What ‘higher-for-longer’ would mean for global public investors

Global public funds walking a tightrope between risk and return

In times of volatility, investors seek a flight to safety. This trend was apparent in OMFIF’s 2022 Global Public Pensions report. Last year, surveyed pension and sovereign funds with over $3tn in assets under management reported an intention to adopt more conservative strategies, demonstrating their intentions to invest in higher-rated government bonds and perceived safe-haven currencies, and to deploy their cash holdings.

At the same time, our findings revealed a parallel trend. Funds were also looking to bolster returns by shifting toward alternative asset classes. The strategy to diversify via alternative asset classes does not come without risks. Though offering higher returns, many of these are illiquid assets.

Facing heightened market volatility, funds are now looking to bolster returns while simultaneously preserving capital and maintaining liquidity in a challenging macroenvironment. Striking this balance will not be easy. As we prepare for the publication of Global Public Pensions 2023 – the second iteration of our flagship report series Global Public Investor – these trends will be at the forefront of our analysis.

Global public funds seeking returns via alternative assets

Following a decade and a half of lacklustre returns on traditional assets, institutional investors have trended toward increasing their exposure to alternative assets. This is particularly true of public pension and sovereign funds. With their large pools of patient capital, they are well-equipped to take advantage of the illiquidity premium offered by private markets.

Traditional asset classes still compromise the bulk of most global public pension fund portfolios. Our analysis of the largest 50 global funds by AuM shows that, as a weighted average, fixed income and public equity allocations still made up over 75% of assets last year. Alternative investment allocations were small by comparison, totaling only 5% to 6% in private equity and real estate and less than 2% in infrastructure.

But this share looks set to increase. Last year’s survey showed that over the next two years, more than 40% of survey respondents plan to allocate more to real estate and infrastructure assets (Figure 1). At the forefront of survey respondents’ allocation preferences were inflation-hedging assets, such as real estate and infrastructure, along with government bonds tied to inflation.

Figure 1. Over the next 12-24 months, do you expect to increase, reduce or maintain your allocation to the following asset classes? Share of respondents, %

Source: OMFIF Global Public Pensions 2022 survey

Risk factors compounding

These allocation decisions made sense in the context of last year’s market conditions. When bonds and public equities faltered last year, a variety of alternative asset classes offered real returns and a hedge against inflation.

But a variety of structural challenges are compounding risk factors. OMFIF’s survey also revealed that the vast majority of respondents (85%) see persistently high inflation as the top challenge over the long term (Figure 2). Other challenges include geopolitical tensions, increasingly common physical shocks due to climate change and an ageing population in most major economies.

All of these factors, to varying extents, were seen as challenges which will affect funds’ investment approach over the medium to long term in last year’s survey (Figure 2). In combination, these trends could add to inflationary pressures, necessitating higher equilibrium real interest rates.

Figure 2. What are the most important economic challenges affecting your investment approach over the medium to long term?

Source: OMFIF Global Public Pensions 2022 survey

Investment implications

If interest rates come down in the next one to two years as markets still anticipate, most institutional investors would not need to significantly recalibrate their investment strategies. But a ‘higher-for-longer’ environment, in which equilibrium interest rates are higher than pre-pandemic levels, may be increasingly likely as central banks in most major economies continue their fight against inflation.

Over time, higher interest rates erode the risk premium which has made alternatives so attractive in relation to traditional assets in the first place. This could prompt major reconsideration of asset allocation. The allure of higher fixed income yields may soon outweigh the pressure to avoid assets that are falling in price. In this scenario, there could be a case to reconsider exposure to illiquid or riskier asset classes. Funds will need to determine the additional risk premium on top of nominally higher interest rates and adjust their exposure accordingly.

Not all assets within a given asset class are equally risky. Some pension and sovereign funds have also been diversifying their fixed income portfolios as well to include credit, high yield and emerging market instruments. These are much riskier than investment-grade debt. And among alternatives, the long-term prospects for valuations in infrastructure may be rosier than in commercial real estate, for example. Moreover, not all funds are equally exposed to illiquid assets, with Canadian and Australian pension funds much more diversified into private markets than other peer institutions.

The key for global public funds will be to balance risk with return over the long term, as they face exogenous shocks to the macroeconomy, which are increasing in scope and frequency.

What to watch for

Are global public funds fazed by tight monetary policy, geopolitical risk and stagflation? How is this impacting their investment objectives? How might their allocations, by asset and region, shift as a result? And what are the implications for fixed income, equities and alternative assets?

These themes, in addition to environmental, social and governance considerations, operating models and data, will be explored in depth in OMFIF’s forthcoming Global Public Pensions report.

Taylor Pearce is Senior Economist at OMFIF.

OMFIF’s 2023 Global Public Pensions report will be launched 30 November 2023.

If you represent a public pension or sovereign wealth fund and are interested in participating in our GPP research, please contact research@omfif.org.



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