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Top issues institutional investors should be thinking about in 2023

After one of the toughest years for investors in recent memory—the S&P 500 Index ended 2022 down 19% while bonds suffered through one of their worst 12-month stretches on record—2023 has kicked off on shaky ground over fears of a looming recession as last year's series of aggressive rate hikes by the U.S. Federal Reserve (Fed) flow through into the economy.

Although it's possible the worst of the damage in equity markets is in the rearview mirror, given the forward-looking nature of markets, there's also the risk that worries over a significant decline in corporate profits and jobs could send equity markets tumbling even further. And, of course, the number-one enemy to markets last year—inflation—may not be fading away anytime soon.

Amid such a challenging and complex backdrop, what issues should investors be focusing on as the new year unfolds? Although there are no shortage of problems confronting investors today, we do believe there are some key issues that should be at the forefront of every investor's mind. So, without further ado, let's cut to the chase. Listed below, in no particular order, are six key issues institutional investors should be thinking about.

1. A recession appears likely. So what should your portfolio's risk allocation look like?

Although weaknesses in leading economic indicators such as ISM (Institute for Supply Management) surveys and PMI (purchasing managers' index) surveys point to a likely recession, it's precisely during these trying times that bonds can be a useful hedge in a portfolio. If a recession were to materialize, the Fed would likely eventually cut interest rates, causing yields on government bonds to fall, and increasing the value of those bonds.

Although forecasting always comes with an inherent degree of uncertainty, our valuation models suggest that bond markets have not fully priced in this outcome, implying that government bonds (in particular, U.S. Treasuries) are still somewhat cheap. Finally, even as some market participants have touted 2023 as being the year for bonds, investor positioning in the bond market still remains net short. This means that there's still a seat at the table, and it may be a good time to go long Treasuries before the trade gets crowded.

Meanwhile, we believe it may be better to exercise some restraint when it comes to equities and currencies. In a recessionary outcome, corporate profits will likely fall, creating a significant drag on equities. And while equity markets have already dropped significantly since 2022, our valuation models still imply that equities are somewhat expensive at these levels. Further downside is possible. But we are also still seeing signs that other investors are feeling somewhat downbeat about equities, which we interpret as a positive sign from a contrarian perspective. Overall, on balance, we believe it may be best for investors to stay neutral on equities for now. If the recession does actually materialize later this year and we get a cheaper entry point combined with more signs of investor capitulation, then that could potentially cause us to favor equities later on.

Finally, let's explore the currency dynamics. Ultimately, the currency picture remains mixed. On the one hand, the U.S. dollar has already strengthened considerably in 2022 against many major asset classes, and it's true that a potential Fed pause could limit upside on the U.S. dollar. On the other hand, if the recession does materialize, a flight-to-safety scenario could play out and prevent a material weakening of the U.S. dollar. The yen and the euro could potentially benefit from a Fed pause, but again, we believe the uncertainty in the outlook means investors should steer away from outsized currency bets.

2. Check your ESG risk exposure and liability

In a rapidly changing institutional workplace, either your organization may be too focused on ESG (environmental, social, and governance) risks or not focused enough. Whichever the viewpoint, institutional investors know that ESG issues can have material financial impacts, and the results from our 2022 ESG manager survey show that climate risk is increasingly cited as a key risk by investors across the globe.

Experts acknowledge two types of climate-change-related risk: physical risk and transition risk. The former is associated with extreme weather events like floods or storms and the damage it causes to assets or economies, whereas transition risks arise from changes in policy and from new technologies which can shift demand toward solutions such as renewable energy. The latter primarily represents a risk to fossil fuel and polluting industries as the global economy transitions away from a carbon-based economy.

While data to measure these risks and other environmental risks remains spotty, sophisticated investors are moving forward, adapting as they go by making use of a wide range of data sets in constructing and managing portfolios. We believe that one helpful way for investors to check their ESG exposure and liability is by focusing on the materiality of an issue, as traditional ESG scores are composed of a large number of issues—many of which aren't material to a given industry or company. For example, at Russell Investments, our Material ESG Score— a proprietary metric—allows us to construct portfolios that tilt toward companies which score highly on ESG issues that are financially material to their business—as opposed to those which score highly on issues that are not. We use these scores in our decarbonization strategy and other ESG investment strategies.

In assessing sustainability and net zero risks, we believe it's also best-practice to make use of data and analysis on carbon emissions, on alignment from the Transition Pathway Initiative and from CDP disclosures (Carbon Disclosure Project)— and to engage with companies and subadvisor partners to promote transparency, accountability and strong risk management.

Of course, ESG is not just about environmental risks. Industry attention to social risks—and the accompanying impact on results and returns—is also rising, and any ESG risk-exposure check should take this into account. In our view, institutional investors would be well-served to understand their investments' exposure to governance risks as well as social risks, including human capital management. Mismanagement can hit a company's bottom line. We believe human capital management should include high attention to diversity, equity and inclusion (DEI) practices at each point along the capital markets value chain.

For more on the changing ESG landscape and the latest regulation, reporting and growing interdependencies, see our 4 ESG trends for institutional investors blog post.

3. How should organizations manage their spending policies given the inflationary backdrop?

2022 was a treacherous year for nonprofits, due to the twin headwinds of market drawdowns and decades-high inflation. The resulting impact on donations was significant. To illustrate this, let's zoom in on university endowment spending policies in the U.S. and their similarity with other nonprofit spending policies.

