Impact of higher rates top of mind for institutions

Despite a partial recovery in markets in 2023 after a horrendous 2022, asset owners are most worried about persistent high interest rates and inflation and how these issues will affect their portfolios, according to investment consulting firms.

Indeed, after plunging 18.1% in calendar 2022, the broad S&P 500 index climbed 16.9% year-to-date through June 30.

Meanwhile, the annualized inflation rate has dropped from a recent peak of 9.1% in June 2022 to 3.2% in October 2023 — but that figure remains well above the Federal Reserve’s 2% target. The Fed’s key benchmark rate has been frozen in a range of between 5.25% and 5.5% since July, but that followed an unprecedented flurry of 11 rate hikes since March 2022.

Institutional assets under advisement at consultants jumped to $47.9 trillion as of June 30, up 2.3% from a year earlier, according to Pensions & Investments data. Over the past five years, that figure has surged by 26.4%.

Bryan Ward, senior partner and head of solutions and sales at Aon Investments USA, which had $4.36 trillion in worldwide institutional assets under advisement as of June 30, said high interest rates remain the top-of-mind concern of his asset owner clients. “Not only how high rates are now, but how long they will remain at these elevated levels given that inflation has remained stubbornly high,” he said.

The high interest rate environment has made both fixed-income investments and cash more attractive on a relative basis than was the case in prior periods, Ward said. “Because of this, we are advising clients to review their fixed-income strategy for additional opportunities, both from a return perspective and current yield,” he said. “Second, we’re stressing caution on equities, particularly public. The higher interest rate environment is a potential headwind to earnings due to higher financing costs. Further, should the economy enter a recession, there will be additional pressure on earnings, resulting in potential equity market weakness.”

Aon is also advising clients to look at allocating to “liquid, uncorrelated alternatives such as low-beta hedge funds,” he said. “Our team is also finding opportunities in private credit and real assets. These strategies build resilience into portfolios and provide diversification benefits relative to long-only equity portfolios.”

Jeffrey MacLean, CEO of Verus, said that his asset owner clients are most concerned about what the higher interest rate regime means for their portfolios. “There are the lingering (negative) effects of the high-rate regime on their real estate portfolios and private equity activities,” he said. “We have moved from a zero-rate environment to a rising-rate regime, which has the potential to cause disruptions in markets.” Verus had $759 billion in worldwide institutional assets under advisement as of June 30, up 12.1% from a year earlier.

Greg DeForrest, executive vice president and head of fund sponsor consulting at Callan, said his institutional clients are also concerned about staffing levels and governance structures for their respective organizations, “including reporting lines and whether discretionary or non-discretionary advisers should be utilized.” They’re also concerned about spending active risk appropriately, he added, “and looking at the right combination of liquid and illiquid assets in their portfolios.”

Callan had $4.71 trillion in worldwide institutional AUA as of June 30, down 1.5%.

Aside from rising interest rates, noted Frank Benham, director of research at Meketa Investment Group, his firm’s clients are also concerned about the potential for an economic hard landing, as well as both political and economic risks in China.

Regarding China, Amy Hsiang, managing principal and director of public markets manager research at Meketa, said clients are interested in learning more about emerging markets.

“Whether or not that translates to actually increasing allocations to emerging markets, only time will tell,” Hsiang said. “We have not seen clients actively avoid China.”

Meketa had $2.81 trillion in worldwide institutional assets under advisement as of June 30, relatively flat from the year before.

However, China, the second-largest economy in the world, is beset by an array of problems, including a slowing economic growth, rising youth unemployment and a real estate market in crisis. MacLean of Verus said some clients are also worried about rising diplomatic tensions between Beijing and the West, which has already disrupted supply chains and resulted in shortages in Western nations.

Rising interest rates also means that some core fixed-income securities are providing higher yields, which is greatly increasing their attractiveness to some clients.

Indeed, on Oct. 19, the 10-year Treasury yield neared 5% for the first time in more than 16 years. Year-to-date, the yield has surged about 56 basis points to close at 4.44% on Nov. 14.

