One key reason for a majority of institutional investors finding themselves in good standing at the end of 2021 is the swift action taken by policy makers to respond to the pandemic in 2020. Looking at the potential for the unprecedented public health crisis to escalate into a global financial crisis, central banks leveraged two critical policy tools: lower interest rates and quantitative easing.

In the short term, not only did the coordinated monetary and fiscal measures help to avert a crisis, they also fueled rapid economic growth. And along with growth came the first inflation in more than a decade. Almost two years in, institutional investors recognize the challenges these policy decisions present, and they rank inflation (69%), interest rates (64%) and valuations (45%) as their top portfolio risks.

Inflation mostly seen as transitory
While inflation is the top portfolio concern, six out of ten institutions believe it is transitory. They are more likely to say inflation is structural (55%), thanks to a combination of loose monetary policy and low interest rates, rather than cyclical (45%). Some may see inflation as a downside to relaxed monetary policy, but nobody is eager to see a change in course. In fact, 68% predict the bull market will end when central banks stop printing money.

Not all believe inflation is a short-term phenomenon. More than one-third (37%) worry that massive stimulus efforts could result in unchecked inflation. Over the long term, more worry that stimulus will result in tax hikes (58%) and increased risk of a future crisis (49%). While stagflation (31%) and future cuts to social safety nets (23%) are additional concerns, one-third of institutions also find that inflation presents an upside of expanded investment opportunity.

Interest rates challenge investment strategy
Inflation poses a number of long-range economic issues, but interest rate policy presents institutional teams with more immediate investment challenges. Low rates are nothing new. Institutions have been living with them for more than a decade. During the pandemic, however, rates went even lower, and in many cases sank into negative territory.

As a result, about one-third of those surveyed have had to bite the bullet and invest in securities with negative yields, including 37% of insurers who need bonds to meet future cash flow needs and risk requirements. But with time the trend may be moderating as only one-quarter of those surveyed anticipate substantial increases in the volume of negative yield securities, which is down dramatically from 53% in our 2021 outlook survey.

Beyond investing in negative yield securities, institutions have had to look further afield for bond replacements, including the 68% who report they’ve turned to alternatives. As a result of the hunt, 69% of those surveyed caution that institutions have taken on too much risk in pursuit of yield.

Given the likelihood of rate hikes in 2022 and 2023, seven in ten say their institution is looking to short-term bonds and ETFs to counter duration risk in their fixed income portfolio.

High valuations and high expectations
The effects of low rates – along with high levels of liquidity – are felt well beyond the bond market. In fact, eight out of ten institutions say low rates have distorted valuations. Another seven in ten (71%) say current valuations do not reflect the fundamentals, and the same number believe the current pace of growth is unsustainable. The effect has been so strong that one-fifth of those surveyed go so far as to throw up their arms and say valuations no longer matter.

Eight out of ten institutions say low rates have distorted valuations

A freewheeling environment coupled with easier access to trading tools has led retail investors to pile into stocks. As a result, eight out of ten (78%) are worried that retail investors have been more careless in speculating on high risk assets. That concern may be well founded as individual investors now say they expect investment returns of 14.5% above inflation over the long term,² a figure 174% greater than the 5.3% financial professionals say is realistic.³

As an example of the risk concerns, six out of ten institutions (62%) believe the meme stock phenomena will create financial bubbles. And overall, 64% worry that easier access to trading is ultimately a threat to the retirement and financial security of individual investors.

Crypto tops correction concerns
Given all the factors at play, institutions see the potential for corrections in a range of asset classes and sectors. Hugely popular cryptocurrency tops the list with more than half of institutions calling for a correction. This is followed by interest-rate-sensitive bonds (45%), stocks (41%) and technology (39%).

But even as crypto is the top contender for correction, institutions are beginning to warm to digital currency. Four in ten consider crypto to be a legitimate investment option, and of the 28% who invest in crypto, 90% say they will maintain (62%) or increase (28%) their allocation.

To attain broader acceptance, it’s thought they will need additional scrutiny, and nine out of ten predict that central banks will have to regulate cryptocurrencies. Few see the potential for crypto to replace reserve currencies (25%) or fiat currencies (28%). However, one-third believe crypto has the potential to level the playing field for developing nations. Just 29% think that emerging market countries should consider crypto as legal tender. Three-quarters worry that the lack of transparency will encourage more cybercrimes – another reason for more regulation.