In 2022, most university endowments saw their assets decrease. Year over year, assets change by the increase or decrease in returns and gifts. Last year, returns were flat to down by double digits, decreasing total assets. University endowment gifts declined, as these gifts are correlated to equity market returns, and usually make up a portion of the increase in assets or are used to make the annual spending payout. Additionally, in 2022, inflation cut the purchasing power of the annual spending payout—making a targeted 5% payout eat into the endowment corpus and real purchasing power of the endowment.

Most universities use a spending formula to smooth the volatility of the annual spending payout. This smoothing makes budgeting easier over short and long periods as the dollars received from the spending payout can be modeled more accurately. To this end, universities are loath to change the formula for calculating the annual payout. Most universities use a rolling three-year average of the year-end endowment market value, then multiply that by the spending payout percentage to determine the annual spending payout in dollars. The rolling three-year average smooths the fluctuations in the payout amount—universities would be loath to make that more volatile.

So what is an endowment-rich, but cash-poor, university to do? The solution is threefold: 1) change the payout percentage in the spending formula; 2) take a one-time distribution in excess of the spending payout; and 3) withdraw excess university funds previously invested in the endowment.

Unfortunately, there are no easy answers to getting more money out of an existing pool of money. Each type of nonprofit is different: public charities, endowments, community foundations, private foundations, and religious organizations. While there are some options for getting a bit more money this year, those dollars are at the expense of growth into future dollars.

4. DB plans: Consider hedging your interest-rate risk at a higher level, if you haven't already

For defined benefit (DB) plan sponsors, one of the greatest risks to a plan's financial health is a decline in interest rates. This is because a plan's liabilities are much more sensitive to changes in rates than a plan's assets are—meaning that when interest rates fall, liabilities increase at a much greater clip than assets if the plan is underhedged. This can lead to significant reductions in a plan's funded status.

With increased odds of a recession striking the U.S. this year, we believe the Fed could respond by cutting rates later in 2023. In our minds, this is a very real risk, as rates typically fall during most recessions. To lessen this risk, we believe that now is the appropriate time for plan sponsors to consider elevating their hedge ratios.

There are typically three main ways this is done: 1) by improving funded status directly via contributions, 2) by increasing the physical LDI (liability-driven investing) allocation at the expense of return-seeking assets, or 3) by increasing LDI duration. Of these three methods, the third is easily the most efficient, and can be accomplished by extending the physical fixed income duration or by using derivatives.

Increasing duration can go a long way in better aligning a plan's assets with its liabilities, while also minimizing funded status volatility. Less volatility in a plan's funded status is particularly important for closed and frozen plans that are fully funded and want to maintain this status without having to make new contributions.

Sponsors in the U.S. can extend their LDI duration by either adding or dialing up their exposure to derivatives, such as Treasury futures, or by increasing their exposure to STRIPS. Many larger plans find Treasury futures an effective way to increase their hedge ratios or fine-tune their hedging positions. STRIPS can also be an effective option for increasing hedge ratios, but it's important to note they don't offer the same potential return as long credit, due to the additional spread.

Ultimately, rates aren't going to go up forever, especially if the economy sours. This is why we believe that for those plan sponsors considering increasing the amount of interest-rate risk they are hedging, there's no time like the present.

5. Does an allocation to private markets make sense in 2023?

History has shown that in private markets, the best investment opportunities can arise in a time of crisis. As such, we believe this year could be an opportune time to commit capital to private markets, including both private equity and private credit. Analyses of past performance has shown that the best vintages are those that start during recessions or soon after, such as the bursting of the internet bubble in the early 2000s, or in the aftermath of the Global Financial Crisis in 2008.1 It is precisely during these difficult market phases that top-tier private markets managers can perform best.

Why? Because challenging market environments provide opportunities for investors, creating conditions that allow more room to make acquisitions at a discount. This trend is consistent with previous recessions or distressed environments, which can create great opportunities for secondary strategies.

By focusing on secondary investments and related strategies, we believe there are numerous opportunities to provide liquidity to the market and potentially attractive returns for investors. One element that is affecting the secondary market is the denominator effect. Equity and bond valuations have fallen significantly, and this has affected the strategic asset allocation of institutional investors, forcing them to create liquidity from various sections of their portfolios.

In this case, private markets managers can step in as liquidity-solutions providers while delivering to their investors really attractive investment opportunities. Looking at opportunities on the secondary side, we usually see that traditional private markets funds start exchanging owners three and five years after launch. This is because this is the time when the portfolio has sufficiently developed and there is enough portfolio visibility for sellers and buyers to gain comfort transacting. So, if we look at the recent tremendous global interest in private equity over the last few years, we can anticipate that an incredible amount of assets will reach the secondary market shortly, in addition to some of the limited partners (LPs) interests that have started to appear attractive. In addition, we are also seeing continued growth in general partners (GPs) continuation solutions—essentially managers looking for sources of liquidity for their existing portfolios that may be attractive to buyers on the secondary market.

When considering private credit, we'd highlight that yields are at their highest levels since the Global Financial Crisis. In addition, upcoming maturities will need to be rolled over at significantly higher rates. Ultimately, we believe that in the current environment, private credit provides investors with highly attractive entry points, the potential for downside protection and heightened governance through the application of both positive and negative covenants as part of credit agreements.

The bottom line

While there's no shortage of issues keeping institutional investors awake at night, we believe that the six listed here demand top consideration in this year. Wrapping your arms around each issue and coming up with a sensible plan of action can help ensure that you're starting off the new year on the right foot. Let us know how we can aid in this effort.