Rachel Volynsky
Rachel Volynsky
Chief Investment Officer, Mercer Canada

At our Global Investment Forum in Canada, it was a pleasure to host a panel of four investment experts to discuss how major new structural trends such as rising inflation and rising rates are impacting asset allocation decisions.


During the past year, economic and geopolitical events have completely shifted the tectonic plates under the investment world in a very short time. As Vladimir Lenin said of the developments leading to the 1917 Russian Revolution: “There are decades where nothing happens, and there are weeks where decades happen.”


Rich Nuzum, Executive director, Investments, and Global Chief Investment Strategist at Mercer, told attendees that he believed we possibly have not even seen the worst yet, warning that “things could get a lot worse”.


Asset owners have been quite restrained in their reactions to the corrections and uncertainties, he said, pointing out that clients are concerned but not panicked, and are diversifying rather than selling.


He added that they have benefited from rigorously following their glidepaths. “It's been tough but they are celebrating their better funded status year-to-date.”


However, Rich warned that investors should not increase their exposures just because they have benefited from rising markets, explaining: “Stocks are way above where they were five years ago, and bonds are back at Global Financial Crisis levels. We adopted liability driven investment (LDI), which we believe was a good thing to do for 10 years, but it hasn’t really been tested over here yet.”


Equity/bond correlation


Asset owners enjoyed natural negative correlation between equities and bonds for many years because the world was in a disinflationary environment. But as inflation started to rise quickly in 2022, this correlation started changing. 


Kevin Zhu, Managing Director, Portfolio Construction Group, OPTrust, told attendees he was concerned about the loss of diversification due to the disappearance of the negative correlation between equities and bonds. This will also affect alternatives, which are largely driven by the same two dominant risk factors, equity and rate. 


Meanwhile, allocating more and more capital to the illiquid space at the same time as the value of bonds drop poses a lot of challenges to institutional investors, said Zhu. “Therefore, we need to think about this not just from a market risk or funding risk standpoint, but also realise that liquidity is probably the more imminent risk that we needed to manage,” he added.


The challenge is that there is now nowhere to hide, and it is not clear how long this new regime will last. Zhu urged asset owners to be nimbler and more innovative when it comes to total portfolio management and prepare for a potentially lengthy loss of the negative correlation between bonds and equities.


He also indicated asset owners might need to consider moving towards a more dynamic balance sheet management approach, and that investors should monitor changes in the bond-equity correlation to better understand prevailing macro regimes as well as the right positioning to their portfolios.


Reviewing LDI strategies 


The panel also discussed whether, given the UK’s recent LDI crisis and liquidity crunch, asset owners should rethink the use of leverage during these times of rising rates and higher funding costs.


Roman Kosarenko, Senior Director, Pension Investments, Loblaw Companies, said LDI has wrongly been perceived as a ‘set and forget’ strategy: “The problem with LDI is that many smaller pension funds had a very simplistic, naive idea of what it is, that it is the most appropriate way to manage pension funds, and it didn’t need revisiting.”


Whereas he thinks those who introduced LDI in the first place, in 2005-2006, perhaps had a more realistic view.


He noted that asset owners need to ask some key questions: “Is the cost of borrowing too high? What are the operational risks? And what is the liquidity situation?” 


He added that they also need to be more realistic and accept that there is no magic formula.


Shortage of inflation-linked investments


If higher inflation turns out to be structural rather than transitory, it will present challenges for portfolio construction as well as inflation-linked liabilities. 


The problem is that there is no cost-effective inflation-hedging solution available in the market and there is a lack of well-designed inflation-hedging products, said Zhu. 


Canadian foundations under pressure


Foundations are facing another big investment challenge, in addition to higher inflation, due to Revenue Canada increasing the requirement for disbursals from 3.5% per year to 5% as of January 2023.


For Canadian foundations to preserve the purchasing power of the fund, the required returns could very easily reach nominal return target of ~10%, which is a challenge, Sam Reda, co-founder, Alpha CCO Logiciel, told delegates. “We have been using an OCIO with two foundations and have been building up protection against inflation, with asset classes such as infrastructure,” he said.


Given all the pressures that asset owners are facing, it is a good time to revisit your asset allocation plan, risk budgeting, structure, and operational management to see if they are still fit for purpose. 


Read our Economic and market outlook 2023


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