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UK Economic Outlook

12 September 2019
Both long dated nominal and real yields fell to new all-time lows with 30-year index-linked ending the month down 0.18% to -2.17% and 30-year nominal yields falling 0.3% to 1.01%. These significant moves were not unique to the UK with yields in Europe and the US also falling. In order to find the cause of such falls we therefore need to look beyond the normal analyst refrain of “Brexit!” 

There have been hints, rumours and threats of a global slowdown for some time but those fears seem to have crystallised in early August. The main catalyst for this was the escalation of the trade war between the US and China with President Trump announcing a further increase in tariffs and then subsequently labelling China a currency manipulator. The designation carries relatively little practical impact given the current presence on the list of Germany, Italy and Ireland, but adding China was certainly not a de-escalation. 

The trade war is not just impacting the US and China; the German economy has been slowing significantly and is on the verge of recession with Q2 GDP negative and survey data from manufacturing firms in August showing companies at their most pessimistic, since the aftermath of the euro sovereign debt crisis in 2012. This has the potential to create a problem on both sides of the pension fund balance sheet i.e. with both assets and liabilities. Firstly a German economy on the brink of recession, combined with global growth fears is not a natural market environment in which investors would be piling into equities or other risky assets. Given most schemes need to close a deficit there is still a need for these asset classes. Secondly the above manufacturing data is one factor that has led to all German government having a negative yield, whereby the Government actually gets paid to borrow money. For pension funds very low, even negative yields, present a unique problem. Is there anything that can be done to alleviate this double threat? 

On the asset side of the equation for many pensions schemes looking to deploy capital an alternative has long-been, well, alternatives. A broad ranging category covering hedge funds, private equity, property and so on. Many of these assets are, in our opinion, very worthy of consideration. However a word of caution, pension schemes are not alone in thinking these assets might be a good idea; in fact there is almost $1.5tn of “dry powder” waiting to deploy in private equity. In context, this represents about 10% of the size of the US Treasury market and a far larger percent of the private equity market. It is therefore vital that investors are sure that money, once committed, is going to be deployed and that they do not overpay for the privilege. These are both areas that we have experience in and can help with.

On the liability side of the equation one area that Kempen have been exploring recently, is to break the link between liability valuations and gilt yields; instead focusing on other ways to derive a discount rate. This may sound heretical, and coming from an LDI manager may smack of turkeys voting for Christmas, but in certain circumstances it can add value and be prudent. To be clear, there will still be a need to purchase gilts and hedge against inflation but the hedging requirements can be reduced meaningfully. Under the approach the discount rate used to value liabilities becomes linked to the assets in the fund rather than gilt yields. In addition it may also be possible to use higher yielding assets as part of the hedge rather than gilts thereby reducing the overall cost of hedging. 

The technicalities of how this can work are beyond the scope of a simple market comment piece but in a month where yields fell to new lows, we thought it was important to highlight an area of research that may provide a ray of sunshine for those coming back from holiday to a dreary September and historically low gilt yields.
 

The author

Robert Scammell

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