Market Outlook 2018: Storms in the distance?

Private pension wealth has seen a steady increase in recent years, according to the Office for National Statistics. Aggregate retirement savings rose to £4.57tn for the period from 2014 to 2016 from £3.91tn between July 2012 and June 2014, a jump of 20 per cent.

At least a third of this increase is due to market factors rather than contributions, according to the statistics watchdog. 2017 saw markets continue this rise.

There’s very little tolerance or cushion to absorb bad news

Kerrin Rosenberg, Cardano

However, as the old adage has it, past returns are not an indicator of future performance, and as long-term investors, pension schemes must pursue strategies that perform well during 2018 and beyond.

2018 is promising for equities

2017’s ‘Goldilocks’ environment, which saw asset values lift across the board and the S&P 500 post positive returns every month, has been driven in part by better than expected global growth.

Forecasts from Consensus Economics suggest growth in 2018 will be faster than 2017 in almost every major economy, averaging 3.2 per cent globally.

Combined with strong earnings forecasts, this growth could continue to maintain what appear to be sky-high equity prices by historical standards.

“I think 2018 is really going to see a continuation of the themes that we saw in 2017,” says Sophia Heathcoat, an investment consultant at Barnett Waddingham.

Jonathan Cummings, an executive director and portfolio manager in JPMorgan Asset Management’s multi-asset solutions team, shares the upbeat outlook about the immediate future.

“You would still expect to experience strong equity market returns in a late-cycle environment,” he says.

Importantly though, the UK’s much gloomier economic outlook means many managers are treating domestic securities with a degree of caution, even in the short term.

A net 36 per cent of global fund managers are underweight UK equities, according to research from Bank of America Merrill Lynch.

For 2018 then, the major challenge for pension funds and their managers will be finding attractively priced assets in markets that have risen across the board.

“We have markets that are in most cases close to all-time highs,” says Kerrin Rosenberg, UK chief executive officer at fiduciary manager Cardano.

Equity valuations are least stretched in European, Japanese and emerging markets, according to several managers.

Valuations alone are not worrying

As well as frustrating allocation decisions, expensive assets can be a cause for greater concerns about markets; namely, that what goes up must come down.

“There’s very little tolerance or cushion to absorb bad news,” says Rosenberg, adding: “In the next few years there are a lot of really big-picture unknowns that could have quite a dramatic impact.”

So should trustees be worried about these highs?

“Bull markets don’t die of old age,” says David Vickers, senior portfolio manager at Russell Investments.

But there are other factors to suggest bull markets may come to an end in the next few years, even if few expect them to end in 2018.

For a start, elevated stock markets and strong growth forecasts leave little room for positive surprises. Any disappointing figures could bring equities back down to earth.

“You don’t have to look very hard to see a minus 20 per cent from the stock market,” says Rosenberg.

Vickers says most earnings forecasts are in fact slightly lower than 2017, but agrees with Rosenberg that there is an element of complacency in markets, especially among US equity investors.

Unexpected inflation is a threat

Another key concern is inflation. The UK’s consumer price index ended 2017 at 3 per cent, down from 3.1 per cent a month earlier, but still well ahead of the Bank of England’s 2 per cent target.

“We know that business cycles... get either killed by central banks or by excesses in financial markets,” says Nikesh Patel, head of investment strategy at fiduciary manager Kempen Capital Management UK. “Both are related to inflation, the former in the real economy, the latter in the financial economy.”

If inflation rises unexpectedly in the UK or other markets, increased duration would start to hurt credit assets, according to Vickers. Central banks would likely have to hike interest rates faster than they had planned.

Investors with concerns about inflation might look to buy American inflation-linked assets, says Rosenberg, which “can do quite well” if prices grow faster than their current rate.

Some areas of bond markets look unattractive already. “One thing we’ve done in the fund is reduce our exposure to high yield, as we believe that valuations aren’t very attractive there,” says Cummings. Fixed income upside is limited by the nature of the asset, he explains, unlike equities.

Another aspect of central bank policy that could impact all markets is the unwinding of quantitative easing, the bond-buying programme that has compressed yields since the global financial crisis.

Currently, central banks are merely slowing the rate of purchase of government bonds. But JPMorgan Asset Management analysis points to 2018 as the year they will tip into being net sellers, removing a key support of asset prices in recent years.

Hedging equity exposure

A combination of these factors means many asset managers are looking out for signs of a recession coming as soon as 2019.

“I think they’re fairly normal concerns as the yield curve flattens or inverts,” says Donny Hay, a client director at professional trustee firm PTL. “It tends to preclude a recession.”

That does not mean trustees should panic or go to cash, he cautions, citing the missed gains experienced by anyone taking an overly cautious view in 2017. “With investing it’s time in the market rather than timing the market that matters.”

Nonetheless, as long-term investors, the risk of recession within a five-year window should be impacting pensions funds’ asset allocation decisions today.

If you’re certain of anything at the moment you should probably have your money taken away from you

Paul Berriman, Willis Towers Watson

Where funds do not afford their managers the luxury of switching between asset classes at their own discretion, it may be time to trim or hedge equity allocations.

“Because volatility in markets is so low you can actually use derivatives,” says Paul Berriman, who heads up Willis Towers Watson’s funds business. “We’re doing a lot of that.”

Equity protection strategies using options allow schemes to insure themselves against harsh drops in the stock market. When volatility is low, the price of options also tends to drop.

“They have been available for a long time for bigger schemes with segregated mandates,” according to Heathcoat, but have only recently started to be offered to smaller clients.

Berriman says carefully selected hedge funds can also help mute the impact of market falls, despite looking expensive when times are good.

Could you survive a downturn?

Above all, industry experts agree that diversification will be a key tool in facing the next few years.

“You want to remain diversified in an uncertain world,” says Hay, adding that he expects defined benefit trustees to continue to extend liability hedging, minimising risk, while employing leverage to maximise returns.

Rosenberg agrees: “Our approach is to have multiple scenarios and to give credibility to multiple scenarios, and to have assets in the portfolio that perform differently under these scenarios.”

Trustees and their advisers should be stress-testing their strategies, and should be prepared to embrace a ‘lower for longer’ approach to investing.

“The thing I’m advising anyone who asks me is that you should always retest your risk tolerance in the good times,” says Vickers. “I’d imagine most are carrying more risk today than they were in 2009, and that’s the wrong way round.”

Focus on long-term strategy

Investment strategy is a complex and time-consuming matter, and without the rising tide of quantitative easing lifting all boats, it is bound to be even more so.

That means some boards are looking to delegate these decisions, either to multi-asset managers or fiduciary managers, according to Hay.

Nonetheless, they should ensure their managers and advisers are responding to the uncertainty of the future in the correct way, focusing on diversification rather than conviction about any one trend.

“If you’re certain of anything at the moment you should probably have your money taken away from you,” says Berriman.

Trustees must take care not to get bogged down by questions about political unknowns, such as the path of Brexit or the Trump presidency, when attending their next investment meetings, he says. “The best answer to that is we genuinely don’t really know.”