Allianz Global Investors Risk Monitor #4

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In RiskMonitor, Allianz Global Investors (AllianzGI) together with Investment & Pensions Europe (IPE) magazine surveys European institutional investors’ perceptions of capital market, regulatory and governance risk.

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Allianz Global Investors Risk Monitor #4

  1. 1. (H2 / 2012)RiskMonitor#4Under Pressure Understand. Act.
  2. 2. Investors’ purchases of sovereign debt more and more appear like a donation to the region’s immediate stability than a source of long-term returns for pension scheme members.2
  3. 3. Content 3 About the survey 4 Introduction 5 Management summary 6 Financial risks 6 Unyielding governments 7 Decades of pain11 A Sting in the tail13 Financial repression13 This time it’s difficult15 Look East!18 Regulatory and governance risks22 Results at a glanceAbout the surveyIn RiskMonitor, Allianz Global Investors (AllianzGI) together with Investment &Pensions Europe (IPE) magazine surveys European institutional investors’perceptions of capital market, regulatory and governance risk. By repeating thesurvey on a regular basis, it is possible to gauge institutional investors’ riskperceptions over time. This fourth survey was conducted from 8 to 26 October2012 both online and per fax. Altogether, the survey gathered responses from155 institutional investors with a total of EUR 1,934.5 billion (bn) of assets undermanagement or assets under advice. The survey targeted institutional investors inAustria, France, Germany, Italy, the Netherlands, Switzerland, the United Kingdom,as well as in the Nordic Region (Denmark, Sweden, Finland and Norway). Due tothe size of its sample the survey does not claim to be representative, but it doescarry enough weight to outline the most important trends among institutionalinvestors in Europe. Allianz Global Investors had agreed to donate EUR 25 forevery completed questionnaire to Allianz Direct Help, an Allianz SE charitable trustdesigned to identify and select humanitarian and other aid projects. IPE hasagreed to donate EUR 15 per completed survey to the IPE ScholarshipProgramme, a fund whose aim is to give grants to individuals pursuing advancedstudy in the area of pensions. 3
  4. 4. Introduction It is different today since we are unfortunately not merely talking about a long-term trend in yield compression andIn my introduction to the previous RiskMonitor, I discussed three financial crises emanated in the new century. Manythe erosion of trust in sovereign debt with regards to investors feel that the market can no longer be trusted. Onehedging costs as measured by a significant increase in CDS of the reasons behind this lack of confidence is that thespreads. In some instances, these costs have been markedly markets’ ups and downs have not been driven by normalhigher than for some global blue chip companies. Now it supply and demand dynamics, but by what policymakers doseems like headline-grabbing risks are on the decline and or are believed to do next. Since the financial crisis, thesignificant progress has been made in order to contain the U.S. Federal Reserve and the European Central Bank haveeurozone debt crisis. The reason for this lies in the deployed masses of money into the markets in pursuit ofEuropean Central Bank’s willingness to fight the sovereign their goals, creating major market distortions and adebt crisis in Europe or – as Mario Draghi put it – to do risk-on / risk-off environment, turning much of investors’“whatever is necessary” to save the euro. Actions and common knowledge upside-down and pushingmoney speak louder than words and doubts, so after governments, central banks and regulators in the driver’sliquidity injections of more than EUR 1,500 bn into the seat of financial markets.eurozone alone since 20081, it has become clear that nofinancial authority is willing to test the abyss just for the Regulation of capital markets and investors will becomepurpose of sticking to principles. Unconventional policy more important not only to improve the stability of theanswers are becoming more and more conventional and it global financial system, but also to help governments tois becoming clearer that Western economies are prepared cope with their debt. In this context, it doesn’t come as ato inflate their way out of debt thus trying to avoid any surprise that projected regulation on capital requirementssystemic shock. However, the sovereign debt crisis is far favours investments in sovereign bonds. Though not capitalfrom being over. controls in a strict sense, but because they massively affect asset allocations of institutional investors and pensionWhat are the consequences? Yields of investment grade funds in a pro-cyclical way, this is a further facet of financialsovereigns are at historic lows – often below the respective repression.GDP growth rates and inflation, leaving investors withnegative real returns. It is no wonder that current interest I am optimistic to see that investors are quite constructiverate levels have become a serious concern among when it comes to watching out for substitutes to sovereignRiskMonitor respondents. This phenomenon, known as debt and readying their organizations for a broader varietyfinancial repression, has reappeared after it was used in the of risks. On the other hand, investors who only focus onUS to reduce public debt from 120 % of GDP in the 1950s to avoiding risks instead of deliberately taking specific risks willabout 35 % in the 1980s. find financial repression a trip of no return.After this (long) episode, the decade-long “great Sincerely,moderation” had a sedative effect on long-term investors.Until the end of the last century, it was rather difficult not tomeet investment targets by simply putting a large chunk ofassets into investment grade sovereigns. Certainly, somewere hungry for higher returns, but the era and the bond James D. Dilworthmarkets’ total returns were benign for liability-driven Chief Executiveinvestors. Those were the days … Allianz Global Investors Europe1 Source: ECB balance sheet time series, data as of November 20124
