Where to From Here?

Robin Diamonte, chief investment officer at United Technologies, recalls a particularly upbeat meeting with her investment committee. A commonly shared belief that interest rates were on the rise was the cause of the excitement.

“It’s all going to be good news from here on, because interest rates are going to go up, and funded status is going to improve,” Diamonte said wryly, remembering the sentiment at the meeting. That was her first year with the company in December 2004. “Here I am, 13 years later, still waiting for interest rates to go up,” Diamonte said.

For CIOs looking to de-risk their LDI programs, the direction of interest rates features as a central variable. Rising rates—which move in the opposite direction to fixed income prices—allow companies to de-risk their plans less expensively. Buying bonds at lower prices, of course, allows defined benefit (DB) plans to match assets with liabilities more cheaply. Moreover, if rising rates translate to higher corporate bond yields, it may prove to be a tailwind for DB plans, as the present value of one’s pension obligation is also lowered and the funded status of the plan is improved given higher discount rates.

Signs that interest rates were finally headed for liftoff were in abundance in 2017. Equity markets went on a tear following a new administration that promised massive fiscal expansion and deregulation. Bond markets sold off on the prospect of inflationary growth with the benchmark 10-year hitting 2.6% in March—the highest level in three years. Signs of wage inflation mounted as unemployment dipped to 4.2% in October, the lowest level in decades.

By the year’s end, however, rates had started to roll over again. For all the tough talk, the Trump administration ran into one stumbling block after another—putting into serious question whether its loudly promised tax reform agenda would make it through meaningfully.

The year was a perfect illustration of the frustration with predicting the direction of interest rates—and underscored the holistic, strategic mindset CIOs need to adopt when thinking about how aggressively to de-risk. “We talk to our managers. We’ve been saying it for a while, and it really looks like we’re at a point now where interest rates can go up,” Diamonte said. “Again, because we’ve been saying it for so long, you don’t want to wait. It’s almost like to the point where, ‘do I want to keep on waiting to de-risk?’”

Diamonte points out that there is much more than price to consider when deciding what interest rates to lock in. There is the key element of earnings volatility that pension costs can introduce, given the vagaries of where interest rates may be, and given market dynamics. “We, like probably the rest of the world, think that interest rates are going to go up and the bond market is expensive,” Diamonte said. “But it’s really hard to wait around.”

Pension obligations and unfunded liabilities are determined at the end of the year and entered into corporate earnings based on Generally Accepted Accounting Principles (GAAP). A swing in markets can therefore impact a company’s crucial Earnings Per Share (EPS) number. “It’s what the number is on 12/31, and what the interest rate is on 12/31, which makes it very difficult,” Diamonte said. “Because you can have bad news that happens in December, and the interest rate could drop. If there is some flight to quality, or something happens with geopolitical risk, everybody pours into treasuries and the discount rate can go down. Even if it goes down for a short period of time, it can really hurt our earnings. Managing volatility is crucial.”

A lack of inflationary pressures, however, is a key reason interest rates have so far failed to go up this year. At the short end of the yield curve, inflationary pressures prompt the Federal Reserve to boost interest rates. And at the long end of the yield curve—crucial for CIOs evaluating their LDI programs since they are looking at long-dated maturities—investor expectations are key. Here, the anticipation of inflation causes yields to rise as investors demand a higher rate of return for holding the long-dated bonds. Higher inflation expectations eat into the inflation-adjusted, or real-yields, and investors demand a higher nominal yield as a result.

Having a solid understanding of why inflationary pressures have failed to materialize—and if they may, in fact, be around the corner—is key for CIOs as they think about de-risking their LDI programs. Indeed, it was the hopes of inflationary growth driven by the Trump administration’s agenda of fiscal expansion and deregulation at the start of the year that caused bond yields to jump then.

So far, though, the lack of inflationary pressures has vexed markets.

“Despite the synchronized growth cycle, the summer months saw inflation go missing in action across many of the world’s economies,” Erik Knutzen, chief investment officer, multi-asset class at Neuberger Berman, wrote in an October report. “In the US, consumer prices started to disappoint in March and wage inflation has flatlined for a year.”

The lack of inflationary pressures has vexed policymakers, too.

Questions about whether inflation is simply lagging or altered by bigger factors remain. Technology, through its hypercompetitive, cost-cutting upshots, is often thought to be a factor. And the growing demand for long-dated, fixed-income securities by an aging population is also cited as a reason holding rates down.

“Federal Reserve Chair Janet Yellen has expressed puzzlement, unable to decide whether this was a result of short-term effects or something structural, such as the rise of online shopping or the baby-boomer cohort entering retirement,” Knutzen wrote.

