Investment Panel (March 2007) - Prepare for a bumpy ride

Steve Cleal
Interim head of strategy and head of balanced funds
Morley Fund Management
Cleal joined the then Norwich Union Investment Management in 1987 and is now interim head of strategy and head of balanced funds. As a member of Morley’s asset allocation committee, he helps formulate the house strategy for investment markets and is responsible for ensuring that the asset distribution of multi asset funds is in line with that strategy.

Duncan Rankin
Product specialist director, institutional business group
Threadneedle Investments
Rankin joined Threadneedle in 2000 as product development manager. He subsequently joined the institutional business group to provide specialist product advice to clients and consultants. Prior to this, Rankin worked at firms such as Schroder Investment Management and Mercury Asset Management.

Richard Graham
Head of institutional business,
Baring Asset Management
Graham is head of institutional business, which includes responsibility for LDI solutions for UK pension funds.

George Walker
Head of UK institutional business
Standard Life Investments
Walker is responsible for overseeing the UK business and for Standard Life Investments’ asset class product specialists. He joined Standard Life Investments in 2001, after over 10 years at Friends Ivory & Sime, where he was UK investment director and head of North American business & client services.


Are early March’s market falls a temporary setback for asset values or is it the beginning of a deeper correction?

CLEAL: The sharp turnaround in equity sentiment in early March caused many investors to ask important questions about the risks involved in stockmarket investing. This is no bad thing. Periodic shakeouts in markets help prevent investors from becoming too complacent and serve to give regular reminders of how volatile stockmarkets can be compared with safer havens such as bonds and cash.
This, somewhat paradoxically, means markets should be more orderly in the long run. The real danger is when investors believe equities can only go up. Any rush for the exit can than cause a seismic shift in share prices, as witnessed when the dot com bubble burst.
Commentators have cited a number of triggers to explain the recent sell-off. These include the announcement by the Chinese authorities they were considering measures likely to reduce equity market speculation.
There has also been a focus on the rising number of defaults being faced by US mortgage companies that have lent to individuals with low credit ratings. This clearly poses a risk to the US economy (with potentially disastrous consequences for the profitability of many companies).
Compounding these issues were signs that a number of investors were more heavily invested in equities than normal, heightening the risk that selling pressure could push the market lower.
GRAHAM: By the time this comes out, much of the market fall may already have happened, but we do believe investors should prepare themselves for more volatility.

RANKIN: We are definitely in the former camp, and the main reason for our optimism lies in the economic fundamentals. We see little to worry about on the economic front: modest, non-inflationary growth continues in the developed markets and China is likely to expand at close to 10pc again this year, but again with little inflation. Interest rates are peaking in the west and this is usually a good sign for equities.
Valuations are interesting. Price/earnings ratios are at levels that give scope for multiple expansion, which is important because, as earnings growth peaks for this cycle, multiple expansion is likely to take over as the main driver of the bull market.
Moreover, equities are valued such that any dip in prices is seen as a buying opportunity, not just by retail and institutional investors, but also by other corporates. The combination of strong balance sheets, shareholder pressure to maximise growth and cheap valuations means mergers and acquisitions remains a strong driver of markets, particularly in the west but also, increasingly, in Japan.

WALKER: Our analysis had been warning for some time that the risks of a correction occurring were rising, given the extended length of the rally we have seen. Notably, investors had been increasing their risk appetite, sometimes in an irrational way as say they scrambled to invest in Chinese new equity issues. Much of this exuberance has already been unwound in the recent market volatility. Nevertheless, certain issues remain, for example the current concern about US sub-prime mortgages.
We believe we are seeing a “normal” rather than a “major” correction, and any set-back should be viewed as an opportunity for investors to review their allocations to equity markets. This is because we do not currently see evidence of excessive equity market valuations, or widespread inflation or credit pressures which would normally signal a major correction at the end of the business cycle.
Our historical analysis of market behaviour indicates the correction is playing out in a pre-dictable pattern and we are monitoring where and when buying opportunities will appear.


