Executive Summary and CIO Commentary
Macroeconomic and Investment Environment
Slower than average economic growth over our forward 7-10 year forecast period, combined with other economic forces, are expected to create an investment environment less favorable than customary for the Council’s largest investment category – equity investments. Economic growth is a key component in supporting long-term return from equities, and the weaker growth we foresee will weigh on the equity markets. In the U.S., we also anticipate interest rates rising gradually and for inflation to strengthen modestly from current levels, compounding the pressure on equity investment performance.
Much of this will be driven by the “unwind” of the current state of economic affairs. The world is awash in available capital and liquidity, the result of unconventional global central banking activity in the aftermath of the Great Financial Crisis (GFC). Interest rates are at historical lows around the world, artificially manipulated downward through “quantitative easing” (QE) programs by the U.S. Federal Reserve, the U.S. Treasury and other central banks and treasuries globally. In some countries, sovereign debt interest rates are actually negative – in fact, more than 30% of the world’s sovereign debt has been trading at negative yields as of late. On the whole, we expect these conditions to begin to unwind during the forecast period, resulting in the conditions we foresee: higher interest rates and higher rates of inflation compared to today’s levels, and subdued economic growth relative to long-term history.
As if the dreary expected investment environment weren’t enough to navigate, we also have significant concerns over present valuations in most investment assets and markets. Low-to-negative bond yields have pushed much of the world’s excess liquidity into the risk-asset markets, pumping up values. Particularly in the U.S., the stock market trades at a valuation level seen 5% or less of the time in history back to the 1880s. At the same time, low interest rates correspond to high bond valuations. Stocks and bonds historically have been lowly correlated, with one asset class generally becoming cheaper as the other becomes more expensive. Today’s very high valuation of both markets simultaneously has not occurred in history back to the 1880s. This matters in our forward environment as expensive assets historically are associated with low forward returns. It also matters that these high valuations apply to the most basic and abundant investments we and our peer public funds make – stocks and bonds. We estimate that the average public fund in the U.S. has 74% of its assets invested in stocks and bonds and expects roughly a 7.50% annually compounded rate of return from the broad portfolio. We judge that this expectation will be disappointed in the 7-10 year forward horizon.
Broad Investment Strategy
Creating investment strategy in unprecedented macroeconomic and investment environment times comes with certain challenges. We can look back in history to find some guidance, but our present situation has no real comparable period. Our traditional investment models rely on things like low or negative correlations among assets, positive risk-free rates of returns on which to judge and build risk premia, normally distributed asset valuations and reasonable economic conditions. We generally assume sensibly efficient and liquid markets to operate within. But in this upside-down world of negative interest rates, seemingly permanent central bank intervention and regulation-impaired markets, our traditional models aren’t as useful and our dependencies bring greater frustration.
Within this report, we detail our investment approach to these unprecedented times, but in short, our investment strategy is based on just a few components:
- Cutting equity risk – we don’t see the forward environment as broadly supportive of equity investments (in particular publicly-traded equity), and from current valuation levels, it is fair to forecast lower-than-average returns.
- Building “downside” protection across the portfolio – from low-beta managers and factor investing in our equity portfolios to increasing allocations to non-traditional assets with more stable NAVs, we look for ways to trade upside potential (which we think is restricted in the upcoming investment period) for more stable, predictable investments that can still produce good results.
- Generating income – an investment environment that is tough on equity investments is an environment that will be tough on the capital gain component of the total rate of return of any investment. We’ve sought—and continue to seek—investments with strong current income and where income is the predominate source of the total expected rate of return.
Lastly, while it is not an investment strategy per se, we’ve followed the strategy of consistently guiding toward realistic expectations regarding returns and investment performance – and doing so as early and as often as possible. The Council cut the long term expected rate of return from the permanent funds from 8.50% to 7.50% in 2011. Council discussions of a coming “low return environment” picked up significantly in 2013 – even while enjoying a 16% rate of return that year. In presentations to the New Mexico Legislature, Council governmental clients and various interest groups, we have stressed realistic expectations. In 2015, the Council took the step of lowering the expected rate of return of the Land Grant Permanent Fund (LGPF) from 7.50% to 7.00% and from 7.50% to 6.75% on the Severance Tax Permanent Fund (STPF). These expectations are among the lowest of expectations by U.S. public funds who invest with comparable levels of risk to the LGPF and the STPF, and we deem them among the most forward-thinking.
TO READ THE FULL FY 2017 ANNUAL INVESTMENT PLAN, PLEASE USE THIS LINK: 2017 Annual Investment Plan