Investing for Not For Profit’s in a higher interest rate environment

“Toto, I’ve a feeling we’re not in Kansas anymore”

Before diving into 2023, it’s important to acknowledge that the market has shifted exponentially over the last few years. Inflation, higher interest rates, and the risk of recession were the key drivers for markets throughout 2022.

Inflationary pressures had begun to build in late-2021, driven largely by Covid-linked supply-side constraints, however, concerns that inflation might be more persistent than originally expected had developed in early 2022. The risks of persistently higher inflation pushed most equity markets materially lower in the first half of 2022, along with the majority of other asset cases. Bond performance was also weaker, with bond prices falling amid expectations of higher interest rates from Central Banks that would be focussed on quelling rising inflation.

The Chinese economy remained under Covid related restrictions for most of 2022, as a ‘Zero-Covid’ policy meant that any outbreak was dealt with by enforcing strict lockdowns that had a significant impact on economic activity and contributed to supply chain issues impacting the global economy. The ultimate reopening of the Chinese economy in late 2022 has seen markets respond strongly, anticipating stronger Chinese economic activity over the course of 2023.

Geopolitical tensions in Europe were also a key focal point in 2022. Following the invasion of Ukraine, a host of sanctions were imposed on Russia by Western nations. As a significant exporter of energy and other industrial and agricultural commodities, these sanctions had an immediate effect on the cost for energy and a range of producer and consumer prices. Of further concern to markets was how the impact of the war in Ukraine would add to greater geopolitical instability moving forward.

So where does this land us?

Whilst annual inflation prints around the globe moved close to 10% in late 2022, more recently through a softening in demand (via higher interest rates), lower commodity prices and easing global supply chains, inflation rates have begun to moderate slightly.

This outcome will be viewed as the first small sign of success from central banks as they try to restrict economic growth sufficiently and reduce demand to a level where inflationary pressures begin to subside. Their focus will also be on labour markets which remain historically tight. This can have the impact of elevated wage growth which, if it becomes “sticky”, risks inflation becoming entrenched, forcing central banks to curb labour demand by producing a period of economic recession through higher interest rates.

Ultimately, this means there is now only a narrow path for central banks to engineer a “soft landing”, with the risks of recession across many economies increasing and the range of economic and market scenarios over the medium term becoming particularly wide. Markets have begun to expect that Europe and the UK will enter a recession during 2023, and believe it is increasingly likely the United States will enter recession as well.

What NFP’s and charitable organisations should consider for their investments in 2023?

A combination of persistent inflationary pressures and the aggressive tightening of rates by central banks have had a significant impact on the economic outlook and has produced a wide range of potential outcomes over the medium term.

For many investors the best approach is to maintain a well diversified portfolio that provides flexibility to respond to a range of outcomes and potential opportunities. A key component of this flexibility would be to ensure a strategic buffer of liquidity is developed given the potential for higher market volatility in 2023. Having the flexibility to take advantages of opportunities during periods of heightened volatility is an area of potential competitive advantage for medium to long term focused investors.

There are however some specific issues that many NFPs may be considering for their respective cash holdings and investment corpuses (long-term investments) including:

1. Reducing Performance Objectives
2. Actual spending rates moving above long-term spending rates and;
3. Determining optimal strategic cash allocation

NFPs with an investment corpus typically have a return objective of a margin above that of inflation (eg: inflation + x% over 10 years). With the surge of inflation in 2022 and the potential for it to remain elevated, meeting inflation-based performance objectives may be challenging over the short-medium term (1-3 years). There is the consideration therefore to reduce performance objectives to what would be perceived as a more appropriate hurdle rate for now. We would highlight that the achievement of inflation-linked objectives has been an issue for some time for many investors, however, was previously more in response to low bond and cash yields in the inflation-subdued years leading up to 2020. The current environment presents a different challenge – cash and bond yields may have increased, but these increases have been outstripped by surging short-term inflation.

Many corpus investors do have long-term investment horizons and potentially have the ability to absorb the short-term underperformance caused by elevated inflation. It’s important to note that inflation is a backward-looking economic statistic and as it slowly moderates, return objectives will fall. Ultimately, what’s important to investors is the expectation of future inflation and the ability of their portfolios to meet inflation-linked return objectives.

Should NFPs have concerns about meeting investment return objectives, the best approach would be to undertake a full review of current investment objectives and the strategic asset allocation, potentially stress testing for above-average inflation, to ensure they remain aligned with your purpose. Alignment to purpose is key – reducing a performance objective may look acceptable in the short term, however, there may be long-term flow on effects that impact your ability to meet your purpose.

Recessionary environments are typically times when the resources of many NFPs are called on the most. This can place an additional strain on financial resources and when combined with the current inflationary environment, short-term actual rates of expenditure may move above desired long-term spending rates. This can sometimes occur in high inflationary environments as many “hybrid”* spending rules have a component in their annual spending calculation that is linked to inflation. This may be quite a new experience for many organisations as prior to 2021, spending levels grew consistently in real terms in response to low inflation and strong capital market returns.

A common approach to deal with the issue of short-term higher spending is to set an upper and lower band around the desired long-term spending rate that ensures actual spending does not rise too high (or too low)**. Whilst “banding” will assist in curtailing overspending in the current times, it is important to remember the objectives of spending rules; they typically aim to maintain long-term purchasing power whilst simultaneously maintaining/growing impact for beneficiaries today. Increasing spending in response to higher short-term inflation as part of a disciplined spending rule is still deemed prudent as ensures current expenditure is maintaining purchasing power. It continues to be important for many NFPs to continue to invest in their organisational capacity despite the economic circumstances. Further, a long-term approach can also be taken to spending as inflation levels could potentially moderate, and higher spending levels caused by inflation may well be a temporary issue that can be absorbed.

Finally, the importance of cash holdings can never be underestimated. With the wide range of potential economic outcomes, 2023 has the potential to have higher-than-average levels of volatility. In the current environment, a prudent approach would be to understand your cash flow requirements over the next three years and understand the optimal level of strategic cash. The rapid tightening in monetary policy in 2022 has seen cash and term deposit rates hit 10-year highs, implying the opportunity cost of holding cash over other higher-yielding assets has reduced. Where possible, NFPs should look to rebuild cash levels to their strategic requirement as well as monitor cash and term deposit rate movements, aligning their cash portfolios to their requirements.

*Hybrid spending rules have two components added together. The first applies a weighting to the previous years’ spending adjusted for inflation. The second applies the target long term spending rate to the remainder of the weighting, applied to the market value of the fund. Most common Hybrid rules are “Yale” and “Stanford”rules.

**In practical terms, with a desired long term spending rate of 4%, the lower band for actual spending could be 3% and the upper band 5%.