Investors Weigh in on OECD's Dire Economic Outlook

The Organisation for Economic Cooperation and Development (OECD) sees 2013 global growth of 2.9%, down from 3.4%, so how will that impact institutional investors?

(November 27, 2012) — The Organization for Economic Cooperation and Development (OECD) has slashed its global economic forecasts, highlighting the risks of a “major” global recession.

“After five years of crisis, the global economy is weakening again,” OECD Chief Economist Pier Carlo Padoan said today in the organization’s semi-annual Economic Outlook. “The risk of a major contraction cannot be ruled out.”

According to the Paris based think-tank’s report, GDP growth across the OECD is projected to match this year’s 1.4% in 2013, before gathering momentum to 2.3% for 2014. In the United States, assuming the “fiscal cliff” is avoided, GDP growth is projected at 2% in 2013 before rising to 2.8% in 2014. In Japan, GDP is expected to expand by 0.7% in 2013 and 0.8% in 2014. “The euro area will remain in recession until early 2013, leading to a mild contraction in GDP of 0.1% next year, before growth picks up to 1.3% in 2014,” the report said.

“Additional easing is required in the euro area, Japan and some emerging market economies, including China and India,” Padoan said. “If serious downside risks were to materialize, further policy support would be essential,” including additional quantitative easing and temporary fiscal stimulus by countries “with robust fiscal positions, including Germany and China.”

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Another OECD report released in July of last year similarly questioned the recovery of the global economy, noting that while pension assets had returned to pre-crisis levels, full recovery remained uncertain. The OECD asserted that pension funds faced numerous challenges and risks, such as accounting and regulatory changes. The report also showed that six OECD countries had not seen assets recover in local-currency terms. Those countries consisted of Belgium, where assets were 10% lower than in 2007; Ireland, 13%; Japan, 8%; Portugal, 12%; and Spain and the US, which were both down by 3%.

The implication for institutional investors, according the consultants from Hewitt EnnisKnupp, is a pursuit of alternative investments–such as hedge funds, private equity, and real estate–among mainly public pensions along with endowments and foundations. Corporate pension schemes are often in a derisking phase, and are thus focusing their alternatives allocation in more liquid areas, such as hedge funds, according to Mike Sebastian, a partner at Hewitt EnnisKnupp. “Less liquid alternatives is still not an area institutional investors can build exposure to very quickly.

He continued: “We’re seeing investors becoming more and more concerned about the prospects for equities–they’re between a rock and a hard place,” he said. “Due to geopolitical and other risks on top of weak bond market prospects, clients are reacting in two main ways: 1) diversifying away from equity risk, or 2) becoming more dynamic.”

So what’s the way for investors to be most successful with alternatives? Clients who can tolerate the cost, complexity, and illiquidity should consider opportunity-type allocations of 40% of their return-seeking assets to private equity, non-core real estate, and hedge funds, Sebastian told aiCIO in August. “For endowments and foundations, they’re already there, but for public pensions, this could be a significant change,” he said, referring to one of his latest papers titled “Go Big or Go Home: The Case for an Evolution in Risk Taking.”

Sebastian responded to the OECD’s most recent outlook by adding that while the US fiscal cliff situation is a major concern, he is hopeful for a resolution. “Even if the fiscal cliff situation is resolved (and we think it will be), the impact on the bond market will be eroded. The implications on the US market’s future ability to repay debts and manage the fiscal situation is dependent on parities getting together and resolving longer term issues.”

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Liability-driven investing (LDI): The practice of focusing on liabilities in the course of setting and carrying out investment strategies. On this we all agree. But while the meaning of LDI has stayed constant in recent years, the implementation of it has evolved—as it should—in line with fluctuating market conditions, opportunities, and increased knowledge within pension funds.

First, there were the early adopters. These schemes did not hold on to misconceptions about mean reversion of yields, like many others did. They set themselves up with governance structures that enabled efficient and robust investment decision-making and were led by consultants who helped make good decisions. These schemes began to implement their LDI hedges four or more years ago, and they usually took the form of interest-rate and inflation-swap programs. A pool of conventional and index-linked bonds would be held to provide collateral for the swaps, as well as some hedging exposure. They began to build their interest rate and inflation hedges with the aspirational goal of being hedged to their funding level measured on a swap or gilt curve basis.

Despite sounding like an obvious step to some, misconceptions and behavioral anchoring have traditionally been the barriers to LDI adoption. Over the years, however, as hedged schemes achieved better funding levels with less risk, these barriers have been broken down. In their place has grown the idea that effective management of pension schemes starts by hedging the largest risks.

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Over the last few years LDI has moved from a regime of “building the hedge” to one of “LDI as completion manager role.” Under this new arrangement, an LDI manager maintains the hedge ratio in pre-defined bounds around the target level. The manager takes into account the hedging properties of externally held portfolios such as corporate bonds, and uses his discretion on a number of factors—choosing gilts or swaps, positioning along the curve, and trading around such market events as gilt syndications or buy-backs. The aim is to exploit market dislocations and execute the cheapest hedge for the scheme.

Through this evolutionary step, an LDI manager can use the large pools of collateral at his disposal to support a synthetic allocation to equities through futures overlay programs. This means a scheme no longer needs to make an allocation judgement between gilts and equities and can target a higher return while still being fully hedged. The LDI manager can adjust the exposure to futures as necessary according to the required risk and return set by the scheme. Not a bad development.

The LDI manager will bring strategic ideas to the scheme’s investment committee, which may be implemented via a change to the overall benchmark. For example, one recently suggested using swaptions opportunistically when pricing became attractive; this arrangement would achieve a portion of a scheme’s interest-rate hedge, but retain some upside if interest rates were to rise in the future.

Overall, active management and strategic ideas such as these have added material value to pension funds over the last four years. Hedges have performed as expected and matched large increases in liabilities as real yields have continued to fall. The relationship with the LDI manager has become one of the most important for pension funds, with the manager expected to attend regular investment committee meetings and brief on the up-to-date level of the hedge, rebalancing activity, and any opportunities that could benefit the scheme. It is no longer the “buy-and-hold” strategy it may have seemed for some in the past.

There are still plenty of late-converters to LDI, too. Many schemes are only now embarking on a hedge-building program and are finding a tougher economic environment consisting of lower yields and probably worse funding levels to start with.

There is a silver lining though: These funds have the benefit of being able to draw upon the expanded tool set of modern LDI. They also have a larger selection of seasoned and competent LDI fund managers than the trailblazers of the mid-2000s—and now they offer increasingly competitive fees.

Yields are low. We all agree on that too. But giving LDI managers some freedom to select appropriate instruments and access a specific point on the curve gets schemes the best value. Also, seeking to secure long-term cashflows through high quality corporate debt can increase yields, so it’s not all bad news for those late to the LDI party.

LDI is not dead; if it were, UK pension schemes would be in a terrifying state. LDI continues to grow in relevance and necessity—and the evolution of the tools required is keeping pace. Pension funds now need to improve their ability to use them.

Dan Mikulskis co-manages investment consultant Redington’s ALM team. He joined in June 2012 from Deutsche Bank, Sydney, where he specialized in managing quantitative trading strategies relating to FX and equity index options. Dan began his career in the investment consulting business within Mercer, London.