a hot political issue in the US. However now, the risks around cuts to oil supply or possible embargoes have pushed gas prices at the pump in the US to well over 4$ a gallon – double what they were 20 months ago. Even sourcing oil elsewhere will bring higher transportation or refining costs. Moodys estimate that a lengthy military conflict leaves oil prices extended in to 2025. Grain prices will see a similar profile. Inflation is now a more engrained problem

Covid raised the profile of supply chain disruption and the war brings further pressure especially in industries like autos, which had already been facing shortages in semi- conductors. However the added pressure especially for German car makers comes from the lack of wiring harnesses, which are typically manufactured in Ukraine for shipment to European facilities. Even transfer to other plants would increase the costs as harnesses are a more labour intensive product. Supply chain disruption remains a theme for markets

Another trend that gets amplified is the slowdown in global economic growth. Well before the war, institutions such as The World Bank, OECD and the IMF had already moved to factor in a gentle slowdown in the rate of global economic growth this year and next. The war because of issues such as the impact on investment, consumer nervousness, supply chain disruption, impaired logistics etc. accentuates that fall. And the impact is not evenly distributed  – with Europe in the vanguard. As an example, the impact of a sustained 20$ hike in the oil price would knock 0.3% off US 2022 growth, but about 1.2% off activity in the Euro area. And if conditions escalated in the Ukraine or moved elsewhere, the prospect of a global recession cannot be ruled out. 

And all of this is happening at a time when many governments were hoping to restore discipline to public finances post the spending surge in the battle against Covid. Eurozone countries debt to GDP ratios rose from 85% pre-Covid to 100%. The hope was that 2022 would be the year to reassess this emergency level spending. EU officials may now hold off reactivating the Stability and Growth Pact in 2023 given the current level of uncertainty. The mood to increase spending was exemplified by Germany’s decision to set aside €100bn for defence  spending. Increased spending commitment to NATO are also likely over the next few years. Moves elsewhere such as Ireland’s reduction in excise taxes on energy also move public finances in the same direction.

We are seeing market moves of 3-4% on a daily basis. Lack of visibility on a solution, coupled with the seismic impact events in Ukraine are having, on what were already “red button” issues for markets, suggest the volatility will persist.

Currencies – the Next Stop for Volatility?

Volatility is on the up in asset classes like stocks and bonds, as governments and central banks  around the globe look for an exit strategy from highly supportive pandemic policies. 

US bond volatility (as measured by the options market index) has practically doubled in the past 4 months and stock markets have been displaying heightened volatility over the same period.

But currencies, by their own standards, have been very calm and  at the lower bound of their historical volatility over the last five years or so. The US dollar has traded in a much tighter band with the Euro since 2017 than in the period before. Indeed at time of writing the greenback is at the same level against the Euro as  it was mid 2020. Movements in Sterling against the Euro have been equally subdued despite the ebbs and flows of the Brexit process.

The key explanation for this has been the basic “absence” of interest rates.

Major Central Banks around the world have kept rates at zero and below for a considerable time. There has been little to choose from in this world of rock-bottom rates and, until recently, a global central bank consensus of keeping these rates low.

Red hot inflation numbers have changed the landscape. The US Federal Reserve had been playing a very patient game, but  in response to faster price rises that they would like, have pivoted dramatically and will now hike interest rates several times in 2022. Some analysts are looking for as many as seven or eight increases and there is a view that these increases could be “front-loaded” i.e. sooner rather than later and in bigger increments.

And the US is not the only actor on the stage. The Bank of England is already out of the blocks with rate hikes and the European Central Bank is a late entrant. Christine Lagarde has been talking up rate prospects.

This new more “hawkish” US Central Bank, could support a stronger US dollar over the course of the year as it wins the race in hike rates. This is a view widely shared. Several of the large US investment banks are very positive on the dollar’s prospects. This bullish view is also visible in the currency funds markets where speculative positioning on the dollar sits at its most positive since 2019.

However there is a risk; and that is the risk of a policy mistake by the US Central Bank. If it proceeds too soon and at pace, could it choke off economic growth? The US economy is set to grow by about 3% in 2022. But we have seen the pace slacken in recent weeks with softer retail sales, lower consumer confidence, less positive tone to economic output and a pull-back in many higher frequency data points. Analysts are also reducing their forecasts for company profits for the first quarter of this year. 