  5. 5. Management summary Respondents do, however, seem cognisant of the danger and keen to break away from the herd to exploreThe good news from this latest issue of RiskMonitor is that alternatives to their own sovereign debt. When asked forfar fewer European institutional investors are worried about government bond substitutes that generate reliable andthe creditworthiness of their sovereign bond issuers. Twelve sufficient yields, answers ranged from covered bondsmonths ago, 35 % deemed sovereign debt risk a huge risk to (22.7 %) to infrastructure debt and infrastructure equitytheir financial targets for 2012; last month that percentage (13.6 % and 13 % respectively), private equity (10.4 %) andhad dropped to just over 13. Likewise, fewer than 9 % of the commodities (5.8 %).155 respondents see overall market volatility as a huge risk.A year ago the percentage was three times bigger. But By far the most popular response was corporate debt. Moreinvestors are far from relaxed on all fronts: since the three than two-thirds of respondents named this class (althoughlatest surveys the share of respondents deeming tail risks as a few respondents warned of a credit bubble in the next sixa huge risk has remained stable at around 15 %. to twelve months). Emerging markets debt (37 %) and real estate (31.2 %) were the next second and third mostThe bad news is that investors are becoming more popular answers. By country of response, some interestingpreoccupied with the miserable and, in some cases, variations appeared: real estate appealed to more than halfnegative yields on sovereign debt. More than 20 % of the the respondents from France and almost half therespondents view current interest rate levels as a huge risk. respondents from Switzerland; private equity attractedThis is substantially more than every other category that has almost 18 % of the Nordic votes.been analysed. This perception is even more pronounced inFrance, Italy and the German-speaking countries. One in Perhaps the strongest relative surprise was the greaterthree respondents named current or falling interest rates as popularity of emerging markets equities (10.4 %) overthe biggest single risk to their financial targets for 2013 developed markets equities (9.7 %). Do the former really(and even rising interest rates are now a greater worry than promise more reliable yields on an absolute basis, or is it thesovereign debt risk). case that relatively investors still feel overexposed to the latter?Although RiskMonitor concentrates on potential threatsover a one-year period, it appears that investors are It can be fairly surmised that Europe’s institutional investorsincreasingly concerned that low yields are here to stay for a have profound confidence in emerging markets from theirlong time. When asked which macro topic kept them up at answer to another new question in this edition ofnight, one-quarter of respondents answered “financial RiskMonitor on barriers to investing in Asia; fewer than 4 %repression”.“It is the only way out since massive liquidity believe the Far East suffers from weak fundamentalshas not had any effect,” said the adviser to one Dutch relative to other regions. At the same time, 28 % pinpointedpublic-sector pension fund. transparency and difficulty in gathering information as their biggest obstacle to investing in this region and more thanCentral bank intervention has effectively disabled the 20 % worry about liquidity. In spite of these concerns, 58 %mechanisms of the market. Large rescue packages by the expect to increase their exposure to Asia. Perhaps this is theU.S. Federal Reserve and the European Central Bank have tell-tale sign of the desire to escape financial repression.more or less created a binary market. This market ischaracterised by strong fluctuations in risk appetite and riskaversion known as “risk-on / risk-off” (RORO).The portfolio manager of a German corporate pension trustadded: “Financial repression emphasizes the alreadyprevalent ‘herd mentality’ among investors, i.e. everybody isforced to invest in the same assets or asset classes, and istherefore really dangerous.” 5
  6. 6. Financial risksFinancial risks So far, so good. Investors’ confidence in the creditworthiness of their own states is on the rise. The news gets better. The sense of danger posed by overall market volatility and aUnyielding governments sharp drop in the value of equities also seems to have quelled since the summer. From a low point in the secondThe title of the previous RiskMonitor was “Rethinking week of June, the STOXX Europe 600 Index has reboundedSafety”. In the first half of 2012 investors suggested a to the high range it reached in March. Peripheral stockvariety of assets they defined as safe, from sovereign debt, markets such as Spain’s IBEX 35 and Italy’s FTSE MIB stillquality equities and hard currencies to event-driven hedge show susceptibility to bad news – recall the mid-summerfunds, swaps, renewables and covered bonds.2 As financial falls and recent sell-offs – but even they have shown morerepression takes hold of mature economies, institutional stability in recent months than previous quarters.investors in Europe are not only having to think even further Yet current interest rates remain a stubbornly big problemon their definitions of safety, and in particular safe havens, for investors trying to meet their financial targets.but also seek new means of return. Amalgamating those responses which categorise current interest rates as a huge risk and those for whom they are aMuch comfort has been taken from the actions of considerable risk, we find this has become almost aspoliticians and central bankers in the second half of 2012. common a worry as sovereign debt risk itself (67.1 % ofThe declaration by new ECB President, Mario Draghi in early responses versus 68 %3).September that the Bank would stand behind governmentsin the eurozone – effectively as a lender of last resort – has In order to achieve our financial investment targets forbecome the most frequently repeated statement within the next 12 months, I see current interest rates …financial circles. Its power is reflected in the diminution ofsovereign debt risk as a major headache for participants in 100 % 4.4 % 4.5 % 7.1 % 7.4 %the current RiskMonitor survey. 90 % 28.4 % 80 % 29.4 % 30.9 %In spring 2012, 21.2 % saw sovereign debt risk as a huge 70 % 45.2 %threat to reaching their twelve-month financial targets. Theprevious autumn the figure had been 35 %. By the end of 60 %this autumn, just 13.2 % felt the same way. In Germany the 50 %fall was starker: from more than four in ten respondents to 43.4 % 44.9 % 46.5 % 40 %less than one in ten in a year. 30 % 41.3 %In order to achieve our financial investment targets for 20 %the next 12 months, I see sovereign debt risk … 20.6 % 10 % 19.9 % 19.9 % 6.5 %100 % 1.9 % 3.6 % 2.2 % 3.9% 0% H1/2011 H2/2011 H1/2012 H2/2012 90 % 17.9 % 24.1 % 80 % 36.5 % 27.6 % As a huge risk As a considerable risk As a minor risk Not as a risk 70 % 60 % 43.6 % This shift in anxiety within the world of fixed income from 50 % 52.6 % creditworthiness to yield is made more starkly when 40 % 55.3 % investors were asked their biggest single financial risk in the 46.8 % next twelve months. Less than 6 % answered sovereign debt 30 % risk while over 16 % said current interest rates. This is close 20 % 35.0 % to a transposition of sentiments of six months ago. Note 10 % 21.2 % that falling interest rates also captures more than 16 % of 14.7 % 13.2 % the vote in this poll. If the two groups concerned most by 0% H1/2011 H2/2011 H1/2012 H2/2012 rates are put together, they account for almost one-third of all respondents, far ahead of those worried by overall As a huge risk As a considerable risk market volatility or even equity volatility. As a minor risk Not as a risk2 AllianzGI RiskMonitor “Rethinking Safety”, June 2012. NB More than 5 % of respondents said there were no safe havens.3 We aggregate responses of ‘huge risk’ and ‘considerable risk’ as ‘major risk’.6