Whatever the cause, the lack of inflationary pressures caused the Fed to reign in its rate hike forecast. And the reverberation through markets because of the pause was even more profound.

“September saw Federal Open Market Committee (FOMC) members lower their ‘dot plot’ forecasts for the path of interest rates,” Knutzen wrote. “But where the FOMC was merely hesitant, the market reacted strongly, lowering its estimate for the pace of 2018 hikes and, at one point, almost discounting a December hike altogether.”

Knutzen believes that inflation is merely lagging. “Our view is that we are currently moving from mid-cycle to late-cycle growth, which implies that some rise in inflation ought to be baked into expectations,” he wrote. “Against a background of synchronized growth, low and falling unemployment, and US corporate margins at record highs, we believe the current softness in inflation could be a lagged effect of weak growth and low energy prices during 2015-16.”

And that view was borne out by the market dynamics of the fall. “September saw signs of a number of markets apparently adopting that view: the US dollar and crude oil rallied, yields rose, energy and financial stocks were bid up, rates markets pared back much of their skepticism about a December hike from the Fed,” Knutzen wrote, adding that the market may still be underestimating inflationary pressures and the Fed’s rate hike schedule. “But we believe that pricing still lags the potential, especially in key indicators such as US inflation breakeven rates. As such, in a scenario of a return to a moderate rise in inflation, the Fed’s forecast for rate hikes in 2018 would be closer to reality than the market’s.”

Rising rates in the US, though, can be stymied by global capital flows. Rates are lower in many other parts of the world, and investors there chasing yield can pile into US fixed-income markets as a result. The real yield on US fixed-income can be even higher for many European investors on the cusp of deflationary economies, and those in Japan as well.

Still, other analysts see the deflationary backdrop tamping down inflation not just as temporary, but structural—and see a sharp turn in those factors in the years ahead.

“We believe the balance of secular drivers over the next several years is inflationary, as a range of factors that have suppressed prices over the past decade are reaching inflection points,” Steve Becker and Alex Stiles, portfolio managers at Goldman Sachs Asset Management, wrote in their most recent report on inflation. “Several factors that have helped contain price pressures over the past decade or longer may be starting to reverse, in our view. We would highlight three that are at, or getting closer to, inflection points: labor supply, income distribution between capital and labor, and globalization.”

Art by Lars Leetaru

As the US reaches full employment, workers will again have the leverage to demand higher wages. And those higher wages will lead to increased demand and inflationary pressure in the economy.

“As oversupply in the labor market is absorbed, workers have more bargaining power and wages should rise, boosting inflation,” Becker and Stiles wrote. “In turn, rising wages should start to correct the skew of income distribution from holders of capital—investors and savers—in favor of workers, who have a higher propensity to spend.”

Globalization, meanwhile—a generational and deflationary force—may also be receding.

“As for globalization, we believe this trend has already peaked. The global spread of supply chains over recent decades has been a powerful disinflationary force, but companies are no longer pushing as aggressively offshore to rationalize costs,” Becker and Stiles wrote. “The rise of protectionist policies in the US and the potential knock-on effects could catalyze onshoring, and drive up production costs and prices of imported goods.”

A major deflationary force continues to lurk in the form of technology, however.

“Today’s technological advances are putting power in the hands of consumers. A key component of pricing power is price transparency, and shoppers can now compare prices of just about any goods and services in real time,” Becker and Stiles wrote. “Stores are incentivized to price competitively because they know their consumers are not only price-conscious, but price-aware. Moreover, more brands are using technology to sell directly to consumers, which takes out a layer of mark-ups.”

The shift from manufacturing to services employment is also weighing down on wage inflation. “One of the biggest long-term drags on wage growth is the skew in job creation from manufacturing to the lower-paid services sector,” Becker and Stiles wrote. “The momentum behind the expansion of the services sector may be past its peak, but the deflationary effects will persist as manufacturing workers retire over the next decade.”

Overall, though, inflationary pressures could be building again for both cyclical and structural reasons. As a global economic recovery gains steam, inflation could finally materialize. And as the labor force tightens amid full employment, a greater share of the income goes to labor—those likely to spend it—and the deflationary forces of globalization recede, those cyclical factors could find a strong structural tailwind.

Rising interest rates could finally come to the aid of CIOs as they de-risk their LDI programs—even if they do materialize well over a decade after many forward-looking asset owners had originally anticipated them. Managing volatility and the impact on corporate earnings, however, means that more should be taken into account than just the cost of the fixed-income instruments needed to de-risk. A shock to the global economy means they could quickly go the other way at an inopportune time.