By: Russ Kamp, Managing Director, Ryan ALM, Inc.
According to the US Federal Reserve’s minutes from early in May, there is a chance that the Fed will have to raise US interest rates “higher and for longer” than originally anticipated. Those four words scare the heck out of me! Yet, the US equity market rallied on the news. Sure, there was no indication that the Fed was contemplating Fed Fund rate increases greater than 50bps at each of the next two meetings, but that isn’t guaranteed. It also isn’t guaranteed that the inputs (war, covid-19, production bottlenecks, etc.) to this inflation crisis will have been eradicated by the end of July 2022.
Perhaps equity market participants feel that interest rates having to rise higher and for longer indicates that a recession isn’t in the near future. Perhaps. But, at some point in the not-to-distant-future bond yields will hit an inflection point that puts real pressure on equities. Remember, pension systems used to have substantial exposure to bonds. Regrettably, that exposure was trimmed quite significantly and consistently as yields fell below the return on asset assumption (ROA) back in 1988. This migration from fixed income to equities and alternatives certainly helped to boost the performance of those asset classes as positive cash flow drives markets higher.
What is likely to happen when holding bonds at attractive yields and with more modest variability starts to impact those fund flows into non-bond asset classes? Could we see significant selling pressure within equities? As pension systems look to de-risk their pension liabilities, they aren’t going to maintain the same level of equity and alternative exposure. At what level of interest rates is that inflection point? We’ve benefited tremendously from a nearly 40-year bond bull market in which plummeting interest rates pushed forward the incredible gains achieved in a variety of markets – real estate, equities, bonds, alternatives, etc. Do you recall how challenging the environment was prior to 1982? It was ugly!
While we sit back and wait for the Federal Reserve to do their thing for potentially longer, US fixed-income investors with a total return focus will get spanked. We’ve already experienced the most challenging performance environment for bonds in the last four decades. If the Fed is true to its pronouncements, total return fixed income programs will continue to see significant losses in principal. Regrettably, the current level of rates (income) isn’t substantial enough to offset much of that principal loss. Now is the time to convert traditional return-seeking strategies to cash flow matched investments that are tailored to meet your plan’s liability cash flows. Importantly, by defeasing benefit payments that are future values, a cash flow matching strategy mitigates interest rate risk. In addition, should we see both equities and bonds sell off, a cash flow matching strategy buys time for the non-bond assets to recover as they are no longer a source of liquidity.
Again, I don’t know about you, but the phrase “higher and for longer” scares me. Given the improved funding that was observed throughout Pension America in 2021 isn’t de-risking the prudent approach as opposed to “guessing” how the Fed will act and more importantly, how the market will respond? Be responsive to today’s environment.
Right on Russ!!. I’d add that the Fed merely has to take its foot off of the ZIRP brake and interest rates will increase on their own toward double digits — very bad for stocks.
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