But failure to hike rates would see the inflation genie well and truly out of the bottle. And there will be political pressure as cost of living has become a red button issue for governments globally. But there will be a need to be nimble – Inflationary pressures may well lessen if we get further away from the pandemic and supply chains get rebuilt. Base effects in energy prices may also make for some moderation.

We are starting this rate cycle at a reasonably elevated inflation level. Policy makers will be unwilling to let currencies weaken too much and import further price rises

Perhaps some of the very few resolutely dovish central banks – such as those in Japan, Switzerland and Sweden – will accept the trade-off of a weaker currency.  

It is clear that in 2022, central banks will be more active, more scrutinized and may need to be more reactive than they have been for several years. For example, we may see the US Federal Reserve actually making decisions outside their normal meeting schedule – perhaps before the next meeting which is around St. Patrick’s day. Also monetary policy across regions will be more differentiated than markets may have become used to. The “synchronised” global economy is no more.

For currency traders, after a long period of “calm”, there will be decisions to be made.

This will translate into  greater volatility in exchange rates

Investment Funds: What’s Selling and What’s Not

It’s been another fantastic year for asset management. Sales of investment products pushed through new record levels in 2021.

But what is selling? Where are investors putting their money? And what is being avoided?

Sifting through Morningstar, Citywire, Lipper, Investment Association and others, can provide direction on what’s hot and what’s not  in the investment landscape currently.

Risk on. 

It was another year when European investors piled into funds at record levels – and embraced risk  by investing into equity funds especially. 

Estimates are for over €720 bn. invested in funds in 2021, with about half going to equities. Global equities were the asset of choice for many, as economies staged a strong bounce from Covid suppression levels, company profits surged and Central Bank policy remained very supportive. In the UK over 1/3 of net retail sales went to equity funds, again with global equities taking the lion’s share. The former darling sector of Equity Income actually saw net outflows.

In Europe, flows into funds exceeded flows into ETFs by about 3 to 1. And according to Lipper, about 70% of investor cash went to actively managed funds as opposed to indexed.

Records were also smashed in the US. Investors poured $1.2 trillion into long term funds and ETFs. This was nearly double the previous record set in 2017. However passive managers substantially out-paced their active counterparts especially in the US equity space.

Bond funds were a bit of a conundrum in this period – as they managed to feature at both the top and bottom of the class. The data still shows an appetite for bond funds – close to €200 bn in Europe , which given the abysmal yields available, coupled with the prospect of Central Banks withdrawing support, seems misplaced. However when we look at some of the top individual funds, it seems more reasonable. Two of Citywire’s three top selling funds in 2021 were bond funds while the third also has material exposure to Fixed Income. However rather than plain vanilla bond exposure these were “strategic” bond funds, with the ability to go anywhere in search of some level of income. This reflects continued investor demand for income in a zero interest rate world. So two of these top three selling funds delivered returns of just 2% – but fully met investor expectations. 

However at same time, looking at the funds that suffered massive outflows, bond funds again featured, accounting for 8 out of the 10 worst.  Root cause was bond market weakness, especially in Emerging Markets but many strategic bond funds were simply wrong footed. Markets (and investors) were unforgiving. The worst fund saw an outflow of just over € 8 Billion! 

Choice of manager mattered as much as choice of asset!

ESG remains a prime driver in gathering assets, both active and indexed. 51% of the money headed to European ETFs in 2021 was directed towards those with an ESG mandate. This is up from 40% in 2020 and 10% in 2019. ESG was especially a feature in the UK, not only winning new monies but taking market share from “non-sustainable” funds.

As well as – what’s selling, it is interesting to look at –  who’s selling? 

Some 18 months ago, I wrote that one aspect of this Zoom world and WFH would be the difficulty of making new sales to new clients. Building  that very critical feature of trust may be harder in the virtual world. This would lead fund buyers to rest upon the tried and tested options and favour incumbent asset managers. This can actually now be seen from a list drawn up by Morningstar of the top ten largest US fund firms at the end of 2021 and at the start. The names and the order are practically the same. 

Making material headway with new clients in “Zoomworld” is tough!

Investors were well rewarded for owning funds and favouring equities in 2021. 

2022 with the prospect of higher interest rates, slower growth, and possible inflation has already proven to be a challenge. It remains to be seen whether the same “risk-on” strategy is vindicated.

The Central Bankers’ Christmas Party – Two

It was the night before Christmas

And all the markets were calm

The traders had all put their books away

So really there was no cause for alarm

But back in the darkened halls of the ECB

And the corridors of the Federal Reserve

Central Bankers, past and present, were keeping a watch

To make sure they weren’t behind the curve

Old Jay sez “we told them we’d taper and told them we’d hike 

But these markets are still hale and hearty”

“Ooh la la!” sez Christine “that only means one thing

It’s time for the Central Bankers Christmas party!”