  7. 7. Financial risks ”Financial repression is a silent way to reduce government Top 5 financial risks debt. It works much more smoothly than a haircut. And let’s What is your biggest financial risk in the next not forget that financial repression is politically easier to 12 months? implement than expenditure cuts or tax hikes,” says Stefan Hofrichter, chief economist of Allianz Global Investors, in Overall market volatility 20.7 % (–3.2 %)* explaining the appeal of financial repression to Sharp drop in equity markets 18.1 % (+1.4 %) democratically-elected governments. Falling interest rates 16.1 % (+1.6 %) And this is the sobering thought: the size of the debt for the Current interest rate levels 16.1 % (+8.1 %) US alone exceeds US$ 16trn. In Europe, for just France, Rising interest rates 7.1 % (+0.6 %) Germany and the UK the figure exceeds US$ 6trn. Given the magnitude of these imbalances, it is no wonder that Reinhart, Reinhart and Rogoff suggest that such debt *compared to survey H1 / 2012 overhangs last on average 23 years. That is the really bad news behind responses on interest rates in this currentDecades of pain RiskMonitor. Investors are waking up to the reality that their fixed income portfolios could be a drag for decades toWhat is propelling this rising anxiety about current interest come; that the Great Moderation which gave such arates? The obvious cause is that returns on the sovereign favourable tailwind to bond yields seems to be well anddebt of most G10 countries lie somewhere between truly over.miserable and negative. This alone is enough to hurt thosetypes of investors constrained by regulation directly or “For the eurozone as a whole, debt-to-GDP ratio is aroundindirectly to hold such assets. One UK investment adviser 90 %, substantially above the targeted 60 %. Assuming anbemoaned the double-whammy on both sides of the annual liquidation effect of 3 % by keeping interest ratesbalance sheet. below the ‘fair value’ level, it would take roughly 10 years to bring the region back to the debt levels that were originally “The continued low interest rate environment is affecting set at Maastricht as upper limits,” says Hofrichter.the liability side of the equation which affected the fundinglevel which puts the pension fund under pressure and For indebted governments, financial repression works bestmakes the cost of SWAPS expensive.” when accompanied by sufficient inflation to erode the real value of the debt. Nothing explains financial repressionWe will explore these consequences in due course. better than to consider the real yield on popular instruments such as the UK 10-year linker. Mid-November,The more profound cause of worry, however, is that this it was –0.65 %. So bondholders were paying Her Majesty’slow interest-rate environment could be here to stay for a Treasury for the privilege of lending it money. Of course,very long time. If the commitment of Mario Draghi to stand inflation-linked liabilities are more explicit for traditional UKbehind eurozone governments is a happy mantra for pension schemes than their peers. In Continental Europeinstitutional investors, the wisdom of economists is a customs are different (and equivalent Treasury debtsobering counterbalance. In their work, the economists instruments fractionally more generous). In theCarmen Reinhart and Belen Sbrancia show how historically Netherlands inflation-linking of benefits has traditionallygovernments faced with huge debts have often passed on been optional, typically dependant on the investmentthe pain to their lenders through “financial repression”. returns achieved the year before. In pension plans in other countries, there is no direct linkage, but individualIn essence, financial repression leaves bondholders and retirement adequacy is hugely determined by real assavers to pay the bills by dint of miserable nominal yields. opposed to nominal returns. The difference is reflected inThe offload is completed by inflation devaluing those concerns about inflation as a risk to respondents’ twelve-miserable yields further in terms of ultimate purchasing month financial targets.power of the lenders. 4 http://www.nber.org/papers/w18015 7
  8. 8. Financial risksIn order to achieve our financial investment targets for the “Markets have been driven by sentiment and quickly movenext 12 months, I see inflation … from risk-on to risk-off without regard to fundamentals. Political announcements have been seen as positive and100 % then evaporate when they achieve little. This will persist 12.4 % 90 % 22.3 % 17.4 % and shows little sign of improvement as politicians and 80 % bureaucrats are unable to really manage the problems of no growth, too much debt and high unemployment” says 70 % the CIO of a large UK pension scheme. 60 % 54.2 % 45.3 % 53.6 % 50 % For this respondent, the consequence is that market volatility will persist in a “risk-on / risk-off” environment. 40 % This in turn suggests that the ‘quality’ of market volatility is 30 % deteriorating, because it has less to do with commercial 20 % 28.8 % 28.8 % fundamentals. If one subscribes to this belief, then it 27.5 % removes the shine from RiskMonitor conclusions. These are 10 % 1.4 % 4.6 % that overall market volatility is posing less and less of a risk 3.6 % 0% to Europe’s institutional investors. A year ago we found H2/2011 H1/2012 H2/2012 88.7 % of respondents felt overall market volatility was a As a huge risk As a considerable risk major risk to their twelve-month financial targets. Six As a minor risk Not as a risk months later the percentage had fallen to 83.7 %. By November it was down to 74.6 %. The decline is even more apparent if we focus on those respondents who perceiveOne in ten UK respondents views inflation as a huge risk to overall market volatility as a huge risk: 27.9 % one year ago;their twelve-month targets; this is the highest level of 8.4 % now.concern ever in the history of RiskMonitor in this category.While almost 8 % of Dutch respondents also view inflation In order to achieve our financial investment targets foras a huge risk, unlike in the UK the numbers of Dutch in the the next 12 months, I see overall market volatility …next category have fallen away. So far fewer Dutch perceive 100 % 1.9 % 1.4 % 1.3 %inflation as a considerable risk. The three other countries 10.0 %where inflation risk is indubitably growing are France, 90 % 16.3 % 25.6 % 24.0 %Germany and Switzerland. Nearly half of all respondents 80 %from Germany and more than half from France now view 70 %inflation as a considerable threat to next year’s financialtargets. 