“There are indeed some opportunities here,” Aon’s Ward noted. “A few years ago when yields were negligible, some investors questioned the validity of fixed income as core holdings in a portfolio, but they are making a comeback now. They went from return-free risk to risk-free return.”

Albert Lim, senior consultant at Russell Investments, said his firm’s clients are principally concerned with how to cope with this “new normal” of high inflation and high interest rates. “Our economists think there is a good likelihood that we will enter a recession next year and this is yet another factor weighing on our clients,” he said. “But we are still advising our clients to remain invested in the market and try to weather the storms. We caution them it is nearly impossible to time the market and difficult to pinpoint attractive entry and exit points, as we saw after the global financial crisis of 2009.”

Nevertheless, Lim said that, at the margin, in the current macroeconomic climate, clients could make some tactical reallocations to long-term Treasuries and high-quality stocks with strong balance sheets and cash flows. “These kinds of stocks tend to perform well during periods of economic downturn and they haven’t done too well this year, so they should protect better on the downside,” he said. “We can find such stocks in the consumer staples and industrial sectors.”

Russell had $1.01 trillion in worldwide institutional AUA as of June 30, up 1.5% for the year.

The portfolio utility of fixed income is “strikingly higher” now than any time since the global financial crisis of 2008-2009, said Robert Appling, managing director at Wilshire Advisors. Generally speaking, many clients have cut public equity exposure in favor of fixed income and select alternative managers, he added.

Phillip R. Nelson, partner and head of asset allocation at NEPC, is not advising significant changes in asset allocation; however, for some clients, a move into fixed income and dedicated Treasury inflation-protected securities might be suitable in this climate of rising yields and still-substantial inflation, he said.

NEPC had $1.5 trillion in worldwide institutional assets under advisement as of June 30, the same figure as a year earlier.

Todd Stewart, managing director of investment research at SageView Advisory Group, advocates caution in making structural portfolio changes due to temporary interest rate fluctuations, but noted bonds “provide stability to a diversified portfolio, they are a reliable source of income, and they have good total return potential going forward. Cash, over time, simply cannot replicate these benefits as effectively as bonds do.”

SageView had $183.5 billion in worldwide institutional assets under advisement as of June 30, up 21.5% from a year earlier.

Alternative assets remain popular with institutional investors.

Within the broad and diverse alternative asset market, Seth Almaliah, senior vice president at Segal Marco Advisors, said he is seeing a lot of client interest in infrastructure investments. “This is a relatively new and exciting asset class that provides impressive yields and new markets to explore,” he noted.
Segal Marco had $454 billion in worldwide institutional assets under advisement as of June 30, 2023, up 18.9% from a year earlier.

Oliver Kunkel, Zurich-based partner at PPCmetrics, noted some clients are concerned about how to properly value these assets. “There are several issues with (pricing), and we are closely monitoring how (asset) managers are coping with this,” he said. “We currently (see) a great uncertainty whether the stated valuation of some illiquid assets reflects their true value. This dampens the demand for illiquid assets.”

PPCmetrics had $968 billion in worldwide institutional assets under advisement as of June 30, up 23.3% from prior year.
Appling of Wilshire countered that it is not necessarily getting harder to accurately value alternative assets. “Private asset valuations have always been challenging given the infrequence and lag in their mark-to-market positions,” he noted.

“Clients are increasing exposure to select alternatives like private credit and private equity. This needs to be balanced with an understanding of each clients’ liquidity needs to ensure the portfolio can deliver on all commitments through a market cycle.”

John A. Haggerty, managing principal and director of private market investments at Meketa, noted that in times of uncertainty and market volatility, the issue of placing value on alternative assets naturally receives more scrutiny. “Private market performance lags public market performance in both up markets and down markets,” he said. “So, the gaps have been greater in recent years with the stock market swings, negative in 2022 and positive for much of 2023.”