Monthly Commentary April 2018
Information rich, attention poor
April has on the face of it been a good month for pension schemes; liability values fell with rising gilt yields and equities returned positively on the back of abating fears of a global trade war and better than expected earnings data (and a remarkable geopolitical shift on the Korean peninsula). But this month I thought rather than a look back, it would instead be worthwhile exploring whether this (simple) approach still has merit. The old way of looking at funding – gilt yields vs equities – is no longer quite so clear cut. In an time of unprecedented data and news availability, and perhaps of alternative facts, “the signal is the truth. The noise is what distracts us from the truth.” [Silver]
When trustees are looking at news, economic data or market events, what is signal and what is noise?
The average level of liability hedge in place for UK pension schemes is now dramatically higher than historically – estimated to be in the region of 75% of funded liabilities from as low as 25% a little over a decade ago, and expected to continue to rise for the next 3-4yrs. At the same time, allocations to equities have dropped from >70% to less than 30%. Assuming our readers’ schemes are slightly ahead of the average path of pension funds, they have already taken significant steps to reduce interest rate, inflation and equities risks – which have historically dominated the risk profile of pension funding. A natural by-product of these is also to have reduced currency exposure (and this is likely to have been explicitly hedged also). These are well trodden ground and are being managed well.
So pension scheme funding levels are only a fraction exposed to gilt yields and similarly only a fraction exposed to equities compared to historical levels. On an “exposure” basis, pension schemes’ funding levels are today only around 25% exposed to gilt yields and 25% exposed to equity prices (whereas historically the combination of these would have explained >80% of funding level changes). Where is the rest? A further 25% is exposed to various forms of fixed income spreads – from investment grade UK credit predominantly, to overseas developed and emerging market bonds, and high yield bonds. The rest is broadly exposed to “alternative” premia, ranging from the likes of real estate and commodities, to hedge funds and private equity (and an ever more narrowly split array of niches in between). How then should trustees consider April, and 2018 year-to-date? On the simple approach, funding would be expected to be slightly better on the back of yields rising by more than equities have fallen; considering the slightly more detailed approach, funding has deteriorated for the average scheme – rising yields have been largely hedged away, credit markets and alternatives (in the broadest sense) have had a moderately negative start of the year.
“So what should trustees be looking at going forwards? ”Nikesh Patel, Head of Investment strategy
So what should trustees be looking at going forwards? The investment risks needing attention now are credit spreads, reliance upon (and realization of) alpha potential (if any), and the success of alternative asset classes in generating absolute returns. And we should not forget covenant, longevity and cashflow/liquidity management. When sorting signal from noise, and assessing whether your strategic, dynamic and/or tactical strategies are successful, the news and data that matters to trustees needs to have relevance to these areas too – a truly holistic and integrated approach.
In such a framework, Brexit (as an example) could be considered far less of an equity investment risk and rather more of a covenant risk; quantitative tightening in the US may not necessarily hurt equity prices (although of course, another taper tantrum could occur), but could materially impact public and private credit conditions more significantly; rising underlying equity market volatility may not be all bad if it creates an environment which lends well to your alpha strategies, and rising rates may not solve the (UK) pensions problem after all.
So the next time you read or listen to a market commentary, economic background or review of markets, ask yourself whether it is interesting, relevant and useful, bearing in mind the (net) risks which actually matter to your scheme.
Two out of three just isn’t enough [with ‘being interesting’ an inherent pre-requisite to being read at all]. I might be shooting myself in the foot a bit... but upcoming GDPR implementation means the readership is about to plummet anyway!
Rate rises put on hold againMark Carney, the unreliable boyfriend has, once again, proven himself to be the ultimate commitment-phobe. Like a serial jilter the MPC now seems to have backed out of a rate rise just at the organist was warming up ‘here comes the bride.’
Prior to Mr Carney’s intervention on Thursday 18th the market was pricing an 80% chance of a policy rate rise at the May MPC meeting. This had followed well telegraphed signals in the February Inflation Report that rates would need to rise. Subsequent speeches by MPC members continued to lead the market to expect policy rates to rise sooner rather than later. Labour market statistics released in April , which have been a key variable in setting policy expectations, were particularly strong showing unemployment had dropped to historical lows and real wages were starting to rise.
Whilst Mr Carney has earned, not unjustifiably, a reputation for flip flopping, he is also Governor of the Bank of England and does know a thing or two about economics. As it turns out Mr Carney’s intervention came a few days before the Q1 GDP data was released showing that the economy grew by only 0.1%; the lowest increase in output since Q4 2012
Once again therefore it seems that the prospect of higher interest rates have been dashed. Market participants have now pushed back the timing of a rise to the end of 2018 (though it should be noted that as at 30-April there remains a 20% probability that the MPC will increase the policy rate to 0.75% in May.) This has been a near permanent theme since the financial crisis as market participants, central bankers and commentators have continuously over-estimated the pace of policy rate increases (see chart). The current situation whereby short-term rates are higher than they were predicted to be is an outlier.
“There are a number of useful lessons we can learn from this sudden change. ”Robert Scamell, Senior Portfolio Manager
There are a number of useful lessons we can learn from this sudden change. Firstly markets are inherently uncertain so don’t get carried away; treat claims of something being certain with a healthy degree of skepticism. An 80% probability of a certain event occurring seems very high, however it still leaves a significant amount of room for the alternative scenario to occur. History has taught us that markets are poor at predicting the future and do not assign enough probability to unusual or unexpected events.
Secondly it is useful to be aware of the risks around a forecast. For example, 50% of people surveyed may think interest rates will increase by 0.5% whilst 50% believe they will remain unchanged. The survey will say that the expected change in rates is 0.25% despite the fact that nobody believes this will be the actual outcome.
Thirdly pension funds have been consistently disappointed by the path of interest rates since the financial crisis. Waiting for yields to rise before increasing hedging has proved to be a losing strategy. It is perfectly acceptable to believe that yields will rise faster than the market is anticipating but this position needs to be scaled appropriately. Unhedged interest rate risk should rarely be the dominant risk for schemes.
We continue to believe that yields, particularly longer term yields to which pension schemes are most exposed, will continue to rise faster than market participants currently expect. We also acknowledge that this prediction is subject to uncertainty and hence any position based on this belief is carefully scaled to take account of these risks!
EXPECTED VERSUS OUTTURN INTEREST RATE SOURCE: BLOOMBERG.