Too soon for a tech break-up
While two in five (39%) institutions predict a correction for the tech sector, few are worried that regulation will slow the sector. While tech giants have recently come in the sights of policy makers, most institutions (63%) believe it’s more likely that tech will continue to grow unabated than to be broken up (37%).

With vaccination rates increasing globally and the public health picture looking more stable than a year ago, institutional investors see a light at the end of the tunnel. Where only 22% projected the global economy would fully recover from Covid in 2021, 45% see it happening in 2022. Conversely, eight in ten (78%) thought the global economy would not escape the consequences of Covid in 2021; the number drops to just over half (55%) for 2022.

Even if they are optimistic about the economic prospects, few think the return to pre-Covid GDP levels will happen overnight, as only 17% think they’ll see it in the first half of the new year. Most see a return to normal levels either in the second half of 2022 (31%) or sometime in 2023 (37%). The smallest number (14%) share a more conservative estimate of 2024.

With growth moving in the right direction, institutions are keenly aware of the economic risks. Perhaps there is no more vivid image of their top concern than the armada of freighters anchored off the Port of Los Angeles simply waiting for a chance to unload.

More than half (56%) say supply chain disruptions pose the greatest risk to recovery. 84% think a major supply chain disruptions will hinder economic growth. As noted, central banks play an outsized role in market performance for institutions and 47% see less supportive policy as a risk. While Covid appears to have taken a back seat to more traditional economic factors, new variants, like the newly discovered Omicron variant, still rank number three on their list of economic risks.

In surveying the economy, institutional investors will look to three key factors as drivers of the growth needed to get back to normal: productivity (58%), improved consumer spending (57%) and improved business spending (52%).

Beyond the confidence in consumers growing the economy, institutions are less likely to say factors such as higher inflation (27%), rising interest rates (21%) and the public health status (17%) will spur economic growth. And as a clear reminder that the stock market is not the economy, only 13% say they’ll look to market performance as a growth driver.

While there is much at play in the markets and the economy, institutional investors have clear views on how the story of 2022 will unfold.

Global economy fully recovers from Covid-19

Global economy cannot escape consequences of Covid-19

Covid-19 variants disrupt the return to normal

Life reverts to pre-pandemic normal

Reopening trade outperforms

Stay-at-home trade outperforms

Big tech is broken up

Big tech continues to grow unabated

Large caps outperform

Small caps outperform

Value stocks outperform

Growth stocks outperform

Developed markets outperform

Emerging markets outperform

ESG outperforms

ESG underperforms

Aggressive portfolios outperform

Defensive portfolios outperform

Active investments outperform

Passive investments outperform

Betting on the reopening trade
While almost 60% say they believe that life will return to pre-Covid normal after the pandemic, a significant number (42%) believe that Covid variants will continue to disrupt the return to normal. In terms of trading, institutions are less focused on streaming and more focused on in-person experiences.

For 2022, 64% of institutions anticipate that the reopening trade such as restaurants, theaters, and travel will outperform a stay-at-home trade (36%) focused on Netflix, online shopping and other touchstones of quarantine life.

With interest rates so low for so long, institutions can draw from a decade of experience that has made them resourceful in pursuit of yield. Add to it the extraordinary circumstances created by the pandemic, such as inflation and negative rates, and they have had to double down on what they’ve learned. Investing in private assets appears a lesson that’s stuck.

Private investment continues to grow
Prior to the pandemic, investment in private assets had been growing among institutions. In 2018 just over three-quarters of institutions invested in private equity (77%), private debt (77%) and infrastructure (76%). In 2021 those numbers have increased to 84%, 81% and 81% respectively. Those who are already invested are not likely to dial back their exposure in the next year, as 91% say they will maintain or increase their investments in both private equity and private debt and 97% say the same for infrastructure investments.

Looking across private market sectors, institutional investors call for the best opportunities to include information technology (45%), healthcare (41%) and infrastructure (40%). Unique to the private markets is the infrastructure sector, which will be getting a boost of confidence from the recent infrastructure bill in the US and other key projects globally.

With so many institutions looking to invest, three-quarters of those surveyed said they expect more private debt will be issued in the coming year. The returns are attractive now as even public markets continue to ascend into record territory, but less than half of those surveyed (45%) believe private assets will offer a safe haven in the event of a market correction.