60 % 60.8 % 61.5 % 50 %But the consequences of financial repression are not 66.2 % 40 % 64.7 %limited to fixed income alone. Clearly the issue is much 30 %bigger. Reinhart, Reinhart and Rogoff identify 26 debtoverhangs (debt-to-GDP above 90 %) in their historical 20 %analysis. They claim economic growth slowed by 1.2 % 10 % 27.9 % 22.2 %during these periods of great indebtedness relative to other 7.7 % 8.4 % 0%periods. As of end October, US debt to GDP was 102.9 %; H1/2011 H2/2011 H1/2012 H2/2012UK’s was 82 %; Germany’s was 80 %; France’s was 86 %. Sofinancial repression spells bad news long-term for most As a huge risk As a considerable risk As a minor risk Not as a riskdomestically oriented assets and investment strategies. Inthe short-term, the major problem with financial repression– of which quantitative easing has played a major role – isthat it subordinates market fundamentals to politicalengineering.8
  9. 9. Financial risksThe same downward trend is evident when investors were The equity-risk premium looks good, as a major Swissasked about the single biggest risk to meeting their multi-employer pension fund reminded us:financial targets. Overall market volatility has alwaysoccupied the top spot in RiskMonitor, but the number of “Fair to cheap valuation should prevent a sharp drop inmentions has declined with each of the last three editions. equities. Such occurrence would allow us to buy cheaper.”Before leaving this topic, it is worth reiterating one pointmade earlier: overall market volatility might be a lessening In the face of financial repression, dividend-yielding stocksfear in investors’ minds, but its impact is greater when have a further appeal of providing income more bountifullyaccompanying sheepish markets trending sideways. One than government debt. At the end of October, dividendmore quote from a Dutch real estate investment manager yields on the MSCI Europe Index were 3.9 %. Germansummarises well: 10-year bonds were yielding 1.43 %.“Overall volatility will affect all markets and drives We explore further alternatives to government debt ininvestors in cash or AAA sovereign bonds, which will hurt Chapter 2. For now let us imagine the imbalance worsensmost markets.” as interest rates fall further. This is a creeping fear among European institutional investors. Just over 30 % classifiedIn order to achieve our financial investment targets for falling rates as a major risk in the previous report; by nowthe next 12 months, I see a sharp drop in equity markets … the percentage has climbed to over 40. Fears are more common and accentuated in Germany, Italy and100 % 2.6 % 2.2 % 4.4 % 2.6 % Switzerland. One reason might be a different book value 90 % 15.9 % accounting of liabilities which in turn implies no interest 22.2 % 80 % 32.9 % 25.5 % rate sensitivity of liabilities. Hence, rising rates in this setup imply losses. 70 % 60 % In order to achieve our financial investment targets for 50 % 61.6 % the next 12 months, I see falling interest rates … 61.4 % 54.7 % 40 % 54.8 % 100 % 30 % 17.0 % 90 % 23.1 % 22.9 % 20 % 80 % 10 % 20.3 % 15.3 % 9.7 % 13.7 % 70 % 0% 40.7 % 60 % 36.6 % H1/2011 H2/2011 H1/2012 H2/2012 45.5 % 50 % As a huge risk As a considerable risk As a minor risk Not as a risk 40 % 30 % 28.1 % 28.8 %In previous RiskMonitor surveys, investors have shown 20 % 20.9 %widespread recognition of the riskiness of equities within 10 %their total portfolios. This time is no exception as three- 14.1 % 10.4 % 11.8 %quarters of respondents view a sharp drop in equities as a 0% H2/2011 H1/2012 H2/2012major risk to their twelve-month targets. For Germans,Italians and the Swiss, this is a growing anxiety. For the As a huge risk As a considerable riskNordics and Dutch, worry is abating. One reason given for As a minor risk Not as a riskthe overall decline in anxiety is the relative attractiveness ofequities to its major competitor for investor capital: fixedincome. 9
  10. 10. Financial risksWe have briefly mentioned the threat perceived by falling A major Nordic wealth manager summed up this problem:interest rates. When asked in a separate question of theirsingle biggest fear, this issue garnered more responses in “The short term impact of raising interest rates forboth Germany and the Netherlands than the second and companies with issued guarantees and no hedge willthird options put together. A French multi-employer impact on buffers and the Profit/Loss account more thanpension fund pointed out that falling rates were so many other factors.”dangerous because they drove up the cost of insuringliabilities. Several other respondents expressed concern at The Nordics are such well-regarded pioneers of interest andtheir lack of full coverage of their liabilities in such an inflation hedges that it comes as a surprise to imagine thereuncertain environment for investing. are institutions lacking such protection. Moreover, the trend among Nordic pension providers, notably in Sweden andYet institutional investors are a heterogeneous bunch. To Denmark, is to persuade their policyholders to foregomisquote Abraham Lincoln, you can’t please all the people guaranteed returns in favour of market returns with someall the time. So while rising interest rates would evidently optional bonus or minimum return, e. g. 0 %.take a weight off the minds of those respondentsregistering red in the chart above, for a growing minority of But there is a further point underlying this quote: return-German and Nordic pension providers rising rates present a seeking assets are not currently reliable enough to coverreal problem. increased guarantees. Most Nordic regulators scrutinise inappropriate risk-taking and do not permit a lax mismatchIn order to achieve our financial investment targets for between liabilities and investments. So we must concludethe next 12 months, I see rising interest rates … that times are hard and buffers slim even in this well- organised region for retirement provision; there is little risk100 % capital left. Finally, it is worth noting that the most worried 90 % 22.5 % 19.7 % 22.4 % in this category, also for Germany, were mostly company- 80 % sponsored or local authority schemes rather than insurers. 70 % 38.7 % 60 % 44.9 % 44.1 % 50 % 40 % 30 % 35.0 % 20 % 26.8 % 26.3 % 10 % 5.8 % 6.6 % 7.2 % 0% H2/2011 H1/2012 H2/2012 As a huge risk As a considerable risk As a minor risk Not as a risk10
