Thursday 12 November 2020

Q&A with Hans Fahlin

How does interest rate equilibrium impact institutional investors? Hans Fahlin, Chairman of Inquire Europe, shares his insights. 

  1. 2020 has been an extremely volatile year. How do you reflect on what has transpired and what are the factors that you are considering now as you assess the risks for the medium term?

This is the biggest economic contraction since World War II. But the other salient factor is that the recovery has been unprecedented. This is not a normal ‘business cycle’ crisis - it is due to a biological, exogenous factor, meaning that a lot of the issues that a recognizable in other crises simply are not apparent with this one.

It is simply different. We aren’t back to pre-pandemic levels, but we are making progress. Monetary and fiscal stimulus has been unprecedented, and has helped the financial markets massively when there were immense liquidity constraints. It has also propped up the real economy by keeping people employed and maintaining consumption levels at a relatively high level.

If you take a look to the other side of the world, China is doing extremely well, its GDP is showing incredible resilience – they are basically back in business. It is a bit more challenging in Europe and the US. The recovery has stalled in Europe due to new Covid outbreaks; monitoring the development of the pandemic is extremely important. We need to be wary of how new lockdowns will impact economies.

If governments andcentral banks roll back stimulus prematurely, it could become a highly risky scenario. The fact that the extra stimulus in the US is being delayed, partly due to the election, is not ideal. The size of US fiscal stimulus will be dependent on which candidate wins the presidency, but also the majority in the senate and the congress. My expectation is that if Biden wins and the Democrats get a comfortable majority in the senate, there will be more fiscal stimulus than if the government is divided.  

  1. Sustainable investing has become even more prominent amongst investors since the covid-19 crisis erupted. In what can you combine quant factors and sustainability?

There are multiple ways you can do this. One way is to constrain the universe to which you apply your model, thereby only including stocks which pass a certain selection or screening process. Another approach is to integrate ESG into your quant factor model by adding information about corporate sustainability characteristics or data use to create ESG factors which will be used to predict returns in your model.

  1. At the end of 2019, pension funds were contemplating how tightening monetary policy would begin to affect strategic investments. However, due to the Covid-19 crisis, it is evident that central banks will continue their efforts to stimulate the economy with loose monetary policy for the unforeseeable future. How will this impact institutional investors?

Some of pension funds may be having a problem now because they had too much interest rate risk on their books.  They were not hedging their funding ratio risk in their portfolio sufficiently. The fact that interest rates have been declining for over a decade has substantially impacted their funding ratios. However, if we view this from the perspective of a central bank, their priority is to deliver on the goals that society is giving them, for instance to achieve inflation targets, and ensure a stable business cycle. This is not always favourable for all stakeholders in the investment environment, but it is simply reality.

I do not have a stream of liabilities to meet, meaning that the mandate that I am required to fulfil is different than some pension funds. In that sense, the last decade has actually been quite a good, because the equity markets and other risky assets have been doing very well. Not all institutional investors are suffering.

Are interest rates unusually low? Or is this the new normal? There is a big debate about the equilibrium level of interest rates. In ALM modelling, when investors make decisions on strategic long -term investing, you need to have a view of what rates are going to be quite far in the future. It is a very challenging question to decide if the current level of interest rates is an anomaly or if it will remain for an extended time. There are multiple arguments for both.

The unprecedented level of fiscal stimulus means that the supply of safe assets is going to be very high, which could be an argument for why rates will rise. However, the trend toward very low rates has been happening for a long time, and the Covid crisis has made it even more acute. We will have slack labour markets, and it is hard to see that inflation will rise in the medium term. It is very difficult to predict where we will be in five years using only data analytics and modeling. One must also apply discretionary thinking.