expected investment returns and risk management in a … · expected investment returns and risk...

Expected investment returns and risk management

in a post solvency-test world?

ACPM Webinar

October 18, 2017

Presented by:

Ben Homsy, CFA

Portfolio Manager

Marc Williams, CFA, F.C.I.A.

Portfolio Manager

Leith Wheeler Investment Counsel Ltd.

2

The Perils of Economic Forecasting

3

History Doesn’t Repeat Itself, But…

Severe Systemic Crises

• 1977 Spain

• 1987 Norway

• 1991 Finland & Sweden

• 1992 Japan

• 1997 Asian Crisis ex-Japan

Extended Recovery

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

-2 -1 0 1 2 3 4 5 6 7 8 9 10

Pe

rce

nta

ge

Date since trough in leading indicators (Years)

Real per Capita GDP Source: Bloomberg, Reinhart & Rogoff

Average Post-WWII recoveries

Extended Recovery

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

-2 -1 0 1 2 3 4 5 6 7 8 9 10

Pe

rce

nta

ge

Date since trough in leading indicators (Years)

Real per Capita GDP Source: Bloomberg, Reinhart & Rogoff

Current US Recovery…

Average Post-WWII recoveries

Extended Recovery

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

-2 -1 0 1 2 3 4 5 6 7 8 9 10

Pe

rce

nta

ge

Date since trough in leading indicators (Years)

Real per Capita GDP Source: Bloomberg, Reinhart & Rogoff

Current US Recovery…

Average Post-WWII recoveries

Severe Crises…

7

History of Interest Rate Policy

0

2

4

6

8

10

12

14

16

18

16

94

17

04

17

13

17

23

17

32

17

41

17

51

17

60

17

70

17

79

17

88

17

98

18

07

18

17

18

26

18

36

18

45

18

54

18

64

18

73

18

83

18

92

19

01

19

11

19

20

19

30

19

39

19

49

19

58

19

67

19

77

19

86

19

96

20

05

Ban

k O

f En

glan

d In

tere

st R

ate

Long-Term Central Bank Interest Rate Source: Bank of England, The Guardian

Interest rate

8

Global Policy Interest Rates

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

2004 2006 2008 2010 2012 2014 2016

Po

licy

Rat

e

Global Policy Rates Source: Bloomberg

United States Canada Europe Australia Sweden Norway New Zealand Japan

How Pervasive Are Negative Yields?

Mar

ket

Val

ue

US$

Tri

llio

n

Source: BofA

Unconventional Easing

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

2005 2007 2009 2011 2013 2015 2017

US$

Bill

ion

Central Bank Balance Sheets Source: Bloomberg

US Federal Reserve ECB BoJ Total

Building Blocks of Growth

Building Blocks of Growth

Working Age Population

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1976 1986 1996 2006 2016

An

nu

al %

Ch

ange

Working Age Population Source: OECD

United States Canada

Participation Rate

58

59

60

61

62

63

64

65

66

67

68

1950 1960 1970 1980 1990 2000 2010

Par

tici

pat

ion

Rat

e (

%)

Participation Rate Source: Bureau Of Labor Statistics, Statistics Canada

United States Canada

Changes In The Labour Force

-1%

0%

1%

2%

3%

4%

5%

6%

Canada

Labour Force Growth Labour Force Trend growth Labour Force Forecast Growth

-1%

0%

1%

2%

3%

4%

United States

Labour Force Growth Labour Force Trend growth Labour Force Forecast Growth

-2%

-1%

0%

1%

2%

3%

4%

Japan

Labour Force Growth Labour Force Trend Growth Labour Force Forecast Growth

-2%

-1%

0%

1%

2%

3%

4%

Germany

Labour Force Growth Labour Force Trend Growth Labour Force Forecast Growth

Hours Worked

32

33

34

35

36

37

38

39

40

1965 1975 1985 1995 2005 2015

Ave

rage

Wee

kly

Ho

urs

Average Weekly Hours (US Non-Farm) Source: Bureau Of Labor Statistics

United States

Building Blocks of Growth

Capital Investment

-20

-15

-10

-5

0

5

10

15

20

25

1990 1995 2000 2005 2010 2015

Inve

stm

en

t %

Gro

wth

US Gross Private Domestic Investment (Non-Residential) Source: Bureau Of Economic Analysis

Recession United States Long-Term Average

Global Productivity Challenges

-1

0

1

2

3

4

5

Pro

du

ctiv

ity

Gro

wth

(%

) Canada

Annual growth rate Trend growth

-1

0

1

2

3

4

5

Pro

du

ctiv

ity

Gro

wth

(%

) United States

Annual growth rate Trend growth

-1

0

1

2

3

4

5

6

7

8

Pro

du

ctiv

ity

Gro

wth

(%

)

Japan

Annual growth rate Trend growth

-3

-2

-1

0

1

2

3

4

5

6

Pro

du

ctiv

ity

Gro

wth

(%

)

