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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.
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2
The Perils of Economic Forecasting
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3
History Doesn’t Repeat Itself, But…
Severe Systemic Crises
• 1977 Spain
• 1987 Norway
• 1991 Finland & Sweden
• 1992 Japan
• 1997 Asian Crisis ex-Japan
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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
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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
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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…
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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
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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
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How Pervasive Are Negative Yields?
Mar
ket
Val
ue
US$
Tri
llio
n
Source: BofA
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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
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Building Blocks of Growth
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Building Blocks of Growth
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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
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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
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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
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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
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Building Blocks of Growth
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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
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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
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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
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• 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
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• 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?
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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
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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%
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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
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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%
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Diversification Remains Important Plans Should Play To Their Competitive Advantages
0%
20%
40%
60%
80%
100%
0%
20%
40%
60%
80%
100%
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Expected Returns In Equities
Earnings Yield:
Dividends & Share
Buybacks
Earnings Growth:
Corporate Margin
Expansion & Sales Growth
Valuation Adjustment:
Mean Reversion of
Price/Earnings Ratio
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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%
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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
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• 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
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Thank You
Ben Homsy, CFA
Portfolio Manager, Fixed Income
Marc Williams, CFA, F.C.I.A.
Portfolio Manager