Pension Tension: Fears About Fallout

Pension Tension: Fears About Fallout

Posted on Feb 14th, 2020

Extending is Pretending in 2020
Trying to extend the longest U.S. expansion in 150 years without much economic capacity left to go will be stressful. The global debt-to-GDP ratio recently hit an all-time high at 322%. Total global debt sits at US$253 trillion, according to a report released by the Institute of International Finance (IIF). “The 2020’s will see a greater incidence of debt distress and restructuring,” according to S. Gibbs, an MD at IFF. Erwan Pirou, CIO, AON notes that there is a “[r]isk of a double-whammy.” Pirou went on to state it’s equally concerning that “Lower yields from (ineffective) monetary easing could raise [pension fund] liabilities, while risk-asset returns might fail to provide a counterbalance if they fall victim to slowing economic growth.”

Investing with a Cycle Approach
Investment strategy needs to accommodate changes across both economic and credit cycles. At the beginning of an Economic Expansion, senior credit will generally be available and can be supplemented with more junior capital and equity (see Figure 1). In Late-Stage Expansion, senior credit availability will increasingly crowd into junior credit stratums and reduce required equity. During a Contraction, less senior debt will be available leaving junior debt and or distressed debt to fill the gap that gets created. Finally, during Early Expansion, junior capital will start to replace distressed debt until senior debt becomes more readily available. Investing successfully across the credit and business cycles requires presence, consistency, discipline and experience to understand the dynamics at hand.

Preparing for Recession
The 2020’s may not be a typical economic cycle with short-term credit availability being the wild card. In addition, some investors posit that this time around we will see up to five longer cycles arrive concurrently at the intersection of economic cycle change : a greying demographic; income inequality; long-term credit; energy source transition; and geopolitical power transition or multipolarity which, when combined, may result in a deflationary debt cycle. Today the financial condition of major developed economies is better off than the last economic cycle Contraction that occurred in 2008. However, in the deflationary debt cycle case, capital markets will lock up, prolonging economic Contraction and the Early Expansion portions of a typical economic cycle (Figure 1). As senior debt contracts into an extended deflationary debt cycle, a larger than normal opportunity set will occur for continued growth in the private credit asset class. Traditional fixed income is not well positioned for this cycle change. This is because refuge in negative-yielding global debt (valued at over $13 trillion) and the prospect of further lowering of rates by central banks may not be feasible for most investors. In September 2019 the Dutch government criticized the European Central Bank’s latest wave of monetary easing, fearing damage to their domestic pension funds. Negative yields impact pension fund and insurance company solvency and increase risk by making asset and liability matching more difficult. While the eve of cycle change is nigh (see Figure 2 that indicates growth is slowing), time remains to seek out non-correlated all-weather strategies like private credit. Current evidence indicates private credit will be the best alternative for investors as it is even less correlated to equities than traditional fixed income. Afterall, interest is meant to be earned not paid.

Investment Implications
Stay calm, think long-term and seek out alternative assets to become fully diversified. Complementing the business cycle approach with additional non-correlated strategies will generate attractive risk adjusted returns over time. Every business cycle is different yet similar. During the global financial crisis in 2008, private credit in particular proved its ability to weather steep market declines. Empirical evidence indicates that private credit, through its features of non-correlation, illiquidity and absolute return, is well positioned for the next cycle’s downturn. For those not requiring immediate liquidity, private credit will also offset public market volatility, making it an attractive substitute for high-quality liquid bonds. Finally, private credit managers with full business cycle experience can help asset allocators thrive during a capital dislocation event caused by a cycle change. Recession 2021 here we come! Will we deflate asset prices right back to where we started from?