Fragmentation
Shift from monetary to fiscal stimulus
Capital abundance
Long-term structural change (aging, climate change and technological disruption)
“The global economy is starting to reflate with stronger growth and higher inflation expected in 2017. This coincides with a period in which monetary policy is likely to become less supportive, creating the potential for increased volatility in financial markets. The changing political landscape introduces an additional layer of uncertainty,” said Deb Clarke, Mercer’s Global Head of Investment Research. “Whilst our four themes reflect some of the key issues facing the global pensions and investment community, organizations will respond in different ways, reflecting their specific beliefs, objectives, governance arrangements and constraints.”
Fragmentation
With further political fragmentation and de-globalization possible, investors should consider stress-testing their portfolios against large equity, bond and currency movements. Reduced levels of liquidity in some markets may exacerbate the magnitude of any sell-offs providing opportunities for contrarian investors and favouring flexible and dynamic strategies.
Increased protectionism and risk around policy implementation has the potential to create additional volatility in markets.
This should provide opportunities for active managers. Political surprises, protectionism and trade tensions also create the potential for substantial currency volatility so investors should have a clear policy on hedging currency risk.
Shift from monetary to fiscal stimulus
Government policy around the world is shifting towards fiscal stimulus while policymakers have increasingly recognized the limitations and unintended consequences of further monetary stimulus. The path of inflation over the next few years will be influenced to some extent by the scale and pace of any fiscal stimulus, as well as the actions taken by central banks. Investors with inflation-linked liabilities should consider direct inflation hedges or real assets such as real estate and infrastructure.
Increased uncertainty around monetary policy in an environment of rising inflation will likely contribute to bond market volatility, creating opportunities for global macro, absolute return bond and unconstrained fixed income strategies. A more aggressive tightening of monetary policy than is currently priced in may cause some companies to struggle to refinance their debt. This could create opportunities for strategies that are positioned to allocate capital to distressed assets.
Capital Abundance
Following eight years of monetary stimulation by central banks, real yields are below zero in much of the developed world; and financial assets have delivered exceptional returns against that background. On a forward looking basis, we believe that generating annual real returns as high as 3%-4% will be a challenge over the next 3-5 years. Portfolios dominated by traditional ‘beta’ (equities, credit and government bonds) now offer a relatively unattractive risk-return trade off so investors will need to consider less familiar asset classes and more flexible strategies in order to meet return objectives. Investors should seek returns from a diversified mix of alpha sources and opportunities also remain for high-quality managers specializing in private markets. Less familiar segments of the credit markets (such as asset-backed securities, private lending, trade finance and receivables) also offer opportunities. In an environment of higher volatility, strategies with the ability to move quickly across markets such as multi-strategy hedge funds or dynamic multi-asset strategies may be helpful in generating returns.
Understanding Structural Change
Longer-term structural forces (demographic trends, climate change and technological disruption) will have important implications for investors. In relation to climate change that might be physical risks to real assets or policy risk to any carbon-sensitive assets. Despite uncertainty around President Trump’s beliefs and US policy trajectory on this issue, climate change remains an issue of global importance and investors should review the extent to which portfolios are exposed to carbon-intensive assets. The overriding demographic trend is global aging with the ratio of the dependent population (children and retirees) to the working age population now rising in many countries. This will challenge some countries to a greater extent than others thereby creating economic divergences at a regional level. In the long-term, as developed world baby-boomers enter retirement, they will draw down their pools of assets, placing upward pressure on bond yields over time.
Technological disruption will create opportunities, particularly for long / short investors able to identify the winners and losers from technological change. Market cap indices may be at particular risk from technological disruption given that these indices hold large weights in the existing incumbents across all sectors. Many private companies are now choosing to stay private longer than in the past so investors may need to be willing to allocate to early stage private equity in order to access these sources of future growth.
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