What effect would any “liquidity crunch” have on schemes looking at implementing liability-driven investment (LDI) strategies? Would a credit shortage make these strategies cheaper to put into place?

CLEAL: Many LDI strategies make use of the credit risk premium, so credit spreads “blowing out” should make these strategies cheaper to implement.
For example, if corporate bonds are used to completely cashflow match a set of liabilities with a duration of 20 years, then every 10 basis point increase in credit spreads would reduce the cost by about 2pc. This assumes the change is mainly driven by changing market sentiment.
If credit-worthiness is deteriorating, then these gains will be offset to an extent by increased expected losses through default. Movements in the underlying gilt (or swap) curve are just as important, and normally more volatile.

GRAHAM: Liquidity has definitely tightened. Easy availability of capital has generated very high amounts of leverage in the global financial system, and as this starts to be unwound, the economic and market effects could be very significant.
We have already seen some evidence of this in the US in the sub-prime mortgage market, where default rates have risen sharply and 22 lenders to this area of the market have declared bankruptcy in recent months. If, as we believe, financial markets have reached a turning point where the tightening of monetary policy prompts a wholesale re-assessment of both the pricing of risk and the appetite for risk on the part of investors, the flight to safety may continue.
Schemes looking to implement LDI strategies in an environment of reduced liquidity are likely to find both an increase in the cost of swaps and weaker performance from fixed income. We believe a more flexible LDI investment strategy, one that allows for sensible positions in both traditional asset classes and safer alternatives, would enable many pension funds to capture investment returns from these market changes more effectively than just focusing on one type of asset class.
By implementing a forward-looking multi-asset targeted return strategy, pension schemes can gain exposure to a range of asset classes within set risk parameters, helping to avoid any “investment torpedoes” while always focusing on the agreed level of investment return.

RANKIN: It depends upon the nature of the crunch, but I think we need to make a distinction here between the terms on which interest rate and/or inflation protection might be available, and the cost of implementing the desired protection strategy.
A situation which is described as a liquidity crunch implies to me that lenders become reluctant to lend and short-term borrowing rates increase. If interest rates rise, this might imply better terms, in the form of a higher fixed rate of return, would become available on interest rate swaps.
But longer term interest rates, which are of more significance to defined benefit schemes, would probably be affected to a lesser extent than shorter rates, and so in practice the benefit of such a situation might be limited.
Higher volatility in interest rates and asset prices might also lead to a widening in the market spreads on bonds and swaps as market-makers seek to protect themselves against the increased risks of their business. So the transaction costs associated with the implementation of liability protection strategy might increase during a liquidity crunch.

WALKER: In respect of global money supply growth, a “liquidity crunch” could be triggered by various sets of events.
A likely scenario would be inflation breaking out much higher than central banks would like, forcing a significant tightening in monetary policy. Let us assume the entire yield curve moves say 100 basis points higher. The net effect is positive for schemes looking at implementing LDI strategies.
As such schemes are usually short duration, say with liabilities of about 15-25 years but holding a bond benchmark with say an eight-10 year duration, then a rise in yields would be rather positive.
On a second interpretation of a “liquidity crunch”, this could occur when a range of companies in an economy have too little cash to cover liabilities as they fall due. They are therefore forced into emergency borrowing of money at less competitive rates, i.e. taking advantage of overdrafts. Such an environment is usually one of increased corporate bond yields generally.
This again may prove attractive to pension funds as they feel relief on their accounting basis for liabilities (higher yields rendering the present value of future liabilities lower). It could present them with the opportunity they seek to remove some interest rate risk thereafter by switching into a more bond-based strategy.
There are two key issues with this analysis however. Firstly, in such a “liquidity crunch” the cover for dividend payments is likely to be reduced. Share prices could be as adversely affected as bonds making it painful for trustees to consider selling any equities in their pension fund in order to buy bonds.
Schemes tend to not have large cash holdings awaiting the opportunity to buy bonds so the chance to enter LDI cheaply in a “liquidity crunch” is not available to most. There is also the fear that bond defaults could increase causing further yield hikes further hurting those that implement during the course of the “liquidity crunch”. This makes the timing of any move particularly important.
Secondly, LDI strategies are increasingly being developed that do not rely on bonds as the underlying assets. Instead interest rate swaps are used to hedge exposures to interest rates, enabling the scheme to pursue an absolute-return investment strategy. The credit exposure of swaps is limited which means they may be relatively less attractive to an LDI implementer if bond yields have risen.
Lastly, every economic cycle is different. The conditions that cause a “liquidity crunch” could relate to an expected or imminent recession and not only the expectation of lower inflation but even a shift towards actual price declines, ie deflation. This, coupled with a flight to the relative safety of government bonds, could depress the general level of interest rates quite considerably.
The appetite for high-quality bonds could therefore exceed the increased issuance from the government or companies, while lower yields would not only make LDI implementation more costly but also more urgent!