So the world’s central bankers, present and past

Got dressed up and met up for a wild celebration

Jay shouts “Ain’t nothing gonna stop us now

Not even a mild bout of inflation

Well there was Powell, Draghi and Greenspan

Yellen, Lagarde and the rest of her crew

With Makhlouf, Macklem, Kuroda and Bailey 

And for some unclear reason Philip Lane too

Pretty soon liquidity was flowing

An unsynchronised conga just begun

Soon no one cared about the difference

Between M3, M2 or M1.

Now all the bankers are telling jokes

About when to expand or when to ease

Poor Kuroda from Japan was getting no laughs

That’s what happens when you only speak Japanese

“Well fire up the Karaoke”, Christine calls out

“It might help ease the tension”

But Phillip grabs the mike, thinks he’s Simply Red

And sings Money’s too tight to mention

Now Philly won’t let go of the mike

And Jay Powell wants to give it a shot

But after 23 verses of Sweet Home Alabama

He’s clearly lost the dot plot

Then a thundering noise at the door

Which opened with a mighty crack

It was little Alan Greenspan, holding a punch bowl

“Look lads, I’m bringing it back!”

There were devils on horseback and pigs in blankets

The finest food from every member nation

But the brandy souffles had taken too long

And were the first real victim of deflation.

But soon things were getting out of control

Authorities had to be alerted

Coz Jerome Powell had had too much liquidity

And like his yield curve he was soon fully inverted

And as if things couldn’t get any worse

Amidst this haze of gin, cognac and sambuca

Screaming “whatever it takes” at the top of his voice

Mario whips out his great big bazooka

Now there were governors swinging from the chandelier

There were two on top of the Holly Tree

And quietly in the corner were Yellen and Lane

Discussing macro-prudential policy

Well after a few days, the dust had settled

And the markets recovered and reset

But Jay looked around, with a glint in his eye

Whispered youz ain’t seen nothing yet!

Asset Management continues to deliver…………………certainly for the asset managers.

.

In fairness, investors generally have also been enjoying good returns through this pandemic period.
2021 will be another record year for the Asset Management industry.
Markets have performed well, investors have poured record amounts into funds, and costs have been extremely well managed.

Headlines about asset managers’ profits in the Financial Times ring with words like surge, skyrocket and sparkle. These are good times for fund managers.

The bedrock of the strong performance has been how well financial markets have done which translates directly into the value of assets under management. In 2020, markets recovered well from their March lows to be broadly positive for the year and as 2021 comes to a close it is still a positive picture. In Ireland the average multi-asset balanced funds registered a return of just over 11% to the end of November, according to the Aon survey.

And the world of “Working from Home” has helped in cost control in Asset Management. Sifting through the commentary from CFO’s at results season reveals how issues like reduced travel costs continue to feature even in year 2 of the Pandemic. Distribution, client service, company research are all possible without building up the frequent flyer miles. Especially in a world where asset managers will have to display their environmental credentials, a Zoom call, while not perfect, may well hold its own compared to an 8 hour flight to Seattle to see Microsoft’s Investor Relations manager.

So some of this cost reduction may be permanent. Further cost reduction is likely as asset management companies review just how much space they need. Richard Keers, CFO at Schroders, a leading asset management company notes how by reducing space in London and Hong Kong, having reviewed changed working habits, they have saved £16M. Over at abrdn, Chairman Douglas Flint talks of re-designing and re-purposing their office space – which hardly means expanding! So it looks like fund manager surroundings are going to change.

Even if the surroundings don’t change, there’s still a possibility that the name over the front door changes. Mergers and acquisitions remains a firmly entrenched trend in the asset management business. This is happening both at the large institutional end of the spectrum and also among smaller brokerage/wealth management firms.
Asset managers are striking mergers and acquisitions to secure profitable growth, acquire complementary lines of business, and tap into new markets or distribution, in an environment of declining fees, rising costs and the onward march of passive investing. Expect this to continue. The “Thinking Ahead” Institute notes than of the 500 top asset managers 10 years ago, 200 have gone from the list today. There is little sign of this letting up.

Asset Management is still seeing pressure on fee income. The rise of ETFs, Smart Beta and even more nuanced indexed products, ensures that the focus on fund management charges will endure. Value for money and transparency will be key drivers in the dynamics of fund pricing.
So are active managers doing what they’re supposed to do?

