A year into the most significant period of rate hikes by the Federal Reserve in decades, you might think that investors would have already cemented their investment portfolio strategies for a higher interest rate world. But some of the biggest investors are making, or first planning, some of their biggest moves now.
Count the largest county pension scheme in the US among the list of elite investors planning to stockpile bonds as a result of the higher interest rate environment. That was the message delivered by Jonathan Grabel, chief investment officer of the Los Angeles County Employees Retirement Association (LACERA) at CNBC’s virtual Sustainable Returns event on Wednesday. And he says that an upcoming portfolio redistribution process will have major implications for the markets and the economy.
“I think the changing market environment with higher prices potentially changes everything, it changes how we think about allocation,” Grabel told CNBC’s Frank Holland. This summer, the LACERA CIO said, the pension plan — which invests on behalf of 180,000 active and former workers in LA County and has roughly $70 billion in assets — will “revise” its strategic asset allocation, he said.
As the pension giant seeks a total return of 7%, Grabel said the summer review will consider changes to stock, bond, real estate and real asset allocations. “To the extent that we can get there [7%] and can get more through safer fixed income investments, it can change the amount of capital we have in riskier complex equity-like investments.”
LACERA is not alone among large investors talking about how the higher interest rates are changing portfolio allocation decisions, especially when it comes to private market stocks and alternative investments. Fellow California pension giant CalSTRS is making a bigger move into bonds, according to a Wall Street Journal report from earlier this month. “Bonds are back,” CalSTRS Chief Investment Officer Chris Ailman told the Journal.
According to LACERA’s 2022 annual report, investments were split between approximately $24 billion in public stocks, $19 billion in bonds, $13 billion in private equity, $6 billion in real estate, $4 billion in hedge funds and $1 billion in real assets.
Last year was the first time in the previous three financial years that the pension fund’s investment portfolio lost money. Although it still managed to outperform the benchmark, the return fell well below the actuarial assumptions for a return of 7%.
Net investment losses for fiscal 2022 were approximately $1.5 billion, down $17.1 billion from fiscal 2021, when net investment gains were $15.6 billion, and which it attributed to “challenging market conditions in the first half of 2022, including war in Europe, high inflation and an economic slowdown in China.”
In contrast, the 25.2% return on investment in 2021 was well ahead of the 7% percentage, which LACERA attributed to the strong performance of global equity and private equity assets.
A shift to more fixed income among top investors will flow through to “the entire economy,” Grabel said. “We are aware that as investors hold less in risky assets, it changes how companies allocate capital,” he said.
“It really increases the demand and the need and the requirement for boards focused on excellence, and where access to capital is,” he added at the CNBC event focused on sustainability and investment.
LACERA was not scheduled for one of its formal three- to five-year portfolio reviews this summer, which was last completed in 2021 and included the creation of new asset allocation buckets.
More bonds do not mean more 60-40 portfolios
This does not necessarily mean a shift back to the 60-40 stocks/bonds approach that had been left for dead during the years of high stock market returns and ultra-low interest rates.
While the traditional investment concept has had a better year in 2023, and some investors are now backing it again, some major institutions say it’s still time to ditch it, including BlackRock. In a report out this week, the BlackRock Investment Institute said the terrible return last year for the 60-40 portfolio followed by the big return this year should both be discounted.
“We are not seeing the return of a common equity-bond bull market as we saw in the Great Moderation. There was a decade-long period of largely stable activity and inflation when most assets rose and bonds provided diversification when stocks fell. We believe strategic allocations of five years and longer built on these old assumptions does not reflect the new regime we are in – a regime where major central banks raise interest rates into recession to try to bring inflation down.”
Bonds won’t provide the “reliable” diversification they have in previous years, “but higher yields mean income is finally back in fixed income,” the team wrote. Overall, BlackRock says that focusing on broad portfolio concepts is a mistake going forward, but for now, rising interest rates mean more focus on income plays.
“The longer interest rates remain higher, the greater the appeal of short-term bond yields. We see interest rates staying higher as the Federal Reserve tries to tame sticky inflation — and we don’t see the Fed coming to the rescue by cutting rates. or a return to an environment of historically low interest rates. This reinforces the appeal of income in short-term paper. Yet we also see long-term yields rising both strategically and tactically as investors demand more term premium, or compensation for holding long-term bonds in an environment of higher inflation and debt.”
Recent comments from Wall Street bank CEOs during the earnings period suggest interest rates will remain higher for longer despite traders betting on Fed cuts this year. Morgan Stanley CEO James Gorman said the Fed could have two more rate hikes, while CEO Jamie Dimon said last Friday that 6% interest rates could be coming, a potential reality that Gorman also said would be “not shocking.”
BlackRock is overweight inflation-linked bonds, the team wrote, based on expectations of sustained inflation.