Rate expectations

As markets ponder the next moves from central banks, we look at how rampant inflation and rising interest rates have impacted transition timing, management and trading.

When the Federal Reserve raised its benchmark interest rate by 0.25% in February – the eighth increase in the space of 12 months - the target range reached its highest level since late 2007.

In Europe, the ECB raised the key interest rate for the first time in 11 years last summer and followed this with three further increases, while in the UK the official bank rate has risen from 0.25% to 4% over the last 14 months.

The decision of central banks to raise rates and rein in their balance sheets had an impact on the asset allocation decisions of asset owners and the impact of this new macroeconomic environment was evident on the timing of allocation events, particularly when reallocating within an asset class (for example, fixed income, long duration to short duration) and in equities, where there were significant regional or sector skews explains Andrew Orr, senior multi-asset transition manager at Citi.

“From a management perspective, the cost effectiveness of hedging and transition strategies came under renewed focus,” he says. “Hedging required an extensive review of derivative and proxy solutions, while the strategy focused on how effectively to contain implementation costs. With regards to trading, the pace and order of executions focused on accommodating market dynamics.”

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Macquarie Capital focuses on expected economic announcements and how they could affect the trading risks in the transition, so it made sense to have a particular focus on those when it knew that central banks had a strong focus on rates and where they were going.

Liquidity challenges

“There were various points last year where we saw liquidity challenges in certain markets,” says Paul McGee, head of portfolio solutions EMEA. “Gilts was one after the UK mini budget where we saw a big sell off and high yield was another where the markets went through quite a risk off phase in September and October.”

There is no doubt that concerns around inflation and where interest rates were going were a challenge for clients when planning events in 2022.

“Our assessment of liquidity in the market was constantly being revised depending on where we were in the cycle,” says McGee. “It probably meant that we were tiptoeing around certain dates more than perhaps we normally would, because we were seeing some significant reaction to central bank meetings and announcements.”

He describes the last 12 months as being among the most volatile periods the firm has encountered and notes that it presented considerable challenges for certain clients and their investment managers in needing to be able to raise cash quickly to meet redemptions.

McGee agrees that finding the right asset mix was more difficult over that period with the late September/October turmoil making many clients take stock and pause what they were doing – and suggests that at least some of these clients are probably still going through strategic reviews.

“We would normally see quite a rush of transition events into a year-end - a bit of housekeeping potentially getting things tidied up - but we didn’t see that normal flurry of activity,” says McGee.

Hedging required an extensive review of derivative and proxy solutions, while the strategy focused on how effectively to contain implementation costs.

Pause for thought

“Instead, clients were just digesting what had gone on. Markets were a bit volatile and they decided to pause and reconsider planned events. So we expect 2023 to be very busy and I think some of that will be from clients who put things on hold in the final quarter of last year.”

James Woodward, global head of State Street’s transition management business observes that making large portfolio changes during volatile markets is not ideal - the perfect environment is a calm market with strong liquidity. But the ultimate decision depends on what the portfolio is and what the investment objectives are because volatility and changes in return profiles can be catalysts for change.

“The important thing to consider here is the opportunity cost of a delay,” he says. “We saw a lot of activity in 2022 where clients wanted to reposition portfolios for new environments. In terms of the asset mix, we have certainly seen clients shift to portfolios that are more likely to provide the greatest suitability in a different return and economic outlook.”

BlackRock expects to see clients rotating fixed income allocations as that asset class becomes more attractive with recent rate moves and has witnessed a marked increase in demand for fixed income transitions versus equity recently. Andy Gilbert, EMEA head of transition client strategy expects this trend to continue through 2023.

It is incumbent on the transition manager to give the client the required inputs and data to enable the latter to make informed decisions with regard to timing explains Nick Hogwood, EMEA head of transition management at BlackRock.

Analytical input

“Earnings, local holidays, economic releases and data prints are all things which can be planned for and worked around,” he says. “However, macroeconomic concerns such as inflation can give clients reason to pause and reassess their situations in light of the changing environment. The transition manager’s analytical inputs with regard to the client’s portfolio in the current context are invaluable.”

All of the challenges that arose in 2022, from the conflict in Ukraine to the impact of rising rates and inflation had a marked impact, leading to a fall in volumes compared to 2021 according to Chris Adolph, director, customised portfolio solutions EMEA, Russell Investments.

“Just as we saw a bounce back in volumes in 2021 following the outbreak of Covid in 2020, so 2023 has already started strongly,” he says. “However, volatility will continue to have an impact. A poll we took of clients at the back end of 2022 highlighted volatility as their biggest overall concern in 2023 and we expect this to impact transitions in the form of wider mean estimates (especially in fixed income, where liquidity has been challenging at times) and wider ranges around those estimates, along with potentially longer time frames to complete events.”