Moving towards the monetary brink?
From the point of view of an institutional investor, 2015 looks like it’s going to be a tough year.
The green shoots of recovery seem to have been caught in the first frosts and our climate’s Indian summer doesn’t appear to be reflected in the markets.
Over the past month, we have seen corrections in equities and some significant volatility in developed markets. There were also some extraordinary swings in the US Treasury market, largely in response to the definitive end of quantitative easing.
It is understandable when markets react to shocks, but the end of QE has been on the cards for more than a year.
However, a lack of confidence is fuelling this volatility, and while inflation remains below targets set by many central banks this is likely to continue. The elephant in the room is asymmetric risk – where risk and reward are widely spread.
We have seen a multi-decade portfolio-rebalancing that has favoured debt over equity
Colm McDonagh, head of emerging market debt at Insight Investment, says central banks around the world are trying to adjust their policy mix, aligning it with government action to try to ensure inflation rises slightly above current targets.
“The fear really is that inflation drops even lower,” he says.
Helen Roberts, policy lead for investment at the National Association of Pension Funds, says although the tide is turning towards higher rates in the UK and the US, Europe remains “in the doldrums”.
“Higher interest rates resulting in higher bond yields should, over the longer term, be good news for pension scheme liabilities,” says Roberts, “but the problem is that interest rates are only expected to normalise over a number of years.”
Indeed, those concerned that low interest rates indicate an end to growth may be reading too much into the situation.
Christopher Jeffery, asset allocation strategist at Legal & General Investment Management, says structural forces weighing on real interest rates are largely independent of the growth outlook.
Rather than a portent of doom for cyclical decline, it signals a global rebalancing in the cost of capital, meaning the rate of future growth is the same.
“There has been no drop in the yield on global equities corresponding to the decline in terminal interest rates.” says Jeffery. “That strongly suggests we have seen a multi-decade portfolio-rebalancing that has favoured debt over equity.
“Looking ahead, the differential in real yields implies that the prospective real returns on equity are substantially higher than the prospective real returns on government debt.”
In the meantime, pension funds continue to derisk as they hunt for yield.
“We have seen increased interest in commercial property, social housing and infrastructure − assets that have long-term stable cash flows but yield more than government bonds,” says Roberts.
Ian Eggleden, a scheme manager at PS Independent Trustees, believes trustees are “a robust bunch on the whole and don’t panic easily”, so are unlikely to behave irrationally.
Protective measures such as hedging, liability-driven investment or strategy changes are available, but “it always seems to be the wrong time to do it”, he says, with LDI tending to lock in high deficits.
“The best thing to do is plan how you will deal with circumstances. There will be opportunities to hedge and you can do it gradually,” says Eggleden.
“There is no overnight solution,” he adds. “It’s hard, but it’s not all doom and gloom.”
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