2021 investment outlook – Feature
The inflation outlook for the next 12 to 18 months is probably the most uncertain it’s been in my 15-year career of trading inflation-linked products. Evan Guppy, Pension Protection Fund
which as a defined contribution (DC) scheme has a relatively young membership and consequently a long-term investment horizon, the return to “a more textbook investing environ- ment” provides opportunities to capture value in equity markets.
Defined bearishness
In contrast, DB schemes across the UK are continuing their path towards de-risking, which is, of course, largely dictated by their lifecycle rather than secular growth outlook. Among the schemes in the Pension Protection Fund’s (PPF) universe, only 11% remain open to new members and 46% are closed to new benefit accrual, according to the Purple Book. In line with that, DB schemes continued to reduce their average equity allocation to 20.4% from 24%, year-on-year. But being underwritten by a corporate sponsor, final salary schemes, by definition, have one foot in the door of the real economy. From travel to hospitality and retail, the economic fallout of multiple lockdowns has been a lot more tangible for final salary schemes. The strength of sponsor covenants will be a key priority, especially as two thirds of companies with a DB scheme issued a profit warning in the first nine months of 2020, according to Ernst & Young.
DB schemes have also been hit by the adverse effects of falling gilt yields, with average pension deficits in the PPF universe ballooning to £229bn from £160bn, Purple Book data shows. The challenge for many DB schemes is how to address the funding shortfall in a low return environment, without moving unduly up the risk curve.
Fixed income – a riskier ride But this risk curve has shifted significantly over the course of the past year as borrowing has surged across the globe. Global debt levels have increased by $15trn (£11.2trn) in the past year and are set to hit $277trn (£208.5trn), or 365% of global GDP, by the end of 2020, according to the Institute of International Finance. Meanwhile, investors have attempted to navigate the low-yield environment by diversifying away from treasuries and into more exotic segments of the fixed income market, be it emerg- ing market, frontier or private debt. This trend is likely to con- tinue in 2021. In this context, the two main headaches fixed income investors might face in the year ahead are a potential increase in inflation and a rise in defaults.
The combination of a potential surge in consumer demand as lockdowns are easing, combined with a slowdown in globalisa- tion and increased central bank tolerance towards rising price levels as a way to manage debt could become triggers for infla- tion, warns Evan Guppy, head of liability driven investing at the Pension Protection Fund. “The inflation outlook for the next 12 to 18 months is probably the most uncertain it’s been in my 15-year career of trading inflation-linked products,” he says. Emerging markets appear to be one of the areas which benefited from investor buoyancy towards the end of the year. In November, $76.5bn (£57.7bn) flowed into debt and equities in the developing world, the strongest level for more than seven years. However, as the 2013 taper tantrum suggests, their fortunes can reverse swiftly, if the macro outlook changes. For Mark Lyon, head of internal management at Border to Coast, default risks are on the rise, particularly in private credit. “Default rates were very low because we are at the top of the credit cycle.
“I think default rates are going to increase,” he adds. “The headline numbers might not be as high as they have been in previous corrections partly because there is a lack of covenants in a lot of loan documents, which means you do not necessarily get the formal defaults. But there are certainly a lot of problem loans which managers are going to have to spend time dealing with.”
More ox than bull After a more than challenging year, there are reasons for inves- tors and households alike to be more upbeat. The news of a potentially successful rollout of a Covid vaccine being the most important. Nevertheless, given that a lot of this good news has already been priced into equity markets and fixed income has become a borrowers’ market, institutional investors might be better off not being overly bullish.
The defining features of the ox in the Chinese zodiac, being a hard worker in the background, making intelligent and pru- dent decisions, should stand them in good stead.
Issue 99 | December–January 2021 | portfolio institutional | 27
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