What converging global monetary policy means for UK pension funds

Over the past decade, the question of interest rate rises has been more ‘when’ than ‘if’ – a mentality that continues to be reflected in many UK schemes’ fixed income holdings.

Scheme decisions are not about making accurate forecasts but instead are a question of preparing for all conditions

Even a few months ago, a view that rates would continue to tick up this year was perfectly warranted. Tightening through the course of 2018, led by a fairly hawkish Federal Reserve, had fuelled the market’s belief in continued incremental increases this year.

Policymakers re-evaluating path ahead

Just a few weeks into 2019, however, the Fed’s dovish pivot confounded those expectations, setting in motion a broader dovish shift across global central banks.

In Europe, central banks have collectively dialled down their confidence in the growth outlook. The European Central Bank’s previously upbeat tone is now firmly subdued, with any form of rate hikes on hold and fresh stimulus packages announced, along with similar stances by the Bank of England, among other European central banks.

A similar change in central bank tone has been mimicked in several economies around the world, ranging from Brazil through to Japan through to Australia. 

At its latest meeting, the Fed went one step further and took hikes off the table in 2019, as members acknowledged the rising risks of the UK’s exit from the EU, the impact of the US-China trade dispute and growing scepticism of inflation moving up.

Despite robust economic growth, low unemployment and equity markets continuing to perform at, or around, all-time highs, the failure of inflation to materialise in a meaningful way has forced policymakers to re-evaluate the path ahead for monetary policy.

Take stock of shifting environment

The traditional correlation between growth, inflation and rates seems to have broken down in long-dated yields, pushing central banks back to the drawing board.

Moreover, recent softening in consumer spending and housing data, weaker manufacturing outputs and continuing risks across a number of geopolitical fronts all point to fairly uncertain times ahead for policy makers and investors alike.

Pension funds, too, now need to take stock of the shifting environment and adjust their positioning accordingly.

The inherent tension between hedging risks and pursuing returns lies at the heart of the trustee challenge. Not many underfunded schemes want to be fully hedged and completely take interest rate risk off the table in a rising rate environment.

In the current context, however, schemes banking on rate rises will have been cruelly punished over the past few months. In March alone, we saw around a 6 per cent rise in liabilities month on month (with intra-month returns peaking at around 8 per cent), undoing much of the good progress made by schemes in 2018. With long-dated real yields hitting all-time lows during March, schemes with high inflation linkage are likely to have faced even higher liability increases.

Prepare for all conditions

The single most decisive factor impacting schemes’ returns versus liabilities through the current climate is the decision to remain strategically underhedged versus liabilities.

At scheme level, this decision can often be the biggest risk schemes are running, given the direct correlation to the UK yield curve. Beyond the more idiosyncratic risks of Brexit, UK long-dated yields are moving in lockstep with the wider dovish shift sweeping across central banks, driving sharp rises in scheme liabilities.

Of course, as markets have priced in reduced expectations of rate rises, equity markets have reaped the benefits of lower yields and risen strongly, inflicting pain on those schemes with less exposure to equity markets while not being fully hedged at the same time.

Given the wider industry shift to diversified growth funds, there will be schemes out there – underhedged to interest rate risks and with relatively low exposure to equities – which have taken the double hit.

The experience of 2019 so far is a textbook example of the need to take appropriately sized views of the risks ahead. The rosy backdrop at the close of 2018 has, in the matter of a few months, become significantly more uncertain.

Scheme decisions are not about making accurate forecasts but instead are a question of preparing for all conditions. Often, it is not the decision itself, but the scale of that decision which proves most decisive in the context of portfolio risk and return. 

Paras Shah is head of LDI at Cardano