Germany

Annual growth rate Trend growth

Downshift in Trend GDP

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1981 1986 1991 1996 2001 2006 2011 2016

No

min

al G

DP

%Yo

Y

US Nominal GDP Source: Bloomberg, Bureau of Economic Analysis

US Nominal GDP Growth 5Y Trend GDP Growth

• Introduced to improve security, minimal impact initially (prudent actuarial Going Concern valuations)

• As market yields fell sharply:

– Solvency Liabilities rose, dominating GC

– Interest rate risk became the main

investment risk (along with mark

to market volatility)

– More desire to remove interest rate

risk (and add diversifying return premia)

• CBs keeping rates low for surprisingly long time

• Temporary easing rules were introduced

• Now more permanent changes considered – Quebec, Ontario, BC, Sask, Others?

Solvency Recap

Going

Concern

ratio

Solvency

ratio

Morneau Shepell News & Views Feb 2017

• Firstly, there is uncertainty as to how Regulators will ultimately amend/replace Solvency rules

• However, early signs are of 2 main approaches

1. ‘Weaker’ solvency tests (e.g. lower funding threshold)

2. No solvency test but a stronger GC test; the assumed wind-up test using market bond yields will become more of a long term sustainability test

Longer term, say 10 or more years for funding

Discount rates based on expected returns; asset mix then matters

Inclusion of margins (PfADs – Provision for Adverse Deviations)

Higher margins if there are more equities

Additional margin if the expected return (GC discount rate) is greater than a reference rate

New Regimes?

So Drop Interest Risk Awareness?

Year

Benefit

Cashflows

• No

• LDI is not merely a product or solution, it is a process

• Obligations are still a stream of cash flows to be delivered

• This profile continues to form part of the risk & mix decision

• Ignoring market timing, bonds will still have a strategic part to play

GDP and Bond Yield Correlation

0

2

4

6

8

10

12

1980 1985 1990 1995 2000 2005 2010 2015

Per

cen

tage

(%

)

Nominal US GDP vs 10Y Treasuries – 7Y Moving Avg. Source: Bloomberg

10Y US Treasury Yield Nominal US GDP Growth YoY%

Expected Returns In Fixed Income

0%

5%

10%

15%

20%

25%

1980 1985 1990 1995 2000 2005 2010 2015

Per

cen

tage

%

Barclays US Aggregate Bond Index Source: Bloomberg

Return Starting Yield at time of investment

Expected Returns In Fixed Income

Decade

Average US Nominal GDP %

YoY

Average Starting Yield at Time of

Investment (Corporate Bond Index)

Average Return (Corporate Bond Index)

1980s 8.0% 10.9% 11.9%

1990s 5.5% 8.3% 9.3%

2000s 4.1% 6.0% 6.5%

2010s 3.7% 4.3% 5.2%

Current 2.9% 2.5% 2.5% +/- 1.0%

Diversification Remains Important Plans Should Play To Their Competitive Advantages

0%

20%

40%

60%

80%

100%

0%

20%

40%

60%

80%

100%

Expected Returns In Equities

Earnings Yield:

Dividends & Share

Buybacks

Earnings Growth:

Corporate Margin

Expansion & Sales Growth

Valuation Adjustment:

Mean Reversion of

Price/Earnings Ratio

Expected Returns In Equities

Earnings Growth

Earnings Yield

Valuation Adjustment

Other Unexplained

Total Return

1980s 5.1% 8.9% 5.6% -2.4% 17.2%

1990s 7.6% 4.9% 7.1% -1.5% 18.2%

2000s 1.5% 5.2% -4.2% -3.5% -0.9%

2010s 9.3% 6.1% 1.1% -3.6% 12.8%

Current 2.9% 4.8% -1.2% - 6.5%

Valuation Multiples and Interest Rates

-

2

4

6

8

10

12

14

16

18

0

5

10

15

20

25

30

35

1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017

10

-Yea

r G

ovt

Bo

nd

Yie

ld

P/E

Rat

io

S&P500 Price/Earnings Ratio vs 10-Year Govt Bond Yields Source: Bloomberg

S&P500 P/E Ratio 10-Year US Government Bond Yield

• Bonds remain but need to be reviewed for their fit in a new environment

• Diversification of return seeking assets remains important

• Revisit the trade-off that may have been made; volatility vs return expectation

– Is it now too large? Have you ‘overpaid’ for lower volatility?

– Models may have placed (too) high a value on (perceived?) low volatility?

– Were some asset classes or products excluded that might be of value?

• May lead to the ability to accept more risk if it is expected to be rewarded

– Accepting short term market volatility for additional long term return

– The split between active and passive management may be affected

• Particularly if active returns come with short term volatility

So What Could It Mean For Portfolios

Thank You

Ben Homsy, CFA

Portfolio Manager, Fixed Income

BenH@leithwheeler.com

Marc Williams, CFA, F.C.I.A.

Portfolio Manager

marcw@leithwheeler.com