How should asset managers position themselves to reduce risks in any market downturn?

CLEAL: So how serious should investors treat these developments? There are already signs that hedge funds have reduced their equity exposure to more “normal” levels and this indicates that further significant selling from this group of investors is unlikely.
Of more concern are the developments in the US economy. The housing market has weakened significantly over the past six months and the low quality of the recent mortgage lending is likely to add to the woes.
Nevertheless, given the uncertainties, equities are likely to remain volatile. Investors should therefore maintain a diversified asset mix to include bonds, property and cash in order to offset some of the risks associated with equity markets. Perhaps the best advice is to accept volatility as an inevitable part of equity investing and focus on the long-term returns which look set to comfortably surpass the performance of cash and bonds.

GRAHAM: In the event that the level of volatility does pick up very sharply from here, we should not rely on the world’s central banks proving as accommodative as they have been in previous cycles.
Policy priorities are changing, and the level of leverage in the world’s financial markets is one of the main causes of concern to policy makers. To react to market weakness by reducing interest rates could risk what economists call “moral hazard” – a further increase in the level of risk taken by investors in the belief they would find support from central banks in the event of difficulties, and precisely the opposite reaction policy makers would wish for.
We had already started to reduce risk in recent months in portfolios before these events and continue to hold cash and structure products where appropriate.

RANKIN: Diversification is the key here. What investors need is a range of assets with low correlations. So a good mix of equities, bonds, property and cash remains the best way to limit volatility. There has been some talk of different assets becoming more correlated, but to our mind the data continues to suggest asset diversification is the best way to limit risk.
Within equity portfolios, investors should also seek to diversify risk. Even in a concentrated portfolio it is possible to provide diversification by ensuring there are multiple themes at work. For example, if you have 30 stocks, make sure they are not all energy plays, or all high beta stocks that will suffer unduly in the event of a general mark down in share prices. Look for different themes that are not dependent on each other. Then, if one story unravels, the others should stay in place.

WALKER: This will depend on an asset manager’s medium-term outlook and whether the recent correction constitutes a “normal” or a “major” event as discussed above.
Our house view has been slightly more downbeat than the consensus on the fundamental macro-economic outlook, as we do not believe the impact of slower profits growth has been fully priced into stock markets. Given our view that we are seeing a normal correction after an extended bull run, we retain a positive bias towards equity markets, although we have also increased our fixed interest exposure as we see inflation pressures easing.
Within equities, we earlier adjusted our asset allocation to favour the more defensive or lower beta markets, such as the UK and the US. These traditionally outperform the more aggressive or higher beta markets, such as emerging markets and the Pacific Basin, during correction periods.
The UK market is currently our preferred equity market, benefiting from attractive dividend growth and considerable merger and acquisition activity.