We've had a difficult start to 2016 and ongoing political factors will continue to have an impact, finds Charlotte Moore
- The first two weeks of January were the worst start of a year on record for the markets
- New emergent forces such as China are reshaping the balance of power globally
- Pension schemes need to be aware of geopolitical risk but not get swept away by them
It has been an unsettling January. The first two weeks of the month were the worst start of a year on record for markets around the world. Nor is there much chance the volatility will abate. Along with ongoing economic concerns, political factors are likely to dominate the rest of the year.
It's often said that markets dislike uncertainty and there is nothing quite as unpredictable as political risk. It is notoriously difficult to forecast how governments and policy makers will behave.
Political risk, however, is nothing new. It is a constant background factor and its influence on markets ebbs and flows. But in recent years there has been a shift in the global world power balance which has increased uncertainty.
Russell Investments senior investment strategist, Wouter Sturkenboom says: "The view of geopolitical strategists is unanimous: the world is moving from unipolar to a multi-polar power."
New emergent forces, such as China and radical Islamic groups, are reshaping the balance of power around the world. In addition, the reluctance of developed nations, such as the US and Europe, to be involved in external wars gives other nations licence to flex their muscles.
This new structure has resulted in much greater volatility. Add in social media's breadth and depth and there is an overwhelming tsunami of discord emerging from every corner of the globe.
But it behoves pension schemes to remain rational and not be swept away by the emotion of the news agenda. Not every political event will have important investment implications. Sturkenboom says: "For example, the war in Syria has limited impact on financial markets as it's not a major oil producer."
Evaluating political risk is about assessing the probability of a particular event occurring as well as determining the impact that event would have on financial markets. For example, unrest in the Middle East is highly likely but unless production is halted at one of the major oil producers it will have limited impact.
In contrast, while there is less of a chance of China's current aggressive stance in the South China Sea escalating into conflict, such an event would have a more significant impact on financial markets. Sturkenboom says: "This would create a very intricate problem which would have many different ramifications for a number of countries, including the US."
In addition, investors need to be mindful that current market dynamics have the ability to further exacerbate any volatility. Mercer's European director of strategic research, Phil Edwards says: "Limited liquidity in many bond and equity markets could lead to larger price moves." Investors needed to prepare to for these larger moves, he adds.
For UK pension schemes, one domestic political concern looms large – the referendum on the nation's membership of the European Union.
Shaniel Ramjee, senior investment manager at Pictet Asset Management's multi-asset team, says: "David Cameron's indications that the summer would be a good time to carry out the referendum caused sterling to be very volatile in the first few weeks of January."
Most political watchers had pencilled in the end of the year for the referendum so this is a considerable acceleration of the timetable. Ramjee says: "The ‘No' campaign is gaining traction, feeding on geopolitical fears and economic uncertainty while the ‘Yes' has failed to present the benefits of staying in the Union."
In many ways, the recent Scottish referendum can be thought of as ‘dry run' for the EU referendum. Standish Mellon Asset Management's sovereign analyst Rowena Macfarlane says: "This can be seen as a template for the type of market volatility which will surround the EU referendum."
Ramjee says: "There is a strong chance that, like the Scottish referendum, the results of the EU poll will be very difficult to predict." The lack of referendums in the UK makes it much harder for pollsters to predict outcomes as there is a lack of historical data, says Macfarlane.
It is probable markets will react to the uncertainty surrounding the outcome of the referendum by assuming a negative result. Ramjee says: "Even though it would take years to untangle the UK from the EU, the market will discount the impact in advance."
The pound is likely to bear the brunt of this uncertainty and will continue to weaken. Ramjee says: "Pension schemes need to consider what impact this weakening of sterling will have on their portfolio."
While unhedged UK pension schemes may benefit from sterling's depreciation relative to the euro, other geopolitical risks could affect other countries' currencies. For example, another eurozone crisis could cause the pound to appreciate.
