By Erik Sherman
There’s abundant uncertainty among central banks as a group recently. Don’t expect significant changes in how pension funds respond. Turning on a dime isn’t their forte — and it’s not necessarily smart.
Confusion of Central Banks
At the opening of August, the Bank of England cut its benchmark lending rate from 5.25% to 5.00%, but inflation was already down to 2%, as the Wall Street Journal reported. Policymakers worried that services inflation had been at 5.7% in June. The quarter-point drop was on a five-to-four vote.
The Federal Reserve held rates at the end of July. Then, a weaker-than-expected jobs report sent markets into a big drop. Wharton School Professor Emeritus Jeremy Siegel told CNBC that the Fed needed an emergency 75-basis-point cut. He changed his mind within a few days as markets recovered.
Maybe the problem wasn’t the labor market. The Bank of Japan had recently increased interest rates to 0.25% from 0.10%, upsetting the carry trade. Japan had been a major source of the low-interest capital that traders would reinvest in places with higher rates and many likely were caught
Then the European Central Bank cut rates by a quarter point in June — the first time in five years — and then kept the rate steady. By a Bloomberg survey of forecasters the next month, the consensus was six consecutive quarter-point reductions.
The Response of Markets
There is no coherent and single explanation for complex economic shifts. Instead, investors reacted to whiplash-inducing market lurches with a sense of impatience, a demand for definitive actions by central banks, generally in the form of interest rate cuts. That’s even as the Fed and others like investing giant Vanguard suggest that the neutral interest rate, which allows efficient economic activity without hindrance or support, is higher than it was in the recent past. In other words, maybe rates shouldn’t return to ultra-low levels.
Mohamed El-Erian — chair of Gramercy Fund Management and former chief executive officer of Pimco — wrote for Bloomberg that market participants have read too much into the news and are overly optimistic.
Institutional investors like pensions, life insurance companies, and others that need long-term stability and predictability must take a more thoughtful approach. Ian Toner, chief investment officer of institutional consultancy Verus, likens it to sailing.
“If you’re sailing a sailboat across the estuary, you’re worried about the wind and the tide rather than the individual waves,” he says. “If you have the helm, you make sure the waves don’t make it too uncomfortable to ride.” But the sailor must remember the primary need to reach the destination.
Toner says that running a large institutional pool of capital has similar qualities. “Learning about the long-term effect of betas [or market volatility] is going to be the biggest impact on your delivery of long-term benefits.” Volatility is tricky because it can harm returns or act as the main mechanism for getting market-beating results.
“When you add on top of that market changes like for example interest rates going from effectively zero to definitely not zero, that changed the interest in fixed income,” Toner says. “Those kinds of changes, tectonic changes, absolutely have an effect on the way portfolios get allocated. Shorter-term things, less so.”
Even within a single entity, there are diverse opinions. At JPMorgan Chase, CEO Jamie Dimon continues to see about a 65% chance of an oncoming recession, as he told CNBC. Meanwhile, JPMorgan economists see a 35% chance of a recession by the end of this year and a 45% chance that one comes by the second half of 2025, according to Bloomberg.
Pensions and other investors that need predictable capital predictability to meet future obligations must be careful and measured in how they respond to changing conditions. John Stoj, a personal advisor at Verbatim Financial and former institutional portfolio and fund manager, describes the process of making changes.
“They are trying to make the best decisions for their client, which may be the fund or the fund holders,” he says. “But they’re all measured against something. It’s very seldom they’re allowed to make bold decisions. That’s the area where hedge funds operate — people who can lose money.”
Instead, people have specialties and manage portions of a portfolio within that area. It could be that when they see significant changes in the market and suspect rates or yields will change, they might develop a strong opinion.
“You have to go to your credit committee or investment committee with your thesis and what you should do in your portfolio to take that into account,” Stoj says. “If they give you the green light, it’s to go overweight slightly or underweight slightly. Especially with pension funds, as they look at it as liability matching.”
“Predicting the future is hard,” says Toner. “You’re always dealing with uncertainty rather than certainty. When things change, you’re adjusting probabilities of different outcomes at the margins. There’s always uncertainty in what you’re doing. And that’s okay.”