  11. 11. Financial risks In order to achieve our financial investment targets forA Sting in the tail the next 12 months, I see tail risk …The Financial Crisis taught all investors a lesson or two. We 100 % 4.4 % 2.2 % 3.3 %are all now familiar with the concept of Black Swans. We 9.3 % 90 %are all now sceptical of diversification – or to be moreprecise, aware of its limitations. In every RiskMonitor, 80 % 33.1 % 43.3 % 33.1 %diversification has always been the most common response 70 % 41.7 %from investors as to how they deal with their biggest 60 %financial risk. So we know that belief holds strong (Note inthe graph below that duration management has crept into 50 %second place, and fixed income hedging is also on the rise. 40 % 45.6 % 48.3 %Both answers fit with the concerns about current and 30 % 40.3 % 38.4 %future interest rates discussed previously). But every 20 %institution will also remember the frightening correlationof almost all kinds of asset classes and strategies in 10 % 16.9 % 14.2 % 15.2 % 9.9 %September 2008. 0% H1/2011 H2/2011 H1/2012 H2/2012 How do you deal with your biggest financial risk? As a huge risk As a considerable risk As a minor risk Not as a risk Diversification 46.3 % (+6.4 %)* Dynamic asset allocation 18.4 % (–2.7 %) A Black Swan by nature comes as a surprise and this is well Duration management 11.8 % (+1.6 %) observed by the investment manager of a Dutch corporate Equity hedging 6.6 % (+1.5 %) pension fund: Fixed income hedging 6.6 % (+3.7 %) “Some of the major risks [RiskMonitor categorises] are Target risk portfolio 1.5 % (–2.7 %) clearly linked, we can imagine a tail risk coming from Other 8.8 % (+0.8 %) sharp equity markets declines, caused by a deepening of the sovereign debt crisis.” *compared to survey H1 / 2012 We are reminded why tail risk is such a worry – it may be a terrible combination of damaging events that can bePerhaps the ultimate lesson is that there are more powerful separated mentally in calculations but in reality appearforces in the world than financial markets; this can be hard simultaneously. In the following chapter, we considerto remember when you’re living in a bubble. That has not further which issues are nightmarish for Europe’sbeen the case for a number of years and is evidenced by institutional investors; and which remedies are available.the considerable attention respondents consistently give totail risk. It has been a huge risk over the past threeRiskMonitor surveys to more or less 15 % of respondents. Ithas been a considerable risk to 45 % on average. Since thesummer of 2012, respondents in Germany, the Netherlandsand Switzerland have become particularly concerned –almost one-quarter of German institutional investors nowhold tail risk as a huge threat to their twelve-monthfinancial targets. In Switzerland, the number has risen fromnone in the first half of the year to one in five. 11
  12. 12. Financial risksIn order to achieve our financial investment targets for In order to achieve our financial investment targets forthe next 12 months, I see limited liquidity … the next 12 months, I see deflation …100 % 100 % 11.7 % 14.7 % 12.3 % 15.3 % 16.7 % 90 % 90 % 31.3 % 32.4 % 80 % 80 % 70 % 70 % 43.8 % 45.5 % 45.6 % 60 % 60 % 53.3 % 59.3 % 50 % 50 % 46.5 % 50.0 % 40 % 40 % 30 % 32.8 % 30 % 35.1 % 36.0 % 20 % 20 % 25.5 % 18.8 % 22.0 % 10 % 10 % 16.9 % 11.7 % 3.5 % 3.7 % 7.1 % 5.8 % 2.0 % 0.7 % 0% 0% H1/2011 H2/2011 H1/2012 H2/2012 H2/2011 H1/2012 H2/2012 As a huge risk As a considerable risk As a huge risk As a considerable risk As a minor risk Not as a risk As a minor risk Not as a riskIn order to achieve our financial investment targets for In order to achieve our financial investment targets forthe next 12 months, I see counterparty risk … the next 12 months, I see change in exchange rates …100 % 4.4 % 3.9 % 100 % 10.9 % 8.0 % 10.9 % 10.2 % 13.1 % 11.8 % 90 % 90 % 80 % 80 % 35.5 % 49.3 % 70 % 54.6 % 70 % 51.9 % 51.1 % 60 % 58.3 % 60 % 54.0 % 61.2 % 50 % 50 % 40 % 40 % 47.1 % 30 % 30 % 43.4 % 34.9 % 35.8 % 20 % 20 % 35.3 % 30.7 % 28.2 % 25.7 % 10 % 10 % 9.4 % 6.6 % 2.6 % 2.9 % 1.9 % 2.9 % 2.2 % 1.3 % 0% 0% H1/2011 H2/2011 H1/2012 H2/2012 H1/2011 H2/2011 H1/2012 H2/2012 As a huge risk As a considerable risk As a huge risk As a considerable risk As a minor risk Not as a risk As a minor risk Not as a risk12
  13. 13. Financial repressionFinancial repression government bonds to generate reliable and sufficient yields. The overwhelming answer was corporate debt, appealing to more than two-thirds of the universe ofThis time it’s difficult respondents [in the chart on the next page percentages are exclusive of each other as respondents could each give upWe began the preceding chapter by discussing the to three answers]. In France, corporate bonds attracted 85 %re-evaluation or redefinition of safe havens. Fears on the of respondents. This did not stop one Paris-based insurercreditworthiness of European member states may have warning of the dangers of a wholesale shift from govvies toabated, but investors’ purchases of sovereign debt more credit:and more appear like a donation to the region’s immediatestability than a source of long-term returns for pension “The low level of safe haven bond yields is fuelling a creditscheme members. Although RiskMonitor concentrates on a bubble. Not a risk in the short-term (and Solvency 2 will12-month outlook, there is a sense in this edition that compress spreads further), but a significant one in the nextrespondents are acknowledging the dawn of a much longer 6 to 12 months.”period of financial repression. In fact, one-quarter ofrespondents named this as the macro issue keeping them There is another consequence of the rising prices ofup at night, far more than the much discussed “fiscal cliff” corporate paper that is already manifesting itself as ain the U.S. or a slowing of China’s growth. short-term risk. The companies that back occupational pension schemes are required by international accountingIt should be quickly added, as the picture below illustrates, standards to measure those liabilities using the discountthat the eurozone debt crisis troubles more than twice as rate of a corporate bond swap curve. When the prices ofmany respondents. But the two problems surely go the related corporate bonds rise and spreads decrease ashand-in-hand. Investors may rightly fear that between an much as they have in 2012, then liabilities, on paper atangry electorate and political sensitivities on the least, look bigger. Swaps can take care of such changesinternational level, they may be a far easier target for but few institutions are that well-matched, not leastTreasuries seeking to creep out of indebtedness. because it sacrifices any opportunity to increase buffers. Towers Watson calculates that corporate pension liabilitiesThe question then becomes which route to take away from for DAX 30 companies rose EUR 22 bn to EUR 281 bn in thewhat once were safe havens but increasingly resemble first half of this year alone due to the rising price ofcostly dead ends. We asked investors for substitutes for corporate and government debt. Which macro topic keeps you awake at night? 54.6 % 25.0 % Eurozone 10.5 % Financial 5.9 % U.S. “fiscal cliff” repression debt crisis Slowing of China’s growth momentum 13
