Robert “Vince” Smith, chief investment officer (CIO), of the $24 billion New Mexico State Investment Council (NMSIC), a permanent endowment for the state of New Mexico and the third largest domestic sovereign wealth fund in the U.S., is all about planning ahead. In a roundtable discussion at MarketsGroup’s Southwest Forum in New Mexico, in September, Smith said “We think we’ve entered [the] late cycle [of the U.S. economy] and our biggest concern is raising and structuring liquidity ahead of the next recession.” IA’s Managing Editor Leslie Kramer caught up with Smith to find out more about NMSIC’s investment strategy with regard to an anticipated recession, how the CIO sees the next economic phase unfolding, and what he has been doing to prepare for it.
IA: What stage of the current economic cycle do you believe we are in?
Our analysis indicates that we’ve moved into the late stage of the business and investment cycle. At the broadest levels, the late cycle entails:
- Economic growth peaks and rolls over;
- Inflation picks up;
- Interest rates rise;
- Risk asset valuations generally are high; and
- Investment returns become more volatile and dispersed.
Recent U.S. economic and market activity have been consistent with that, and we should expect it to continue as a normal course. We think we’re fairly early into late cycle at present. However, late cycles can last awhile; this one has the potential to be on the more durable side.
IA: Given that, what is the NMSIC doing with the sovereign wealth fund’s portfolio in reaction to this late economic expansion?
Generally, we think there are three things to do as the late cycle shows itself: Diversify equity exposure; raise and structure liquidity; and refresh investment policy statements and other guidance.
In terms of diversifying our equity exposure, we are reducing our allocation to publicly traded equities and increasing exposure to investments that produce a preponderance of their total rate of return in income, i.e. real estate, real assets and credit.
To raise and structure liquidity, historically, traditional core bonds were used for liquidity and as a buffer against equity market volatility, but with interest rates at today’s low levels, core bonds have lost a significant degree of their traditional advantages.
Instead, many funds have been looking into other ways to structure liquidity, such as using very long duration Treasuries and crisis risk offset (CRO) strategies, which mix very long-duration Treasuries with trend‐following commodities strategies and “alternative risk premia” strategies. We’ve looked into those two strategies, but have settled on using good, old-fashioned cash and shorter duration Treasuries to pre-position expected liquidity needs.
The last market downturn (2008‐2009) caught many public funds by surprise, and they appeared to not have—or for other reasons, to not have deployed adequate liquidity to fully rebalance their risk assets.
We have a group investment staff who looked at the portfolio positioning of over 70 large public funds during the Great Financial Crisis (GFC). The stock market bottomed in March 2009, and according to these fund’s June 2009 CAFR reports, many funds were underweight relative to their targets or risk assets, so we surmised that people either ran out of liquidity, or they didn’t rebalance to their risk targets correctly when the major risk markets were about as cheap as they were going to get.
We drew the lesson that we need to raise and structure liquidity just as we were getting into the late cycle, so that when we do get a downturn we would have plenty of liquidity to be balanced back into our risk assets.
IA: How would you compare this economic cycle to the last one?
The last cycle ended in 2009, with only a six-month late cycle. From the time we were solidly in the mid-cycle until the recession it was only about six months. Normally, a late cycle lasts a while longer.
We think with this one there is potential that it will last long longer than normal. Fiscal stimulus coming into the economy has been a little weirdly timed. We normally don’t see tax cuts in the late cycle. We are running a budget deficit, and usually in the late cycle we are running a surplus. Also monetary stimulus hasn’t become restrictive yet, and we think the Fed is now catching up to normal policy interest rate increases, so we see it still as more normalization than tightening.
We still have some stimulus in the system, but we think it will go away pretty quickly, although it can come back quickly too, if the Fed determines things are turning over. We think the Fed feels pushed to get rates up so it can cut them in the next recession and have some impact.
Also, this time around, the pressures we normally start to see building in the economy, at this point, are rather muted right now. Inflation is relatively tame, for example. Overall, we think there is more potential that this could be a longer late cycle than normal.
IA: When do you expect the next recession to hit?
We wouldn’t look for a recession until 2020, and that could be at the back end of the year. But the stock market will sniff that out six month early and start rolling over. We could see some worse market environments than we have now in mid-2019 and early 2020.