No, based on early numbers, not so far in 2021. A new report from AJ Bell shows only 1/3 of active equity funds outperformed their stated benchmark in 2021. And US and Emerging market equities remain the main sources of value destruction – even over a 10 year period, according to the survey. And some charge high fees despite serial underperformance.

Fund costs are moving up the regulatory agenda. The Central Bank here has looked for greater visibility in the issue of performance fees. In the UK, the FCA looks for fund managers to assess the “value” of their funds which includes how they perform, once a year. Surveys show that high net worth individuals favour performance based fee structures.


If the democratisation of investing means that more people are becoming more engaged with their money, more demanding of information, then an industry that has historically been opaque needs to become more transparent.

Language Lessons

It has been the economic surprise of 2021 and there are still voices on both sides of the argument.

Inflation has taken off as a concern for investors, consumers, producers and policy makers. The most recent number to grab headlines in the US was a staggering 6.2% – the largest since 1990. At the start of the year, 2.1% was the expected figure. 

The path to these price pressures is paved with supply chain delays, higher energy prices and higher wage bills in certain challenged sectors.

Central Banks built a defence by viewing all of these as “transitory” – which of course they may be. However the issue is when inflationary expectations are changed. Investors and manufacturers may have grown accustomed to living in a low inflation world – but there are signs of a change. The concept of “pricing power” is once again being mentioned. A recent survey in the US  has shown the proportion of  businesses thinking of raising prices is close to 50% – the highest since the early 1980’s. 

Inflation is certainly making its way into the corporate psyche and is front of mind for many CFOs and CEOs in US companies. If we look at the conference calls of the S&P 500 companies in this third quarter reporting season just ending, the percentage of companies citing inflation is over 60% –  double the norm of the past 5 years. Interestingly this hasn’t really fed through to lower profit margins yet.

Is this surprise in inflation numbers going to lead to a shock on interest rates?

For some commentators, the greatest crime a Central Bank can commit is “being behind the curve” i.e. not recognizing a change in the economic environment and having to catch up, but with the risk of inappropriate interest rate policies. 

Making this assessment is even trickier now as many Central Banks have made changes to their operating framework. Basically entities like the ECB and the Federal Reserve in the US are likely to tolerate higher inflation rates before they pull the rate trigger. In the US, for example, the Fed is looking to target average inflation over a time period rather than a spot level.

As we stand today, policy makers, certainly in the US and Europe, broadly hold on to the transitory narrative but there have been some interesting changes in language in the past few weeks. 

Closest to home, ECB chief Christine Lagarde now feels inflation will stay high for longer then she previously forecast. However she has pushed back on calls for rate hikes, sticking with the view that inflation will fall back somewhat in 2022. It is worth noting though that the ECB inflation forecasts are among the lowest around.

The actions of the Federal Reserve In the US probably matter most. Here we have had the most clearly communicated policy; namely of no action on rates until the jobs market was clearly improving. The chairman of the Fed, Jerome Powell, is reluctant to raise rates while there was still slack in jobs market, despite the surge in prices. The 6.2% number did have something of a “sticker shock” about it and the inflation numbers have been highly politicized. The situation has been complicated by the fact that we will see several changes in composition of the Fed board this year. And it is true that the most recent job numbers have been stronger.

Will this change the time-table? Comments from the Treasury Secretary Janet Yellen have become somewhat more neutral,  noting that Covid is likely to play a greater part in calling the shots on inflation and interest rates.

Most clear cut is the view of the Bank of England, which appears to be itching to hike rates. Andrew Bailey, Governor of the Bank, admits to being very uneasy about inflation being above target, suggesting action will be taken sooner rather than later. Bailey puts in very simply “We are in the price stability business”.

This more nuanced language we have heard may not change the sequence of rate rises – UK followed by US, followed at some point by the ECB – but may herald a change in time frame.

However beyond time frame, we are leaving a period when the interest rate policy of the major blocks was highly synchronised. This resulted in the very muted volatility we have seen in exchange rates – this too may change. 

Still Absolutely Not So Fabulous

Three years ago on this blog, I looked at Absolute Return Funds – funds that were still very much in vogue and in demand. They were the top selling fund type in 2016 and 2017 according to Investment Association figures. These funds typically offered cash plus 4% or more and the promise was that this would be delivered at a significantly lower risk level. Performance issues had already surfaced but the party-line for managers was to stick to their guns and rhetoric.