  14. 14. Financial repression Where do you find a substitute for government bonds in order to generate reliable and sufficient yields?* Traditional asset classes Alternatives Corporate bonds 68.8 % Real estate 31.2 % Emerging market bonds 37.0 % Infrastructure debt 13.6 % Covered bonds 22.7 % Infrastructure equity 13.0 % Emerging market equity 10.4 % Private equity 10.4 % Developed market equity 9.7 % Hedge funds 5.8 % Multi asset 7.8 % Commodities 5.8 % 0% 10 % 20 % 30 % 40 % 50 % 60 % 70 % 0% 10 % 20 % 30 % 40 % 50 % 60 % 70 % * up to three answers possibleWe began this edition of RiskMonitor by referring back to Respondents from the Nordic region exhibit perhaps thethe debate on ‘safe assets’ from the previous edition. We most adventurous nature: for one in six investors, bothcontinue that debate here by looking at substitutes for emerging markets equities and private equity weregovernment debt. The grim joke is that a risk-free return deemed reliable substitutes for government debt. Anotherhas become a return-free risk. And yet the asset class choice worth noting is the high interest from France insectors of highly-rated debt and publicly-quoted equities, infrastructure debt. This attracted twice as many responsespreferably denominated in a hard currency, have remained from France than the universe average of 14 %. From thethe traditional bedrock of investors’ portfolios, not least for UK, 24 % of respondents registered an interest, althoughreasons of liquidity. To these strata, quality real estate can this comes as less of a surprise as the National Associationbe added. of Pension Funds there has liaised with the government to create a platform for infrastructure investment by UKBut this edition of RiskMonitor suggests that the tectonic pension plans.plates are shifting. It says something about the state of theworld that more than one-third of investors feel emerging Real estate was third most popular as a category, butmarket bonds are a reliable and sufficient substitute for second favourite among Swiss investors, attracting almostG10 government debt. Emerging market countries now half the voters there. Finally, the fact that fewer than 10 % ofhold close to 70 % of global reserves, versus around 30 % in respondents ticked the box for developed market equity isthe mid-1990s. The average yield for Asian EM debt, for noteworthy. At the end of June, 80 % of dividend-payingexample, is higher than median G7 debt – the HSBC Asian shares in the S&P 500 were yielding more than Treasuries.Local Bond Index registered a 6.1 % total return in US dollars But then, as with emerging market debt, Europe’sfor 2012 to the end of September. We must add institutional investors already seem happier putting theirimmediately, however, that investors are not talking about money further afield: emerging market equities are moreentire substitution. As one German life insurer notes: popular than developed equity as reliable substitutes to government bonds for yield generation. But as a concluding“These choices are obviously not surrogates for govvie note of caution on the relative current attraction ofbonds – we invest in covered bonds more to compensate.” emerging market equities: current average dividend yields in Asia of 3.1 % are lower than those in Europe.5Nevertheless, the fact that 56 % of Dutch institutionalinvestors, 55 % of Austrian investors and almost 48 % of theirGerman peers feel comfortable using emerging marketdebt for secure returns is remarkable. Perhaps it is nocoincidence that in both of the bigger countries, fallinginterest rates are named as the biggest risks to financialtargets over the next twelve months. 5 Source: Datastream; MSCI Asia ex Japan, MSCI Europe as of 31 October 201214
  15. 15. Financial repressionLook East! for about 50 % of global output by 2050 and China will likely have surpassed the U.S. as the world’s largest economicThe strong showing of both emerging market debt and power in 20206. In 2012, Asia holds more than 60 % of theequity in the poll is explored further in this edition of worlds currency reserves and its local currency bondRiskMonitor. We surveyed European institutional investors’ market has more than doubled since 2005, now accountingallocation and appetite for assets in Asia. Allocations and for 8 % of the global outstanding debt7. Thus, the majority ofexposures are not exclusive, i. e. respondents could vote for respondents are content to buy the Asian story.more than one. Two-thirds of respondents have exposureto Asian equities. Regionally by response, the Swiss top the One Dutch public-sector fund claimed:league with 85 %, followed by the Nordics with 75 %. Almost36 % of the entire universe of respondents has exposure to “Asian equity = Asian bonds + International corporateAsian debt. Germany was notable here for its widespread equity in return, but with lower risk and better correlation.”interest: nearly 48 % of respondents have exposure. TheDutch came in second at 44 %. Not everyone, however, is happy looking East. Another asset manager owned by a Dutch pension fund said:Nearly one-third of the total universe acknowledgedindirect exposure via large corporates doing significant “Changes in the legal system are necessary to make thisbusiness in the region. Only 15 % of respondents claim to region more popular. The risk-return profile is getting toohave no allocation to Asia directly or indirectly. From France, high; often this is visible via foreign currency movements.”the percentage was almost 29; from Germany, thepercentage was almost 24. From the UK, on the other hand, It is worth noting that while almost three in fivefewer than 7 % of respondents claimed to have no respondents said they would invest more in Asia, theexposure. reverse was true in the Netherlands where 58 % said they would not. Only the Nordics were more hawkish, withLooking to the future, almost three in five expect to raise almost 94 % declaring their allocation to Asia could onlytheir exposure. Given the strong fundamentals of the reduce from the present situation. Given the overall bigregion, this may come as little surprise. In 2010, for appetite for investments in Asia across all of Europe, it isexample, Asian exports to the US were close to US$ 400 bn worth to look at what have been the peculiar obstacles thuswhile imports from the US just US$ 158 bn. According to far to investing in the Far East.estimates by the Asian Development Bank, Asia will accountAppetite for assets in Asia is strong – regardless of existing exposure to the region 58 % 36 % 66 %SwitzerlandUKNordicsItalyGermanyFranceAustriaNetherlands 100 % 80 % 60 % 40 % 20 % 0% 20 % 40 % 60 % 80 % 100 % further investments in Asia planned exposure Asian bonds exposure to Asian equities European average European average European average6 Source: Datastream; Allianz Global Investors Capital Market Analysis7 Source: Datastream as at March 2012; AsianBondsOnline 15