One of our consultants is (St. Louis-based) Macroeconomic Advisers (an independent research firm, which was acquired by IHS Markit in Sept. 2017). Joel Prakken, chief U.S. economist at the firm, indicated to us that some recession modeling they’ve been doing says the same thing. The late cycle could last till 2020, and there is risk of a recession in 2020.
IA: How do you see the stock market reacting to the current cycle?
We still see growth in the economy, but the stock market has it priced in already, so we wouldn’t expect to see double digit stock market returns, but instead a weaker market, with returns 0% to 7%. You never know though, the market could take off tomorrow and could give us good returns, but there is a low likelihood that will happen.
I think we will continue to see volatility, but we still have a good economy. We tend not to get bad markets when corporate profits are still growing and other indicators are saying that the economy is still in decent shape. But one feature of the late cycle is that we normally get more volatility in stocks.
Obviously, we don’t know how bad the next recession will be, but we have modeled for a 35% downturn in stocks. That would make it an average bad one.
When did you start decreasing public equity in your portfolio?
We have been decreasing equity, since late 2014, early 2015. We did an asset study in 2014, and cut our target weights modestly, while the economy was still mid-cycle but valuations had risen to quite high levels. We worked our way into the lower targets during 2015 and 2016.
We raised the weight of our real estate, real return and private equity allocations. Essentially, we are lowering our allocation to stocks by selling to fund capital calls, as they come in from those three areas.
The 2016 election results surprised the markets, including us, and stocks repriced to correctly account for the potential impact of tax cuts, increased government spending (military, infrastructure) and deregulation. The stock market literally jumped 35%-40% from the election through last January, from already high valuation levels. We cut allocation targets to stocks again in the fall of 2017.
Since the end of 2017, stocks have done very little. This year’s returns are less than 1% or flat, which is classic late-cycle activity: volatility and lower return. Our target stock allocation is 40%; that may be as low as we go. We are now at 44%, so just under the public fund medium of 46% to 50%–not too far off pace, but below.
If stocks really ran from here up another 30% to 50% we might go back to the Council and suggest we take some more out of that allocation, but no one anticipates that.
IA: You mentioned increasing your allocation to other risk assets; can you talk about your weighting in those assets?
Since the end of 2014, we have been moving into other risk assets, which would include real estate, private equity, real assets and non-core fixed income; we include them all in our “other risk assets” allocation or portfolio. Generally, we moved away from public equity and into those areas, because we are focused on income-pricing assets at this point in the cycle. Real estate and non-core fixed income produces a lot of income; our real return portfolio produces a boatload of income, so we are really trying to get out of things that need the price to go up for us to make returns (stocks) and into things that generate income. That is the basic direction.
NMSIC PORTFOLIO ALLOCATION : 2014, 2016, 2018
IA: Can you talk about your overall portfolio strategy going forward?
As we mentioned earlier, we are in the process of raising and restructuring liquidity for this next downturn. We have looked at a number of ways to do it. The traditional way is to depend upon core bond allocations for liquidity, as interest rates always fall in economic downturns and bond portfolios gain value when rates fall. But interest rates are already so low, they’ll fall, but they won’t fall far. So the gains out of normal bond portfolios will not be that much, or can’t be; making the risk /reward of the traditional approach less attractive.
So, we have put that strategy aside and others seem to be doing the same thing and looked into other ways to raise and restructure liquidity.
The CROs, we described earlier did not appeal to us very much either. The long duration nature of the bonds in a rising interest-rate environment can really produce some bad returns. We were not very comfortable with the trend following strategies either. I’ve never invested in them.
We had a little experience with risk-premia strategies, but were not satisfied with those returns when we had it in 2011 through 2016.
So, we took the strategy of having low-duration fixed income, which is mainly cash, just old-school cash, ahead of the recession. We did a liquidity study about a year and quarter ago and came up with a figure of 10% cash that we needed to hold. During the early- to mid-cycle, we hold very little cash, because markets are usually rising swiftly and reliably and producing good returns. So, we will invest it (the cash) in risk assets during the next recession.
IA: Any advice for other investors looking to weather the current cycle?
I’d suggest that investors make sure that their fund’s investment policy statements and other guidance, particularly regarding rebalancing procedures, risk limits and lines of authority are in place. You don’t want to be making “Game Day” decisions regarding those things when the world is falling apart. We actually think that was part of the issue with some funds we reviewed in 2009. Game Day decisions don’t work.