I thought it was a sector worth revisiting.

My conclusions three years ago were broadly that it was quite a challenging ask, lots of over-promise and under-delivery, and more than any other sector picking your manager was of key importance as there could be a wide range of returns.

The world has changed profoundly for Absolute Return funds and their managers. In the past two years (2019 and 2020), investors lost patience and this sector saw the worst redemptions in the industry. Redemptions were described as “brutal” by one manager. In 2019 and 2020, European domiciled Absolute Return funds saw over €40 billion head for the exit door. One very high profile fund went from £26.8 billion to £2.6 billion in 4 years.
The picture is similar with large pension funds though harder to map. While the overall allocation to Alternative Assets has grown, within the sector areas like Private Equity and Infrastructure have probably increased the most from a lower base. If we take hedge funds and multi-asset as a proxy for Absolute Return, in the very recent past they look to have lost ground. The picture is more stark in terms of future investing intentions. European pension funds plan to reduce allocation to hedge fund and multi-asset funds.
Many absolute return managers blamed the absence of volatility, and then, when there was volatility, it was the wrong type. Trends and asset moves became very short-lived and un-investable. Others blamed constant bull markets ,which reduced their shorting profits, even though relative performance is what determines absolute success in this sector.
I looked at the performance numbers for three of the major players in this space in the Irish market.

One YearFive YearTen YearVolatility
Fund A-0.7%1%2.6%4.6%
Fund B4.1%0.2%n/a5.9%
Fund C9.8%3.3%4.3%7.4%
Average Managed15.8%6.1%7.6%9.7%

                                                                                                (Source: Aon; Annualised %pa)


A few things stand out.


Performance as we know has been poor but also it’s hard to see any broad recovery in the sector numbers in the near term despite what the managers may have hoped for. It is also interesting that the best of the three is the one with the highest volatility level – edging closer to that of a standard managed fund. This is also reflected in CityWire statistics in the UK where the better performers in their Absolute Return sector display higher volatility levels. This would seem to point to the difficulty of earning high returns while only taking on lower risk.


How did the Absolute Return industry respond?

There have been a number of responses.
We have seen fund name changes and modification of investment objectives. For example this summer, a long standing Absolute Return fund morphed into a “Flexible Macro” fund.
We have seen fund closures and cash returned to investors. One industry leader closed a high profile fund recently in the face of desperate performance and massive redemptions.
We have also seen changes in the people actually managing the funds in the hope that new faces or a new approach would do the trick. This has meant both retirements and sackings.

There is still a large number of Absolute Return funds out there, and making a choice between managers is more important than allocating to the sector given the range of returns which remains a feature.
There is little evidence to suggest that using hundreds of analysts, steering groups, and ending up with thousands of holdings actually works any better.
There is still a role for uncorrelated asset classes in portfolio construction. Currently asset classes such as Private Equity or Infrastructure garner most attention.

An absolute return fund with genuine alpha generation potential can play a role but it would help if there was a true reset of expectations in terms of what cash plus returns can consistently be achieved.
The simple learning from the emergence of Absolute Return funds is that the link between risk and return has not been broken.

Emerging Markets – is it over?

Emerging Markets have long played a role In investment portfolios whether pension funds or retail investors. Investing in sometimes more “exotic” markets has been seen to be a way of tapping into higher returns while diversifying away risk.

Investors could have exposure to Coca-Cola bottlers in Argentina, software companies in India through to supermarkets in South Africa and all at (certainly in the early days) extremely attractive valuations. It became one of the most exciting themes in financial markets.

Emerging Markets (EM) as a term was recognised in 1981.

Investment fundamentals were based on super normal growth prospects due to features such as new wealthier middle classes across Latin America and Asia increasing the quantity and quality of their consumption at pace.

There were periods when EM provided turbo-charged returns to investors, and came to be seen as a separate asset class in itself.

Is the case for such investment still intact?

There are two aspects to this question – the near term impact of Covid and the longer trends that drive Emerging Market dynamics.

Pandemics increase whatever inequalities exist pre-crisis. Today poorer access to vaccines and weaker policy responsiveness are causing EM economies to slip back.

As recently as July, the IMF increased its growth forecasts for advanced economies while revising down the figures for the developing world. Excluding China, Emerging Market growth in 2022 will be significantly lower than for advanced economies. Rather than catching up with advanced economy growth rates, many emerging economies are slipping back and some run the risk of falling onto fragility.
This softer economic picture is compounded by policy responses such as interest rates. While developed market economies are still very much in the “lower for longer” phase, 50% of emerging market central banks have already raised interest rates.