Assessing the pension scheme's tolerance to such currency volatility would be sensible. Edwards adds: "Putting a currency hedging strategy in place to protect against major moves against sterling could be valuable from a risk management perspective."
It's not only sterling which will be volatile as the date of the referendum approaches - so too will equities and bonds. Macfarlane says: "Gilts have been underpinned by the strength of the UK economy."
However, the domestic economy is very reliant on Europe so that resilience might be under threat if the UK leaves the EU. Macfarlane says: "If it appears the UK is likely to exit, then the value of UK government bonds could be under pressure."
Schemes should consider steps to mitigate the impact of the EU referendum on both sterling and other domestic assets. Edwards says: "Diversifying the asset allocation, not just by region but also by sector and stock, is a sensible way to manage not just the Brexit risk but other geopolitical threats."
Diversification should be applied to the whole portfolio not just the equity allocation. Chief investment officer at Buck Consultants at Xerox chief investment officer Simon Hill says: "Schemes should allocate to those assets which have limited correlation to equity markets such as property and infrastructure."
Not only should pension schemes consider the implications of the referendum on their asset allocations but they should also start to think about the regulatory impact of exiting the EU.
Ramjee says: "Would the removal of the burden of EU regulation be an opportunity for pensions schemes? Or is domestic regulation a more important force in this industry?"
Whether it is the European referendum or other political events, pension funds should ensure they have given their investment manager the right mandate to perform the best in choppy market waters.
Schemes cannot react quickly enough to market corrections caused by fast moving political events. Hill says: "Neither trustees nor consultants are well placed to take advantage of short-term market timing but active fund managers have this capability."
Trustees should ensure their investment managers can manage their portfolios dynamically. Edwards says: "A manager with a flexible mandate will be able to capture those opportunities which arise due to market over-reactions to any perceived crisis."
For defined benefit schemes, the most advantageous short-term benefit is likely to be felt in their liability-driven investment portfolio.
Edwards says: "Interest-rate triggers will help investors take advantage of any volatility in gilts by increasing liability hedges should yields temporarily spike upwards." This is likely to be the most effective way to capture these market movements, he adds.
Hill agrees: "It's likely there will be opportunities over the next 12 months for schemes to increase their hedging at a more favourable price."
While schemes will need to hunker down and weather a certain degree of market volatility, they should be cognisant of the impact this will have on their risk management. Hill says: "The regulator has talked about integrated risk management – this should be built into all of their decisions."
Monitoring the actions of policy makers and being aware of geopolitical events will be vital. But other major trends, which have the ability to cause political upset, should not be neglected. Hill says: "Investors have slightly lost sight of the political implications of radical economic shifts."
The radical drop in the price of oil and commodities will continue to have significant economic and political impact. Hill says: "The consequences of the collapse in the price of oil cannot be overestimated – it is the most important commodity for the global economy."
The scale and speed of the shift in the price of oil has profound consequences for producers. Hill says: "For example, this presents significant political consequences for Saudi Arabia while it also tries to manage the threat posed by instability in the region."
While the negative impact of the fall in the value of oil on producers has been felt, the associated consumer benefit has been more elusive – which could also have political implications. Hill says: "This lack of response is something which should be watched carefully as it could have profound implications for policy makers."
Hill adds: "It's easy to overplay the importance of politics when it has a limited impact on economics and to miss how great an influence major asset price and economic moves can have on politics."
The government will set up an infrastructure bank to support investment and to co-invest alongside investors including pension funds.
The Retail Prices Index (RPI) will be reformed and aligned with the housing cost-based version of the Consumer Prices Index, known as CPIH, by 2030, the Treasury has confirmed.
Estatee agent denies a shareholder’s absence from voting is an issue, finds Minerva Analytics.
In this live blog, Professional Pensions' sister title Investment Week collates all the breaking market news, analysis and opinion on equity, bond and currency movements as well as the impact of trade wars, tightening monetary policy and the Brexit negotiations....
Attractive valuations and prospects for economic recovery support small-caps