It’s The End Of The World As Institutional Investors Know It

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Institutional investors are anticipating that a decade of low interest rates, low volatility and high investment returns may well be coming to an end in 2018. But just because they see dramatic change on the horizon doesn’t mean they are ready to strike a more defensive pose. Instead, these professional investors see the potential for global growth to continue and nobody wants to be the first to leave the party before it ends.

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As the outcome of dramatic change, institutional decision makers forecast higher levels of market volatility, greater dispersion of returns, and lower correlations for 2018. Three-quarters say it all adds up to an environment that favors active management. Survey results show they’ll look to take advantage of growth opportunities around the world with tactical allocations in equities and put alternative investments to work for both yield replacements and enhanced return potential.

The institutional mindset

  • Three-quarters say today’s environment favors active management
  • Three-quarters worry that a long period of low rates has created asset bubbles
  • Six in ten believe rate increases will have a negative impact on performance

Active management, tactical allocations, and alternative investments

Given these factors, institutional decision makers foresee plenty of risk on the horizon: Geopolitical uncertainty and potential market spikes, inexplicable market growth and potential asset bubbles, and the specter of rising interest rates all factor into their outlook for 2018. While many anticipate that these factors may translate into an uptick in volatility, it appears that a large majority of institutions believe there is opportunity to be found in the fury.

In order to be better positioned for a changing market, respondents in the 2017 Natixis Global Survey of Institutional Investors appear to be making adjustments to allocation plans rather than a wholesale shift in portfolio strategy.

Key investment trends include:

  • Active management: Institutions demonstrate a clear preference of actively managed investments and continue to allocate the majority of assets to these strategies.
  • Regional diversification: On the heels of double-digit returns for the S&P 500 in 2017, institutional investors are betting on Europe and Asia as growth drivers for 2018.
  • Alternative investments1: Low yields have institutions looking for fixed income alternatives and in many cases focusing on the higher return potential of private markets. While they may believe the constants of post-crisis markets will begin to shift in 2018, it appears that institutional investors are not worried about their world changing. The so-called smart money is moving forward with long-term plans.

Risk, returns, and realistic assumptions

Faced with what they believe to be more volatile markets, institutional investors are building investment plans with an average return assumption of 7.2%. Confidence in their ability to achieve these results remains high with 64% reporting that they anticipate no changes in their return assumptions over the next 12 months. Given that a majority of institutions anticipate increased volatility in equities (78%) and bonds (70%), it’s no surprise that one-quarter of respondents believe they may actually reduce their expected returns in 2018. But it is surprising to see that one in eight institutions say they will actually increase return expectations in the year ahead.

Even though three-quarters of institutions believe their targets are realistically achievable, it should be noted that few think meeting these performance goals will be an easy task, as evidenced by the nine out of ten (92%) who say meeting long-term return assumptions is a challenge for their organization.

Where the risks lie

Despite a positive outlook on their ability to generate returns, these investors realize the task will be difficult if their greatest worries about risk are realized. Geopolitics top their list of risk concerns in 2018 with three-quarters (74%) of institutions saying this factor will have a negative impact on portfolio performance. Much as we saw on the heels of Brexit and the Trump upset in 2016, institutions have witnessed once seemingly improbable possibilities come to light in 2017. A nuclear-armed North Korea, investigations into Russian meddling in the US elections, populism, protectionism, and potential trade wars all factor into geopolitical risks. While none has resulted in market upheaval to date, it appears that institutions are more concerned about the question of when it will happen, rather than if it will happen at all.

Institutional Investors

Bubble trouble

Beyond politics, nearly two-thirds of institutions (65%) see the potential for asset bubbles (where rapid price inflation far exceeds the fundamental value of the underlying asset) in both stocks and bonds. More than three-quarters (77%) believe that the prolonged period of low interest rates is the projected cause of asset bubbles, and while they may be a concern, it is surprising to see that bubbles are not causing high levels of anxiety for all respondents. In fact, one-quarter of respondents believe asset price bubbles will have no impact on performance at all in 2018. But bubbles alone are not the only rate-driven concerns for institutions.

Institutional Investors

The biggest bubble

Institutional investors may believe bubbles have formed in both the bond (42%) and stock (30%) markets, but concerns for these traditional assets pale in comparison to the 64% who say there’s a bubble in Bitcoins. First introduced conceptually in a 2008 whitepaper penned under the alias of Satoshi Nakamoto, this cryptocurrency has soared almost 1,000% to a dollar equivalent of nearly $10,000 in 2017. As if to confirm its bubble status, the currency jumped 11% on November 15, 2017 when digital payment specialist Square Inc. announced it would accept the currency as payment on its mobile system.

Institutional Investors

Rates pose double troubles

Institutional investors view rate concerns through two distinct lenses. First, after working under the reality of low rates for nearly a decade, six in ten institutions believe interest rate increases will pose performance risk in 2018. In essence, when rates finally go up, many are worried that the ensuing drop in value of current bond investments could upend portfolios built on traditional assumptions about fixed income. Despite the short-term risk management concerns, many may also be glad to see rates rise, which will help to reduce long-term liabilities.

It’s likely that institutions will watch central bank policy developments across the globe carefully. In the US, leadership change at the Federal Reserve Bank in early 2018 is likely to draw the attention of these decision makers as they look to be assured that the Fed continues to telegraph interest rate moves. Globally, many will want to ensure that if the historic monetary policies constructed over the past decade are to be unwound it will be the result of slow and thoughtful action.

Institutional Investors

The speed at which rates increase will be of particular interest to institutions. With a 7.2% return assumption, a pop in inflation and particularly wage inflation may be cause to revisit long-term performance goals. Further complicating the potential problem of a rate increase, this would be the first bear bond market that many of today’s traders have ever seen.

Second, the current low rate environment presents another risk concern as institutions seek to generate the income needed to shore up long-term obligations. For many it has meant moving further out on the risk spectrum to pursue higher yields. With institutions reaching for lower-rated and riskier issuers to meet their objectives, it’s no wonder that seven in ten believe institutions have taken on too much risk in pursuit of yield.

To better position portfolios for a potential rising rate environment, 31% of institutions say they will look to manage durations in their fixed income portfolios. Another quarter (23%) say they will increase their use of alternative investments as they seek out yield. Just under 10% (8.4%) of respondents say they are not taking steps to reposition their holdings.

Article by Natixis Investment Management

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