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Despite a strong equity market since the end of March , plan sponsors have seen only modest improvement in funded status as rates remain at historic lows. This may leave plan sponsors wondering, “What happens to my funded status if equities stumble?” It’s a reasonable question given the potential sources of volatility on the horizon, from the US election to developments in the pandemic. We think it ties directly to another question that we’ve been discussing with plan sponsors: Is now a good time to broaden the return-seeking opportunity set in an LDI portfolio?
First, some context: The collapse of the US economy in the first quarter was unique in that it was brought about not by the usual suspects, such as tightening monetary conditions, but by the exogenous shock of a pandemic and the required rapid shutdown of much of the economy. The corresponding collapse of financial markets was unique as well. In most economic downturns, higher-beta sectors, like technology, decline the most. But during the COVID-19 sell-off and the subsequent rebound, the technology sector was one of the top performers, as many people moved to a work-from-home environment and became more reliant on technology, e-commerce, and social media. At the same time, lower-beta sectors, such as infrastructure and REITS, both of which may offer defensive qualities given their stable cash flows and yields, provided less protection than expected in the sell-off and, for the most part, lagged the market in the rebound. Stocks in these sectors generally underperformed on recollections of 2008, when real estate was at the epicenter of the crisis, and concerns around potential rental and utility-rate forbearance, which we believe will prove to be exaggerated.
As a result, we think some defensive areas of the equity market are on sale at a time when plan sponsors may want to consider adding them to return-seeking portfolios. In our framework for return-seeking portfolio construction (see our recent white paper), we incorporate both defensive equity strategies, which seek balanced upside and downside participation (e.g., 95% upside capture/85% downside capture), and “bridge” strategies, which aim to deliver meaningful downside mitigation when funded ratios are under duress — particularly in “perfect storm” environments where the twin headwinds of falling equities and falling rates can devastate funded status. Examples include liquid infrastructure, real estate, and “growth” fixed income strategies (the latter generally focused on dedicated or rotational spread sector exposure).
As noted, the current environment may present an attractive entry point for some of these areas of the equity market. For example, we think segments of the liquid infrastructure universe, such as utilities, are attractively valued. And real estate cap rates (net operating income divided by real estate value) may offer compelling net rental yields relative to Treasuries (Figure 1), given performance during the drawdown and recovery and the compression in yields facilitated by central bank purchases.
- Liquid infrastructure: We include industries such as utilities, transport, communications, and renewables in this category. We believe the structural opportunities around renewables and grid modernization offer a longer-term growth runway for many infrastructure companies as global economies seek to reduce reliance on carbon-based energy.
- Real estate: Due to contractual lease obligations, REIT earnings are generally less volatile than those of broad equities, potentially providing some downside mitigation in a drawdown scenario. In addition, balance sheets have improved substantially since the global financial crisis. We think these attributes are underappreciated by the market. And the structural changes to real estate resulting from long-term trends, some of which have accelerated under COVID-induced quarantines, could lead to substantial dispersion between winners and losers, creating opportunities for active managers. For example, cell towers/data centers are benefiting from increasing data usage while brick-and-mortar retail is shrinking.