Canadian pension fund OTPP’s chief economist forecasts tough times ahead: COVID spending has papered of the cracks of existing problems; it yields nothing but there are few alternatives to fixed income and inflation is on the way.
There is no easy silver bullet for frustrated investors looking for an alternative to rock bottom developed market fixed income yields, said Millan Mulraine, chief economist at C$204.7 billion Ontario Teachers’ Pension Plan. The list of alternative allocations currently touted spans gold or more exotic assets like Chinese government bonds, yet few provide the same leverage, liquidity or depth for portfolios as US and developed market fixed income. They should only be viewed as a bridge until developed market yields recover on inflation and growth, and the ensuing easing of financial repression.
The challenge is compounded because yields are likely to stay low for a while yet, said Mulraine who joined OTPP in 2016 to lead the economics team, tasked with macro-oriented research to inform the fund’s investment decisions. Central banks are close to spent on the fiscal and monetary ammunition needed to spur growth, having bought forward future growth to navigate the pandemic with government leverage and lower rates. “2021 is shaping up to be a good year for markets, but I cast a wary eye beyond 2021,” he said.
Moreover, challenges wrought by the pandemic have come on top of existing problems. “Not much has changed from the pre-COVID trajectory that we were on. We have just papered over the cracks and are dealing with problems with less fiscal and monetary room.” Listing below-trend growth, crimped global productive capacity and lower yields impacting returns, he said shaping a portfolio at OTPP, which has earned an annual total-fund net return of 9.5% since it was founded in 1990, has just become infinitely more complex.
According to OTPP’s most recent annual report (2018) fixed income accounts for 41 per cent of the asset mix. Of that, 37 per cent is in Canadian government bonds, 27 per cent in foreign developed market and sovereign bonds, 25% in real-rate products and 11 per cent in provincial bonds. Elsewhere public and private equity account for 35 per cent or AUM, inflation-sensitive assets 15 per cent, and real assets 26 per cent. The remainder is in credit, absolute return strategies and money market funds.
Mulraine’s wary eye on inflation is also keenly informing OTPP’s direction. Inflation has been in a “sweet spot,” laid low for two decades thanks to accommodative central bank policy providing a boost for asset returns. Although Mulraine doesn’t believe prices will spike in the short-term, he does warn that a shock could be in the offing. “The inflation outlook is more uncertain now than it has been over the past two or three decades. I wouldn’t be surprised if two to three years down the road we have an entirely different inflation regime where inflation is surprising to the upside,” he said.
OTPP is preparing the portfolio by ensuring diversification across geographies and making sure natural hedges are in place. Allocations to real assets where valuations rise in line with inflation are also a vital cushion and insulation as bonds take a hit.
“If inflation goes up, we know real yields will continue to be depressed. This is one approach we should consider when navigating the environment for the next five years.”
Indeed, it is in times like this that OTPP’s high allocation to private assets comes centre stage.
“It is no secret this is one of our sources; it is likely to be more of the same,” he said. Here, success depends on geographic diversification, and he notes an increasing emphasis of exploring assets outside North America. “We think in a more meaningful way how we do this allocation. North America has paid back handsomely, but this may not be the case going forward,” he says, pointing to new pockets of strength around the globe in other markets.
For example, OTPP has around $15 billion invested in APAC across public equity, private equity and infrastructure, and recently opened a new Singapore office to accelerate its ambitions for the region.
Meanwhile, OTPPs celebrated internal management (around 80 per cent of AUM is managed in-house) is a vital component to alpha generation in private assets across real estate, private equity and infrastructure.
“You can ride over the vicissitudes of the global business cycle with private assets; there is that smoothness you can get to your return. When you sell that asset, you can benefit from upside. It’s an important part of our portfolio and revenue generation. We have pensions to pay, we can’t just play in public markets and when things aren’t going our way, sit in our hands.”
