Scene + Heard

Through the Blizzard: 2016 – 2017

Snowy day reflections on 2016 and 2017. 

CIO217_Landscape_SH1_James-Yang.jpg Art by James Yang

With a blizzard buffeting the northeast, it seemed like good time to reflect on 2016 and 2017. 

In with the old, out with the new could be a theme for 2017. But is there a need to reinvent the wheel? Although it’s always said you cannot base the future on past results, it’s interesting to see what works in each climate. 2016 brought some changes not many anticipated, and 2017 has already shown signs of market elation. Yet news of immigration reform brought a fickleness to the markets that has some scratching their heads when assessing their November/December allocations. We thought it might be a good time to reflect on what worked for 2016, and what is important for 2017 by starting a discussion. We intentionally kept the questions vague.

High Seas

Obviously, 2016 had many challenges that may have made investors feel as if they were commanding a ship on high seas. “People forget that 2016 was one of the worst starts to a year in history,” Chris Ailman, chief investment officer of CalSTRS, said. We started the year with concerns about China and a hard landing, and then suffered until around Valentine’s Day. After the day of love, the market started to slowly crawl to higher ground. “Not with a lot of gusto, but just sort of creeping,” Ailman says. The low-return environment was, obviously, not very exciting. And later in the year, with Brexit and the US elections, we learned how very wrong pollsters and pundits could be

With Brexit, pundits predicted the day after would be apocalyptic for Britain. "It was so volatile," Ailman said. But the timing was the reason Brexit is indelibly etched into some of the minds in the industry. For most public pensions, June 30 is year end. It was akin to having a very slow year, and just when you think you've laid it to rest, on the very last days, a tornado strikes

"To have all of that transpire the last week of your year, it still left scars. To our board it was almost like revisiting 2008 again," said Ailman. The funds reeled from positive returns-to negative-to positive returns. "But looking back now, it's almost much to-do about nothing." Brexit is a two-year event, and yes, the pound has been hammered and businesses are rethinking things within the changing the landscape, but Britain didn’t disappear.

Afterward, the US election just made you want to press fast-forward, chuckled Ailman. "And I still think it took about 1% off the GDP because the talk was so negative." Although it can’t be measured, he thinks the downcast faces and negative chatter affected a large swath of the economy, from businesses to worker productivity to consumers. "And obviously, we now know that there were so many companies that just sat on their cash because they did not know what to do. And I don’t think CEOs had any confidence about what to do."

The vetting was wrong. Pollsters were wrong. In the UK, Ailman says he pays attention to the bookies. And even they were wrong. But then there was the sweet rally in the last 45 days of the year which made it all worthwhile

Course Correction

"You look back on 2016 as a calendar year and even though we started with one of the worst years ever, we made a pretty decent return," Ailman says. "We got a double digit return out of equity. We’re going to make a decent return in real estate, a decent return in private equity. As we have been predicting, a flat-to-negative return on fixed income—we have been saying that for several years, but we haven’t been getting it. And although we don’t care so much about calendar years, they’re like a pace per mile in a marathon, it’s going to be a good year, in the 8% range."

Now, about 2017 and what will matter. With 2016 so hard to predict, 2017 is going to obviously be very complex, globally and even in the US, Ailman says. "Everything is single-day events. You know, tweets here, tweets there. You’ve got the French election coming up. You’ve got the German election in the fall. When you had the Italian referendum, obviously, the pollsters had it right. But it went against kind of the globalization theme. There’s just going to be a lot of concern about the Euro and those two elections."

Voters are reacting to the uncertainty, and it will likely cause stress to the global markets. "So, 2017 is a tough year to figure out, but I think we’ll make money."

Over the next two years, Ailman is shifting to become more global in the equity space, and will continue to be heavily invested in Environmental, Social And Governance (ESG). He’ll always be looking at mega trends, or in Californian parlance, "long waves."

Ken Frier, partner at Secor Asset Management, also recommends overweighting non-US equities over US equities, "because the long-term valuation multiples for non-US equities are just more appealing." He has found it’s better to wait for markets to start performing before increasing allocations.

This "patient value" approach has worked when managing global equity exposure, such as investments in Brazil. "We bought Brazilian equities in March 2016, and captured most of last year’s 70% rise."

For 2017, he’s casting a cautious eye toward bond markets. As for emerging market countries, he continues a positive outlook toward Brazil, as well as Russia, Thailand and Taiwan, which, he says, "look attractive based on our criteria, whereas most of the emerging country stock markets fail on our criteria because they have low expected returns or because they have yet to perform." Turkish equity has also been "terrible in US dollar terms because of the political changes there, although by our calculations, the expected returns for Turkish stocks look quite appealing."

He adds, this is a very challenging time to be a chief investment officer. "If we project that the mainstream asset classes go back to historical norms for valuation, it’s hard to get to 7% annual returns for a typical institutional portfolio over the next decade," he says.

What worked in 2016 for James Gannon, head of Client Strategy and Research in the Americas for Russell Investments, was moving from equities into LDI fixed income, which, he says, continued to help pension plan sponsors de-risk and increase their hedge ratios.

In 2017, he predicts more investors will extend duration on fixed income and they may be able to decrease surplus risk while keeping expected return the same. They may also be able to keep surplus risk the same and increase expected returns by moving some of their traditional LDI holdings into a longer-duration strategy and the rest to equities, he says, which will be increasingly important in the low-return environment.

Institutional knowledge of servicing capabilities and infrastructure will be critical for 2017 and beyond, says Pete Cherecwich, executive vice president and head of Americas for Corporate and Institutional Services (C&IS) at Northern Trust, which will give global firms and advantage when it comes to "extraterritorial reach of national regulatory initiatives." He notes variation margin for un-cleared swaps is coming March 1 in the E.U and the US. "While the application date of Markets in Financial Instruments Directive II (MiFID II) is January 3, 2018, preparation for compliance will be a dominant driver of foreign exchange changes and investment across the market in 2017. The directive’s heightened standard around best execution has wide-reaching impacts on trading approaches."

Let’s keep this discussion of what’s important for 2017 and beyond going. What are your thoughts?

| Christine.Giordano@strategic-i.com | 212-217-6929