Covid in EM will cast a long shadow in many forms.
Longer term productivity of human capital will be impacted by pandemic-driven loss of schooling time and again EMs have fared worst. In 2020 children in advanced economies missed about 15 days of school; in EM economies this figures was closer to 50.

So it’s clear Covid is a serious set-back for emerging economies. But in many ways it only exposed existing vulnerabilities.
The slipping relative economic growth picture for EM was already in place. Following the financial crisis, economic growth rates for developed economies fell by 50%, but for EM economies the drop was a more precipitous 70%. 2013 was the probably the last year when EM economies had an outstanding growth advantage.

When EM economies had their days in the sun, there were several more ingredients which supported the market explosion – interest rates were generally on a downward track, commodity price rises were supportive and trade globalisation moved up a gear.
Emerging economies exports surged as trade went from 39% of world GDP in 1990 to over 60% by 2008.

Throughout the period from 1980’s onwards, another very supportive force was a move to more liberal democracies especially in Latin and South America. The prospects for greater political stability, less corruption and higher and fairer incomes could only be positive for investors.

Against this backdrop and with attractive valuations, global pension funds and others rushed to capture this frontier market premium and drive markets up.

However today, many of these longer term trends are challenged.

Both near term and longer term, EM economic growth prospects are poorer. The share of countries where output per head is superior to the US continues to fall. Another feature is that from here interest rates cannot fall further and some policy makers are already in hiking mode. 2023 may see US rates themselves move up. Another positive pillar for EM in the past – globalisation – may have stalled and because of Covid may shift into reverse.
We’ve also seen a pause in the drive to more liberal and accountable regimes. The humanitarian disaster in Brazil, civil unrest in South Africa and roll back of fiscal reforms in Chile are all global signposts of this change of direction.

Investors need to take on board these longer term trends, as well as the short term impact of the global pandemic, when considering investing in Emerging Markets. This more challenging environment is visible in the market performance of EM. Over the last 10 years, global equities are up by 11% per annum; the figure for EM is 3.6%.

But as well as the “why” of investing, there is the question of the “how”.

Broad EM indices bring a number of issues. They can be highly concentrated. China for example accounts for 35% of the total index. This is up from 7% in 2003 . In the same period Mexico has gone from 8% to 2%. Concentration is also high at stock level. The top 3 stocks account for 16% of the index and the broad technology sector accounts for more than a third. This is not the widely diversified index that it may have been in the past. Events and policy decisions in China (such as the recent crackdown on educational tech companies) will have a profound impact on many EM benchmarks.

Are EM stocks cheaper? Yes – but the gap is nowhere as big as it was when interest in EM was very much in a growth phase.

There will always be room in investor portfolios for stocks and sectors that offer growth potential at reasonable valuations. For many years this was the EM investment case. Today the sector faces as many headwinds as tailwinds and needs to be an active decision not just a default response based on investment muscle memory.

US Economy 2021: Fire and Ice

Where does the US Economy go from here?

There are two clear views – and they are almost diametrically opposed to one another.

And we are seeing the data swing from supporting one view to the other, on an almost daily basis.

One view is that too much money is being pumped into the economy, that inflation is now embedded at worryingly high levels, the Federal Reserve is behind the curve and we need interest rate hikes soon.

The other is growth has already peaked and the negative impact of the new Delta variant is yet to be seen in economic forecasts, and that we may be facing into a slowdown.

What are the facts?
Inflation today is indeed well above target, and has policy makers on edge. Data for June shows prices up over 5% compared to 12 months ago. The US Central Bank’s target is 2% on average. Even taking out some of the more volatile elements like food and energy we still have a 4% inflation rate in the US today. By contrast here in Ireland we’re looking at 1.6% and price increases of about 2% for the Euro area as a whole.

The key question – is it temporary? That’s certainly the view of the administration and the Federal Reserve. They believe that over the coming months improving supply chain bottle-necks and continued re-opening will ease this price pressure. And many of the price increases are simply recapturing ground lost during the pandemic. This means that the Federal Reserve, despite admitting to being somewhat surprised by the higher prices, can stick with its low interest rate policy. However the inflation debate is becoming increasingly politicised as Republicans highlight the rising cost of living for ordinary Americans and raise concerns over a stagflating economy. We should expect inflation to move up the political agenda. Importantly though surveys show that while consumers do expect higher prices in the near term, longer term expectations remain anchored at just over the 2% mark.