One key reason for the continued focus on private assets is the eight out of ten (78%) institutional investors who say that there is still a significant delta between private assets and public markets. Even still, many worry about what it costs to obtain those returns, as 69% believe current fee terms are generally too high in relation to expected returns.

Real estate
Lingering concerns about the effects of remote work on the real estate sector may have some concerned about the viability of commercial real estate and a white-hot housing market may spur concerns about residential, but there are three clear reasons that 85% of institutions expect to maintain (52%) or increase (33%) their investment in the sector.

First, most anticipate a broad return to office for most workers as only 2% of respondents think work-from-home will be adopted on a permanent basis. More than three-quarters believe businesses will come back to a hybrid model of 2–3 days per week in the office. More importantly, real estate may help address their top two portfolio risks for 2022: Real estate has traditionally provided an income that’s not tied to interest rates, and real estate has historically provided a hedge against inflation.

So even though 29% say there is a chance the sector could experience a correction in 2022, it’s a chance they’re willing to take.

As institutional investors go farther afield for diversification, returns, and opportunity, a growing number are venturing into ESG investing. While the largest number (49%) say the shift is part of an effort to align assets with organizational values, the past two years have delivered a clear performance argument for ESG as well.

In fact, two-thirds (66%) of institutional investors believe there is alpha to be found in ESG, a belief that has grown stronger with proof as annualized returns for the S&P ESG Index outperformed the S&P 500 1.53% for the one-year period ending October 29, 2021 and 2.06% since its inception on January 28, 2019.¹ Along the way, the share of institutions finding alpha potential has grown from 54% in 2019, to 62% in 2020, to the current level of 66%. After seeing these results, half of institutional investors surveyed believe companies with better ESG practices generate better returns.

Beyond the performance advantage, institutional investors see the value ESG adds to their investment analysis. Three-quarters of institutional investors believe ESG is integral to sound investing. This level of conviction is evident in terms of how strategy is implemented. Two-thirds of institutions say they integrate non-financial ESG factors alongside traditional financial factors in their investment analysis. At the same time, the number reporting that they practice exclusionary screens – a practice more in line with old-school socially responsible investing – has declined from 55% in 2020 to 45% today.

In addition to enhancing their investment process, institutional investors are exploring the potential for ESG strategies to open up investment opportunities. Impact investing is one area for potential growth. Four in ten (42%) say they currently deploy impact strategies, and more than half (54%) say they are increasingly pursuing impact investments. Another 37% are turning to thematic strategies in their approach to ESG, and two-thirds (68%) say they are pursuing opportunities in new energy such as solar and wind projects.

Looking at institutional sentiment in 2022, it seems that reports of the death of active management are greatly exaggerated. In fact, as asset owners look at prospects for the next year, 75% project equity volatility will be on the rise, 63% see the same for bond markets, and 48% anticipate that dispersion will increase. As a result, 70% of those surveyed believe markets will favor active management in 2022.

While seven in ten of those surveyed say their active investments outperformed the benchmarks over the past 12 months, the approach is firmly entrenched in portfolio strategy. Currently allocations stand at 71% active and 29% passive. Little is expected to change in the next three years, as they project a 70/30 allocation that favors active. This forecast reflects institutional sentiment over the past five years.

The rationale for active is clear in the eyes of institutional investors, as 70% say they will invest in active funds to achieve better risk-adjusted returns. Half also report that active provides better all-around risk management, and another 40% say active helps them to better adjust to changing market trends and short-term market movements.

On the passive side of the equation, institutional investors see the large flows into index funds and ETFs and caution against overreliance on these vehicles: Two-thirds say large flows in and out of passive investments exacerbate volatility. Six in ten (57%) say the popularity of passive has increased systemic risk.

Another six out of ten (58%) among institutional investors say the growing use of passive shows the market is ignoring the fundamentals. Half go so far as to say passive distorts risk/return tradeoffs.

Institutions have spent the past 18 months navigating a historic market environment that’s been marked by first-of-its-kind events, all-time highs and all-time lows, not to mention the worst public health crisis in a century. Now, looking at a world that feels a little bit closer to normal, they see potential in the year ahead and express confidence in their ability to handle whatever comes their way. It seems as though the collective sentiment confidently says, “Bring it on.” (As long as it isn’t an end to quantitative easing, an interest rate hike, a prolonged bout of inflation that becomes cyclical, rather than structural, or a meltdown in the tech sector.)

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