  16. 16. Financial repressionFewer than one in twenty respondents have concerns but now Malaysia and Thailand rank in the world’s topabout the economic fundamentals in Asia. More than 28 %, 20 countries for doing business. This is according to theon the other hand, bemoaned the lack of transparency and International Finance Corporation and the World Bank’sdifficulties in gathering information. The Dutch office of measure of government rules and regulations on business.9one global investment consultancy tartly replied thatindirect investing in Asia was okay, but direct investing did One in five respondents said exposure to Asia was bound bynot work. Many commentators contrasted the quantity and investment limits. The answer was more than one in four inquality of commercial information available with that in Germany, whence one investment adviser made a clearEurope. plea to rethink such bounds:“Market characteristics are not sufficiently developed for “We believe that the limits should be increased because ofthe requirements of European standards,” said one Dutch the rising exposure of EM and because of the positive trendreal estate manager. for many of the EM currencies.”The CIO of a UK Corporate Pension Fund added that Asia is It is worth remembering that over the past five years, many“less well known to the investment team and the trustees. Asian currencies have appreciated against the euro, BritishMore time needs to be spent understanding the risks and pound and US dollar. The Malaysian Ringgit has increasedhow different asset classes operate. And there is less more than 22 % against the euro, for example. Moretransparency around these markets.” significantly, the appreciation is expected to continue. Research by Allianz Global Investors suggests that majorFundamental issues, such as the free float of quoted Asian currencies, with the exception of the Indonesiancompanies, remain. The Philippines’ stock exchange, for Rupiah, will appreciate in the coming decade by an averageexample, hopes to instigate a minimum 10 % free float by of 1 % annualised, with the Renminbi notably faster at 2.4 %the end of 2012. On a sharper note, Transparency annualised10.International’s Bribe Payer’s Index 2011 has just three Asiancountries in the top half of countries surveyed (one of While Malaysia, Cambodia, Korea, Singapore, Taiwan andwhich was Japan) while six were in the bottom half, Vietnam were all specifically mentioned by respondents asincluding China, where perceptions of corruption in the target destinations, the most popular countries were theprivate sector are second only to Russia8. On the other hand, most populous. Of those that stated a preference, 17 % saidnot just reliable centres such as Singapore and Hong Kong, India; 24 % said China.What is the biggest obstacle for moving investments to Far East? 30 % 28.1 % 25 % 21.6 % 20 % 19.4 % 16.6 % Difficult 15 % Market information characteristics gathering/ Limits set by 10 % (e.g. liquidity, transparency 7.9 % own investment Risk considerations market depth, guidelines volatility) 5% 3.6 % Regulatory hurdles Weak fundamental 0% outlook compared with other regions8 Bribe Payers Index 2011, Transparency International9 “Doing Business 2013” IFC and World Bank10 Allianz Global Investors “The Case for Emerging Market Currencies in the Long Run”16
  17. 17. Financial repressionIt should be noted that another 24 % also made it clear thatthey are looking for broad country diversification.There is a similar story when looking at asset class. While7 % of respondents stated infrastructure and just over 10 %are looking to real estate – direct and indirect; there is moreof a mix when discussing the major asset classes. Hence,equities attracted 55 % of respondents and bonds 41 %, butin many cases the same institutions are looking for broadexposure via both asset classes. 17
  18. 18. Regulatory and governance risksRegulatory and regulators to maintain open minds on what constitutes safe assets in order to avoid pro-cyclical regulation. Earlier thisgovernance risks year, a Rotterdam Court overturned the Dutch regulator’s demand on an industry-wide pension fund to greatly reduce its exposure to gold.Both regulatory and governance risks generally are not on Interestingly, the Netherlands was third most worriedthe rise for Europe’s institutional investors. Even stricter country about stricter regulation. A national reformregulation, regularly the biggest risk in this category, has package introduced this autumn included a new discountticked down over the second half of 2012. rate, the Ultimate Forward Rate (UFR), for liabilities with a duration of longer than 20 years. One Dutch fiduciaryIn order to achieve our financial investment targets over manager, which labelled stricter regulation a huge risk,the next 12 months, I see stricter regulation … disclosed that it had had to unwind some long-term interest rate swaps for clients in response to UFR’s100 % introduction. Although in Germany, 47.6 % of respondents 90 % 23.2 % 17.8 % 23.5 % 17.3 % classified stricter regulations as a considerable risk, no one 80 % here deemed it to be huge. 70 % In order to achieve our financial investment targets over 60 % 47.4 % 39.0 % 47.3 % the next 12 months, I see limited own risk management 50 % 47.7 % capabilities... 40 % 100 % 30 % 90 % 21.1 % 25.5 % 30.0 % 30.4 % 31.6 % 28.0 % 20 % 23.2 % 31.1 % 80 % 10 % 70 % 5.8 % 5.9 % 7.3 % 3.7 % 0% 60 % H1/2011 H2/2011 H1/2012 H2/2012 50 % 57.2 % 47.1 % 54.7 % As a huge risk As a considerable risk 56.7 % 40 % As a minor risk Not as a risk 30 %Drilling down to country level, however, reveals some 20 %interesting trends. Swiss and Nordic institutions seem more 10 % 20.3 % 17.5 % 20.4 % 12.7 %preoccupied than other regions by stricter regulations. They 0.7 % 2.2 % 2.2 % 1.3 % 0%represent a major risk to twelve-month financial targets H1/2011 H2/2011 H1/2012 H2/2012for a significant minority in these two places – 42.8 % inSwitzerland and 40.3 % in the Nordic region. As a huge risk As a considerable risk As a minor risk Not as a riskThe corporate pension fund of one Swiss multinationalmade the following observation: We find differences again between the general and country-level results on the topic of in-house capabilities“Stricter regulations are fine as long as this also means to monitor and manage risk. In general, this risk has fallenthat responsibility is shifted over to the regulators.” slightly over one year, but gently risen over the past six months, notwithstanding the higher efforts and resourcesThis sentiment will no doubt find sympathy in other institutional investors planned to commit to this area11.countries where the regulators of pension providers are So, no strong change of directions; and indeed one in five– by accident or design – taking much greater interest in respondents currently say their own risk managementinstitutions’ activities. James Dilworth, CEO of Allianz Global capabilities pose no threat at all to twelve-month financialInvestors Europe, made a plea in the previous edition for targets. On the country level, however, other trends 11 More than 54 % of the respondents said that in 2012, they planned to spend more in order to deal with governance and regulatory risk than in the previous year. Only 3% said they would spend less. Cf. RiskMonitor “Rethinking Safety“.18
