Now that we’re in the midst of 2020, it might be easy for investors to forget how big a turnaround 2019 actually was for financial markets. One way to look at it is through the Aon Median Solvency Ratio, a quarterly survey that gauges the financial health of an important slice of the institutional investor community, Canadian defined benefit pension plans.

The ratio draws on a large database of plans to compare total assets to total pension liabilities on a solvency basis, while taking into account different legislative requirements across the country. And last year, the change in the median solvency ratio was remarkable – to put it mildly. It began 2019 at a low point – 95.3 per cent – suggesting that the median DB pension was less than fully funded. By the end of year, however, the ratio hit 102.3 per cent – a gain of seven percentage points that suggested the median DB pension plan was now in a surplus position.

That illustrates what investors already know: 2019 turned out to be a very good year in financial markets. The question now is whether markets – and, by extension, pension plan solvency – can stage a repeat performance in 2020. We have our doubts.

First, let’s take a closer look at the numbers. By Q4 2018, investor sentiment had soured, with what looked like good reason. The U.S. Federal Reserve had been raising rates; worries over slowing global economic growth were growing; trade tensions were heightening. By the end of the year, negative returns for major equity indexes, including the S&P/TSX composite (-8.9 per cent), MSCI World developed country (-0.6 per cent) and MSCI Emerging Markets (-6.9 per cent) indexes, were the norm. The S&P 500 (+4.1 per cent) provided one of the few, though hardly encouraging, exceptions.

But then, in 2019, sentiment turned. Central banks, led by the Fed, signalled that they were done raising rates (the Fed began cutting them in July), while trade tensions began to ease. Investors put their concerns over slowing growth on the backburner, and markets took off. Returns from the S&P/TSX, the S&P 500 and other developed country indices ended the year up over 20 per cent, in Canadian dollar terms; the MSCI Emerging Markets Index gained double digits.

That equity rally coincided with resurgent fixed income markets as bond yields fell: the FTSE Canada Long Term Bond Index gained 12.7 per cent, while the FTSE Canada Universe Bond Index of all-maturity bonds gained 6.9 per cent.

Those strong returns had positive implications for pension plan investment portfolios. Yet the fixed income rally had one downside for pension solvency: as bond prices rose, yields fell. The Government of Canada 10+ year bond yield declined by 37 basis points through the year. That yield, importantly, serves as the base rate for annuity purchase rates; when those go down, it puts upward pressure on defined-benefit pension plans’ liabilities, which correspondingly puts downward pressure on median solvency. Stellar asset returns last year helped pensions weather the impact of lower yields, but so did a technical change from the Canadian Institute of Actuaries, which published annuity purchase guidance that increased the spread over the base rate by 20 bps – effectively upping annuity purchase proxy rates. That provided a partial (one-time) offset against the effect of declining bond yields on the Median Solvency Ratio.

So what do we see from 2020? In short, we believe that this year is likely to be more challenging. Global markets are in a transition phase of higher uncertainty, in which the going looks likely to be harder for investors. Central to this gloomier outlook is the way we see the global economy shaping up this year and beyond – as well as monetary policymakers’ capacity to respond effectively.

It’s true that the headlines on trade, including a partial truce in the Sino-American conflict, have been encouraging so far this year. Yet trade tensions remain – and they remain at risk of growing. As well, global growth is still a concern, as much as some investors might want to wish it away. According to the International Monetary Fund, growth for 2019 is likely to come in at 2.9 per cent – the lowest mark since 2008-2009. The IMF sees an uptick in 2020, to 3.3 per cent, but that represents a downward revision to previous estimates.

Last year, as the risks from an escalation in the U.S-China trade conflict rose, we saw central banks go on a rate-cutting spree to stave off a sharp global downturn. In this way, they extended the already-long expansion phase of the business cycle. But would cuts be effective again? Going forward, we should be a bit wary of the argument that lower interest rates will produce much faster growth, for two reasons. First, interest rates are so low to start with that cuts might have less impact than if they were coming from higher levels. Second, there is the difficulty that in trying to extend what has already been the longest U.S. expansion in the last 150 years, it matters that the economy might not have much capacity left to grow without stress.

Equity markets barrelled through slowing economic growth (and lower corporate earnings growth) in 2019. In 2020, elevated valuations might significantly constrain the upside for risk assets. That will be especially so if underlying pressures on corporate profitability, which we began to see in 2019, continue this year. Pension plan solvency, in particular, could face the risk of a double-whammy. Lower yields from (ineffective) monetary easing could raise liabilities, while risk-asset returns might fail to provide a counterbalance if they fall victim to slowing economic growth.

Our view is that money can still be made this year, but we find it quite difficult to argue that 2019’s rebound can carry on unchecked. The further we look out, the harder it is to see anything other than seriously impaired return potential for markets in 2020.

Erwan Pirou is Canada CIO for Aon.

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