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Investment outlook

With a large, global fund and a 70 percent allocation to equities, we have to be prepared for considerable fluctuations in the fund’s return and market value.

Risk management and volatility

The risk in the fund is largely driven by the share invested in equities and how much equity prices fluctuate. Movements in interest rates, credit risk premiums and exchange rates will also affect risk, as will changes in the value of investments in unlisted real estate and renewable energy infrastructure. As an investor, we need to have good systems for analysing and managing the risk in the fund.

Measuring the risk to which the fund is exposed is a difficult task. To obtain the broadest possible picture, we use a variety of analyses and calculations. We monitor the fund’s concentration risk, expected fluctuations in markets and fund value, factor exposures and liquidity risk. We also perform stress tests and hypothetical scenario analyses on the portfolio. Some investment strategies expose the fund to an increased risk of rare but large and to some extent unpredictable losses. We closely monitor exposure to strategies of this type.

Expected absolute volatility is a measure of how much the annual return on the fund’s investments can normally be expected to fluctuate. This is calculated using standard deviation based on a three-year price history. The fund’s expected absolute volatility was 10.3 percent at the end of 2023, or about 1,620 billion kroner. In other words, the value of the fund can be expected to fluctuate by more than 1,620 billion kroner in one out of three years.

Expected absolute volatility for the fund. Percent (left-hand axis) and billions of kroner (right-hand axis).

Expected return on the fund

The expected real return on the fund is an important consideration. Expected returns are not directly observable and hence need to be estimated. We outline our framework for estimating expected returns on the key asset classes the fund invests in in a discussion note published in 2022.

At the end of 2023, our models indicate that the expected real return on the fund is around 3 percent. The most recent estimates are considerably higher than the low point of around 2 percent reached at the end of 2021. The increase in the expected return on the fund has been driven by a large increase in real interest rates over the past few years. The increase reflects monetary policy tightening around the world in response to the post-pandemic rise in inflation. It marked the end of a near-decade of negative real interest rates.

Expected real returns on the fund's benchmark and key asset classes, in percent.

An increase in real interest rates without a corresponding increase in expected equity returns points to a decline in the equity risk premium, which is the compensation investors demand for taking on stock market risk. Developments in real interest rates and risk premiums are both important for the expected return on the fund. It should be noted that estimates of expected returns are uncertain and can vary considerably depending on the methodology.

Scenario analysis

Macroeconomic developments, financial conditions such as real interest rates and risk premiums, and geopolitical risk are all important drivers of the fund’s expected return. To analyse the risk associated with events that may occur, we use forward-looking scenario analyses. Such analyses look at the expected return on the fund in various scenarios and provide us with insight into what may lead to serious losses for the fund.

Each year, we publish the results of analyses of a number of hypothetical scenarios. These scenarios may change from year to year to reflect market developments and events that could impact economic performance. Aspects of our 2022 scenario analyses remain relevant, such as the consequences of a regional military conflict. The risk of this scenario is still present, but a lasting economic conflict could also lead to substantial losses for the fund. We have therefore included such a scenario in our latest report.

In 2023, we analysed three potential scenarios that could have a significant adverse impact on the fund's value over time:

Debt crisis

Persistently high real interest rates and debt trigger a deep and protracted recession. Public and private sector balance sheets are stretched. Interest rate sensitive sectors with relatively higher leverage are hit particularly hard, with a crisis in real estate being one of the features. The ensuing recession is protracted for both developed and emerging markets. High levels of public debt limit the ability of governments to combat the recession.

Divided world

Tensions between countries increase, resulting in a protracted policy-driven geoeconomic conflict that leads to decoupling. The decoupling has a negative and persistent impact on output growth. At the same time, the decoupling (e.g. re-shoring and near-shoring) leads to higher inflation. Trade and capital flows between the two economic blocks decline permanently. Due to the competition between the two blocks, there will be increased investments into strategic sectors.

Repricing of risk

Equity risk premiums are currently at historically low levels. A shallow recession triggers equity risk premiums to normalise to slightly above historical levels. The hit to equity cash flows is relatively transitory. Inflation does not go down all the way to central bank targets, leaving central banks having to manage a difficult trade-off between fighting inflation and stimulating growth.

We analysed how these scenarios might affect the fund’s value and calculated potential losses over a period of up to five years. The equity market is vulnerable in all these scenarios. The sharp rise in real interest rates over the past two years means that the risk of losses on fixed-income investments has fallen.

Estimated market value of the fund under each scenario and potential losses in percent.

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