And what about economic growth? Figures for the second quarter of this year showed a very robust 6.5% rate of growth. However this was actually lower than forecasters had pencilled in. Consensus was expecting the number to be over 8%. While the US economy is now back to its pre-pandemic level, it is also past its peak rate of growth for this cycle.

Looking into the second half of 2021, we will see a waning of the fiscal package that has been supporting workers and businesses through the crisis. There has also been a knock to consumer confidence from the current surge in prices. This paints a less positive picture for consumer spending overall. But now added into this, is the impact of the Delta variant and the roll back we are seeing in the reopening process. Hospitalisations are back to mid-February levels. We have seen some companies push back on when they would look for staff to return to the office, and major events, like the New York Auto Show, being cancelled, all with a knock -on effect on businesses. Reintroduction of face masks in some areas is also unnerving consumers. Vaccine hesitancy and breakthrough cases are both plausible causes of concern.
Policy makers are alive to the threat Delta could be for the overall economy. At the recent meeting of the US Federal Reserve, Chairman Jerome Powell noted how they were monitoring impacts on restaurants and workplaces. The Fed’s current view is that this is a manageable risk, but slow-downs in vaccination rates are a worry. Generally most current economic forecasts don’t factor in a Delta variant knock to the 2021 picture, so if we see a continued upward drift in cases, we could see a wave of economic downgrades.

It’s clear we will see a loss of momentum in the US economy in the second half of this year – the question is how much.

Financial markets naturally are very focussed on whether the outlook is more towards Fire (surging inflation, higher interest rates) or Ice (slowing growth, undermining profit forecasts).

Economists seem quite divided.

However the general population is more clear on where the risks are. A survey by Monmouth University in New Jersey last week pointed to inflation being the key concern for only 5% of households, while Covid and the overall economy were the biggest concern for nearly 30% of US households.

And in terms of where the real risks lay – this seems about right.

Fund Management – Next Steps

It’s business as usual for fund managers – in fact it’s better than usual.

Recovering markets and consistent positive funds flows have pushed global industry assets under management to a new peak of €93 trillion. That’s up 11% on the previous year. Closer to home European asset managers saw their assets up 5% to over €25 trillion.

Investors both retail and institutional continue to add to their holdings. In Europe investor inflows in 2020 were over €750 billion – that’s the highest since 2014 and one of the highest in the last 13 years.

Two recent reports, well worth reading, from McKinsey and Accenture respectively, paint a generally positive picture.

Most of the fund inflows have been into equities and this accelerated into 2021. Both Active and Passive strategies have made ground. The absolute size of flows into Active has been greater than into Passive. For example in June, active strategies recorded €21 billion of inflows compared to €14 billion for Passive. This still represents a greater momentum of growth for passive products, given the different size of the asset base.

And the asset management business is still very profitable. Despite continued pressure on fee income – down by 1/3 in last 7 years – fund management groups grew their profit margins again in 2020. There is continued focus on costs. Zero travel costs during the pandemic continue to be cited as a positive in many company annual reports. Looking at the costs of running the business compared to the income earned, this has been managed down to 59% from levels of 70% ten years ago.

Corporate activity in the asset management sector continues at pace. Globally, figures from PWC suggest that 2021 is on track to be a record year for M&A.
Ireland is no different. The last 12 months have seen a flurry of deals ushering in further consolidation in the domestic fund management arena. Increasingly the deal rationale is moving beyond just cost synergies. There have been several examples of large asset management companies looking to acquire financial planning and advisory operators to ensure great stability around route to market. This reflects a global trend. Ireland has also seen corporate activity as a fall out from Brexit as some players have opted to exit the market because of uncertainty and others enter, to ensure EU access. There has also been some regulatory driven activity which will see further changes in the Irish asset management landscape.

One fund management trend which continues to break records is that of ESG investing. In Europe overall, flows into ESG funds ballooned to EUR 233 billion in 2020, from EUR 126 billion the year before, according to Morningstar. Responding to investor demand, asset managers launched a record number of 505 new ESG funds and repurposed more than 250 conventional funds in the last year. Regulatory pressure and government policy continue to underpin this drive. This year fund managers need to categorise their funds in terms of ESG credentials further increasing transparency for investors. It is hard to see this reversing.

Increasingly ESG will become a “walk the walk” as much as “talk the talk” for fund managers themselves. Fund management companies will need to demonstrate that they operate to the same high ESG standards that they expect of their investee companies. Gender balance, rotating directors, environmentally rated buildings etc. at the fund management company level will matter for business development. The CEO of Schroders, one of the world’s leading managers, points to and welcomes this level of scrutiny on the fund industry.

