Four Global Trends to Watch For

Coverage of the 2011 Global Investment Conference.

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727423_amsterdam_binocularPension plans today are wrestling with a fundamental contradiction: how can plans, especially underfunded ones, reconcile the need to make more money in a low return environment with pressing concerns about market volatility and risk management? As sponsors wrestle with this conundrum, they should consider that significant and lasting changes in global equity and debt markets suggest that meaningful changes in asset allocation, risk assessment and manager selection may be appropriate.

There are four key trends that plan sponsors should be aware of. The first is the increasing correlation of global equity markets; as economic policy coordination among major economies becomes the norm, the traditional approach to geographic diversification with its regional allocations will likely not deliver as much diversification and volatility reduction as in the past.

Rising Correlations Among Global Markets (Click to enlarge)
Percentage Change 1991-2000 vs. 2001 – 2010

Pyramis Chart 1

Second, global growth is increasingly driven by exports and companies are seeking opportunities in export markets, especially rapidly growing emerging markets. This means that equity selection is becoming more about picking the stocks of companies with prospects in global markets than about picking regions. These two trends suggest that plan sponsors should review structures that allocate capital by region and consider managers with a global stockpicking approach rather than more traditional regional research and portfolio management.

Third, plan sponsors should consider the possibility that risk will come in very different forms in the next decade compared to the past ten years. For example, Canadian plans should consider rethinking their home country equity bias. While the Canadian market has been an unquestionable success for the last decade, that success has been due to the dominant proportion of the market devoted to resources. Resources markets are highly cyclical and driven by global factors – see, for example, the recent impact of Middle East uprisings on oil markets, and imagine what a similar development in China would mean for Canadian equities. There are many ways to invest in the long-term growth of the emerging world that would diversify a Canadian investor’s positions in home country stocks.

Volatility In A Long-Term Context (click to enlarge)

Pyramis Chart 2

At the same time, the perceived risk that investors attach to emerging market equities is likely to decline as those markets continue to deepen and become more liquid, developing economies account for an ever-higher percentage of world GDP, and the creditworthiness of their governments continues to improve.  These shifts suggest that the amount of equity and the distribution of that equity exposure could look quite different in pension plan allocations in coming years.  To the extent that global stockpicking and greater emerging market exposure create new currency risks for plan sponsors, Canadian pension plans are sophisticated enough to hedge their asset choices effectively.

Fourth, and last, the likely end of a 30-year decline in interest rates coupled with the deterioration of developed market government creditworthiness means that pension funds should consider the possibility that they could lose money in bonds over a meaningful investment horizon. While asset allocation models often prescribe significant bond holdings, plan sponsors should consider the return implications at the plan level of a low-to-negative return on bonds.  They should also evaluate the composition of their fixed income exposures, and consider rebalancing toward types of debt that have secular tailwinds or that provide a cushion in a rising interest rate environment, such as emerging market debt, corporate debt, bank debt and floating rate debt.

DEX Long Term Bond Yields At The Low End Of History (click to enlarge)

Pyramis

The increasing pace of globalization, the rapid rise of the emerging markets and the reversal of decades-long trends in capital market trends suggest that plan sponsors should consider significant changes in asset allocation, plan structure and manager selection, and risk assessment.  Small changes at the margin of traditional practices or structures may not appropriately reflect the magnitude of the changes occuring in markets.

John Power is Senior vice-president, U.S. Equities, Pyramis Global Advisors

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