  19. 19. Regulatory and governance risksmanifest themselves. In Germany, for example, the issue Which of is your biggest governance and regulatoryis growing, albeit at a low level. When the opinions ofGerman institutions were first canvassed four editions ago, risk in the next 12 months?46 % declared that in-house risk management was no cause Stricter regulation 32.7 % (–5.1 %)*for concern. To now, that percentage has dwindled to 14 %.Having said this, German-based respondents are still not Limited own risk 25.3 % (+6.0 %) management capabilitiesgreatly perturbed. The sense that internal processes must Rising reporting requirements 17.3 % (+11.6 %)be improved is strongest in neighbouring Switzerland,where one-third of respondents reckon their own risk Organisational complexity 10.0 % (–3.3 %)management capabilities pose a considerable risk. Pressure from sponsor 8.0 % (–4.6 %)In order to achieve our financial investment targets over Other 2.7 % (+0.5 %)the next 12 months, I see rising reporting requirements … Pressure from trustees 2.0 % (–3.2 %)100 % Heterogeneity of investment 2.0 % (–1.0 %) 90 % 24.3 % set-ups cross-border 32.0 % 33.8 % 34.3 % 80 % *compared to survey H1 / 2012 70 % 60 % 50 % 54.6 % While stricter regulation remains the prime concern, it 47.7 % 51.1 % 44.5 % has lost as many votes as own-capability limits gained. But 40 % the fastest riser has been rising reporting requirements, 30 % attracting nearly 12 % more respondents. Other issues such 20 % as organisational complexity and pressure from sponsors 18.3 % 19.0 % 17.8 % also make a significant showing. 10 % 15.1 % 2.0 % 2.2 % 3.3 % 0% We have undertaken additional analysis of respondents’ H1/2011 H2/2011 H1/2012 H2/2012 remedies for dealing with these biggest risks. The most As a huge risk As a considerable risk popular response is to improve in-house capabilities: As a minor risk Not as a risk we find one-fifth of the respondents raising existing comprehension of risk or recruiting new staff. A similarFears over rising reporting requirements are found share of respondents has or is updating their processes andin similar places as fears over stricter regulation: The systems – this answer applies to the issue of organisationalNetherlands, Nordics and Switzerland are the only countries complexity, as much as limitations of capability and risingor region where rising reporting requirements are deemed reporting requirements.a huge risk (albeit by a small minority). In Italy, by contrast,either regulators must be resting their pens or the country’s One Dutch pension fund said of organisational complexity:pension providers are extremely well managed. Here,rising reporting requirements represent a negligible risk “It concerns internal organisation and has directly nothingto all respondents. The UK is almost as confident: 93 % of to do with the asset management. I cannot changerespondents registered similar sentiments. anything, so I observe, adapt and integrate the new structures into my working environment.”These first three issues score highest when we askedrespondents for their biggest single risk from regulation or Noteworthy is that both these remedies are moregovernance. popular than increased outsourcing. The one exception here regards fiduciary management. Nearly one in ten respondents said that they had or would adopt fiduciary management to cope with the twin burdens of regulation and governance. Two other kinds of activity are communicated by the rest of the responses. The first is lobbying, notably in response 19
  20. 20. Regulatory and governance risksto stricter regulations. More than one in ten respondentssaid that they lobbied authorities to have their voiceheard. But the final action was even more popular andespecially relevant to pressure from sponsors and trustees:communication.“We share information with the sponsor and advisor andhave fruitful discussions in order to prevent the sponsorfeeling not in control,” said the asset manager of one Dutchcorporate pension fund.A UK peer saw a more direct but equally valid reason forcommunicating: “to manage expectations”.But we conclude on a most relevant summary of howpension fund management ought to be, from theNorwegian subsidiary of a multinational giant:“Reduced risk on investments, more complex riskmonitoring.”There seems no more fitting way to end a survey of thehabits, fears and aspirations of Europe’s institutionalinvestors regarding risk.20
  21. 21. Regulatory and governance risksIn order to achieve our financial investment targets for In order to achieve our financial investment targets forthe next 12 months, I see heterogeneity of cross-border the next 12 months, I see pressure from trustees …set-up …100 % 100 % 90 % 90 % 34.3 % 80 % 43.3 % 45.1 % 36.7 % 80 % 46.1 % 42.0 % 70 % 55.9 % 70 % 61.0 % 60 % 60 % 50 % 50 % 44.4 % 40 % 40 % 42.7 % 48.0 % 43.6 % 55.3 % 41.7 % 30 % 30 % 37.1 % 28.7 % 20 % 20 % 19.4 % 10 % 10.5 % 10 % 11.3 % 15.3 % 8.9 % 7.0 % 8.7 % 7.3 % 0.8 % 0.7 % 1.5 % 1.9 % 0.9 % 0% 0% H1/2011 H2/2011 H1/2012 H2/2012 H1/2011 H2/2011 H1/2012 H2/2012 As a huge risk As a considerable risk As a huge risk As a considerable risk As a minor risk Not as a risk As a minor risk Not as a riskIn order to achieve our financial investment targets for In order to achieve our financial investment targets forthe next 12 months, I see organisational complexity … the next 12 months, I see pressure from sponsor …100 % 100 % 90 % 90 % 32.4 % 37.8 % 23 % 37.3 % 80 % 39.1 % 39.9 % 80 % 46.7 % 57.1 % 70 % 70 % 60 % 60 % 50 % 50 % 41.5 % 57,2 % 47.6 % 42.5 % 40 % 43.5 % 40 % 49.0 % 34.2 % 30 % 30 % 30.1 % 20 % 20 % 20.0 % 17,1 % 18.1 % 15.8 % 16.4 % 10 % 15.2 % 10 % 10.5 % 10.6 % 1.3 % 1.4 % 0.7 % 2,6 % 2.3 % 1.9 % 3.3 % 3.7 % 0% 0% H1/2011 H2/2011 H1/2012 H2/2012 H1/2011 H2/2011 H1/2012 H2/2012 As a huge risk As a considerable risk As a huge risk As a considerable risk As a minor risk Not as a risk As a minor risk Not as a risk 21

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