Politicians have failed to give pension funds the certainty they need in their preparations for Brexit, and trustees must now attempt to insulate their portfolios against a number of threats, writes Kames Capital's Stephen Jones
Unfortunately, with no clarity over the manner of the UK's departure from the EU, our politicians have failed us. Accordingly, this becomes an exercise in adverse-scenario planning.
Brexit is not like sterling’s ejection from the European exchange rate mechanism; the ramifications are likely to prove far-reaching and severe economic disruption is a clear possibility.
Key points
Ensure your asset governance is up to a quick assessment of events as they develop, being careful not to react to ‘noise’.
Try to maximise secure real asset exposure at reasonable cost – not going to be easy.
Consider scope to internationalise the asset mix – accepting that if, by some miracle, parliament approves a compromise deal, then sterling has the potential to rise significantly.
It is a feature of the human spirit to dismiss worst-case scenarios as unlikely – or as something that will happen to someone else. Those tempted into denial would do well to remember that Syria welcomed 8.5m tourists in 2010. Argentina and Turkey didn’t go looking for surging inflation, a currency slump and collapsing demand either, but they got these nonetheless.
What could happen?
The nightmare scenario for a UK pension fund sees weak asset returns and domestic stagflation – a structural uplift in UK inflation and weak domestic economic activity, which raise the quantum of potential scheme liabilities and take the discount rate lower.
In part, this is already taking shape. Measures of longer-term expected UK inflation are rising even as actual prices are falling, gilt yields are returning to historic lows and, as I write, global asset markets are experiencing upheaval unrivalled at this time of year other than during the Great Depression, the second world war, the 1987 stock market crash and the global financial crisis of 2007-08 – bad company to keep.
The implication is sadly predictable: the already high cost of hedging a severe Brexit outcome is rising.
Whichever way you look at things, Brexit should lead to a higher level of inflation than would otherwise be the case. That is in part down to greater costs – either if wages rise to motivate a domestic workforce into the jobs hitherto apparently taken by lower-cost migrant workers, or through increases in import prices from probable currency weakness. The more unpleasant the Brexit, the higher the inflation that results.
Many pension schemes will already have some form of inflation hedging in place and, if these are established using overlay structures funded by London interbank offered rate ‘engines’, they may already be finding that these engines are misfiring, given the difficulties experienced last year.
In a messy-Brexit scenario, this is likely to continue and will need to be monitored. Otherwise funds are advised to hold as much – and as strong – indirect inflation exposure as possible through appropriate equities and similar other asset types.
Long-duration nominal investments are hard to justify, beyond a possible spasm lower in yields if/when the economic outlook is judged to have deteriorated. They are already expensive – 50-year gilt yields are just 1.7 per cent – and are vulnerable to pressure from higher inflation.
Portfolios could shift away from domestic markets
Further, across the globe populist pressures continue to build. Jeremy Corbyn is currently the bookies’ favourite to be our next prime minister; a lurch into the unknown that will concern asset markets. Pressure to fund greater public spending through higher gilt sales will be considerable.
Taking the above together, the temptation to move assets offshore could prove irresistible. Any switch out of UK risk markets is, however, hard; on a range of metrics they appear cheap. Sadly, and as the much-publicised difficulties of UK retailing attest, apparent value may mask a value trap: hard to sell, hard to hold.
Overall, parliament’s failure means pension funds, and UK business more broadly, are condemned to waste scarce resources on efforts to mitigate a range of adverse outcomes. A plague on all of them!
Stephen Jones is chief investment officer at Kames Capital.
