By: Russ Kamp, Managing Director, Ryan ALM
Do you believe that we will see inflation maintained at elevated levels for some time to come? Do you think that bond yields eventually migrate higher to reflect this more robust inflation? After 39 years of a bull market in bonds, do you think that we might just be witnessing a reversal in interest rates? Do you think that equities are a hedge against inflation? Your answers to these questions should drive your asset allocation strategy. As a reminder, we’ve had the wind behind our sails for 4 decades! It’s been perhaps the greatest investing environment ever experienced. Wow, despite what has been a historic time for markets, Pension America’s fortunes aren’t great as most pensions (especially Public) have a deficit-funded status. Are they about to get worse?
The chart below was shared by John Authers, Bloomberg, in his daily blog (which is so good). He captured it from the updated analysis provided by Elroy Dimson, Paul Marsh, and Mike Staunton, “a trio of British academics then working together at London Business School”. Their original work, “Triumph of the Optimists” was published two decades ago. According to Mr. Authers, it is “a massive work of data analysis, aiming to build a history of stocks, bonds, and bills for the whole 20th century, across the globe, to measure the equity risk premium — the average extra annual return compared to bonds or bills that investors gained by taking the risk of buying stocks.” The recent update takes the analysis through 2021 (thank you, gentlemen). There are many charts in this version (and in John’s blog), but I found this one to be the most relevant.
If you believe like I do that the 39-year bull market is ending for bonds, that elevated levels of inflation are here for the time being, and that interest rates will eventually reflect the inflationary environment, then US stocks will have a difficult time for the foreseeable future, as they are NOT an inflation hedge in the short-term. As the numbers above reflect, real equity returns are only 3% during periods of elevated inflation. This future period is also troubling for bonds, but since Pension America, particularly public and multiemployer plans, has increased the exposure to risk assets the more modest equity returns will be quite devastating if this period lasts for any length of time.
What to do? We’ve been very consistent in our messaging. A bear market for bonds will create significant headwinds for total return bond programs. It is time to use bonds for their intrinsic value… very predictable cash flows. Match those bond asset cash flows to liability cash flows (i.e. defease). Not only will the plan’s liquidity profile be enhanced, but you’ve now eliminated interest rate risk for that portion of the assets that are defeased! Furthermore, by bifurcating the plan’s assets into liquidity (beta) and growth (alpha) buckets you are extending the investing horizon for the growth assets to grow unencumbered, as they are no longer a source of monthly liquidity. This lengthened period of investing may actually bridge an uncertain time for equities and equity-like products that are ahead for us. Pension systems need to secure the promised benefits and stabilize the funded status while keeping contribution expenses contained. Our approach accomplishes those goals. Call us at 561-656-2014!