And as the dust settles somewhat on this new landscape, expect to see a lot more investment in the brand by fund management companies. Practically all fund managers (97% according to the Accenture survey) see brand as a key competitive differentiator. Given the amount of change of names we have seen in the industry, the majority of companies believe they have decreasing brand awareness today. Allied to this will be a drive by many companies to ensure and promote their brand as fully aligned with best practice ESG principles. Expect to see a lot more investment in brand and brand awareness from the fund management industry.

While underlying profitability and trends were not really impacted by the pandemic, how fund managers worked, was revolutionised. Highly complex organisations moved 100% to a WFH structure smoothly and efficiently. It had been reasonably common already, especially in the UK, to accommodate “star” managers by allowing them to work remotely, whether that meant the Scottish Lowlands, York or Kensington High Street. The pandemic saw this now applied to marketing, client relationship, administration, finance etc.
The future is likely to be about striking a balance the need to coach, mentor and develop softer skills which may require office attendance; and the need to recruit and retain talent where some prospect of WFH would be a positive. Expect a “hybrid” outcome with perhaps a greater degree of structure than some might be currently imagining.

Irish Financial Services – can you trust them?

    You can’t go the distance
    With too much resistance

        Billy Joel, A Matter of Trust, 1986

    Trust in Irish Banks and other financial institutions is on the floor.

    And the disappointing thing is that in the last two years things don’t appear to have got any better.

    And trust matters.

    A 2021 survey across 28 countries and 59,000 customers revealed trust as the single most valued aspect in banking and it was ranked first across every single country surveyed. Bolstering this, a 2019 Accenture survey noted that globally consumer trust in financial institutions was “high and rising”.

    Set against this, the Irish Banking Culture Board recent report makes for very difficult reading. The data was gathered by Edelman which is the global leader in measures like trust and reputation for corporates, governments, media etc.
    This survey solely covered banks. While there is a battery of numbers, some stand out. 46% of respondents have low trust in banks compared to only 19% who would hold them in higher regard. This wholly negative outcome is at odds with a more positive view globally on banks – and by a wide margin.

    And the momentum is going in the wrong direction.

    Based on respondents aged 45 and over, only 18% feel that the sector has improved since 2008. 43% feel things have gotten worse.

    The gloom continues when the survey looks at the role banks could potentially play in the current crisis. 73% of respondents believe banks should play a key role in re-invigorating the economy but only 38% feel they have, and that quite simply banks have failed to step up. This places it bottom of the pile for the sectors included.
    .

    Admittedly the data is nuanced. Respondents were slightly more positive when asked about their “own” banks as opposed to the sector overall. And younger people (up to the age of 24) were also less downbeat. However the younger age cohort is likely to have lower engagement levels with banks, have greater exposure to many of the disruptors in financial services, or simply a shorter memory.

    The picture painted by the survey is not that surprising given the news-flow in the past 18 months in the broad financial services sector. We have seen continued fines in the tracker mortgage debacle, branch closures which can dis-enfranchise vulnerable clients, banks doing U-turns on refunding customers, court cases over pandemic insurance pay-outs, stock-broker fines and sanctions etc.

    The challenge for those seeking to improve perception and reputation across this broad sector is how to combat headline risk. Headlines, quite often specific to one company, can have repercussions for the sector overall.

    Trust is high on the agenda for financial regulators. Andrew Bailey, when at the UK Financial Regulator, made the point that trust is not just about knowledge or skill but equally about honesty and good intentions.

    In Ireland, trust features as one of the five principals that the Central Bank works to in ensuring fair and transparent market place for consumers and counterparties in general – “vision is for a trustworthy financial system supporting the wider economy”.

    Derville Rowland, Director General Financial Conduct, stated it most eloquently and managed to bring Confucius thought into the Irish financial regulatory landscape (I think for the first time!) concluding that “Without trust, we cannot stand”

    Trust must be recovered and this will be a long journey. The Financial Regulator makes the point that a truer definition of compliance is more empowering and ambitious than perhaps our minimalist interpretation; a truer definition being more about accomplishing and achieving.

    Given where we’re starting from, the IBCB and the sector overall has a truly great and meaningful opportunity, and taking account of the regulator’s more ambitious and aspirational casting of compliance, we should strive to make it not only about regaining public trust – but also respect.