Dealing with political challenges

The political shocks of 2016 have created a series of interlocking challenges for UK pension schemes. Trustees will need to determine whether low-bond yields will persist and how to invest when uncertainty abounds.

Even before the UK voted to leave the European Union, pension schemes faced a significant challenge. Too many had hoped for too long that ultra-low interest rates would not continue. This lack of acceptance of the new normal meant many did not hedge interest-rate risk, resulting in deficits reaching record highs.

But it seems the longed-for return to historic norms might now become a reality. Both Brexit and the Trump victory have raised questions about whether the governments are on the cusp of a major change in strategy.

Lane Clark and Peacock investment partner Paul Gibney, says: "Policy makers in the UK and US, as well as other governments, have indicated they want to introduce fiscal stimulus."

Pension schemes face an interesting dilemma. Does the return of fiscal stimulus mean that governments will be less reliant on loose monetary policy? And how should pension schemes invest in a world where economic rationality is so out of favour?

While a return to fiscal stimulus will be welcome, it will not provide sufficient ballast to enable governments to turn off the monetary policy tap. Pension schemes should be realistic. Even though 2017 will be the ninth year since the global financial crisis, it is likely central banks will continue loose monetary policy.

Hermes Investment Management group chief economist Neil Williams, says: "The problem is that central banks do not know how to turn off the taps without creating significant disruption."

Rather than allowing the prospect of fiscal stimulus to distract them, pension schemes should assume this lower interest rate environment will persist and accept the new normal.

Williams says: "Not only will interest rates be lower for longer but when they do rise, they will peak at much lower rates than historic norms." Williams expects the US Federal rates to peak at 1% while the Bank of England will not even consider a rate hike until 2018 at the earliest. "And that's on an upbeat economic reading," he adds.

Lower for longer

There are number of factors which will keep interest rates lower for longer. The first is the anaemic state of global growth.

While demand remains weak, fiscal stimulus will have a limited impact. Williams says: "European countries will pursue fiscal stimulus partly in order to provide a balm to unhappy electorates."

Members of the eurozone will be able to bolster government spending as most have now reached the Maastricht criterion of getting the zone's aggregated deficits to less than 3% of GDP.

This fiscal expansion, along with more protectionist policies in the US and Europe, will cause inflation to rise. "But it will be the wrong type of inflation, as it will be driven by cost rather than demand," adds Williams.

Cost-driven inflation tends to be a flash in the pan, petering out quickly. "Central banks will have to turn a blind eye to this inflation and leave interest rates low as it will not persist," says Williams.

In the US, however, there is a better chance of inflation being wage led. Gibney says: "A tight labour market in combination with greater immigration controls could result in demand-led spike in inflation."

But while a tighter labour market could encourage the Fed to raise rates, the amount of debt on this - and other - central banks' balance sheets will act as a deterrent.

In total, the four largest central banks have spent $13bn on quantitative easing since the global financial crisis, says Williams. "That gives them considerable skin the game. If they take markets off-guard by turning off the tap, they may feel some of the pain," he adds.

"In addition, the net debt to GDP ratio in the UK, the US and the eurozone is more than twice the size of Japan's when it limped into its ‘lost decade' in the mid-1990s," says Williams.

Not only was Japan's net debt to GDP ratio less than half of the UK's, most of it was held domestically. Williams says: "International investors, however, hold a third of UK gilts, half of US Treasuries and a half of Eurozone bonds."

These investors care about currency risk and about credit ratings. Williams says: "Central banks will have to remain the single biggest sponsor of government debt to underpin these debt ratios and re-assure foreign investors."

For pension schemes, the combination of a low interest rate environment and fiscal stimulus could prove a challenging double whammy.

Cheap funding

Until now governments have resisted the siren call of ultra-low interest rates as an opportunity to access cheap funding. But it looks like this will now become a more acceptable policy.

Henderson Global Investors head of rates Mitul Patel, says: "Pension schemes should recognise an increase in supply in government bonds comes with a risk." An increase in supply could undermine the quality of the government's credit rating, he adds.

Given the increased supply of government bonds and a continuing low yield environment, it's unlikely there will be a marked increase in bond yields over the medium term.

Structural constraints will keep an even tighter lid on inflation-linked bonds. "Demand from pension schemes is so strong that prices barely move," says Gibney.

Pension schemes with a significant proportion of their interest-rate and inflation exposure already hedged should look for assets which provide inflation-linked cash flows but are not precise match to their liabilities. "For example, long-lease property would provide these characteristics," says Gibney.

Some argue that a persistent low-interest rate environment demands a more flexible approach. Patrick Thomson, head of international institutional clients at J.P. Morgan Asset Management, says: "Trustees need to recognise traditional investment allocations will not work when bond yields are so low."

In a low return world, schemes will need to be more active and more inventive, says Thomson.

Schemes should scour the financial universe for those assets which will enable them to meet their goals. Thomson says: "The portfolio should be well diversified and have exposure to those assets which are likely to perform well, such as alternatives."

As well as loose monetary policy existing in tandem with fiscal stimulus, policy makers are likely to implement protectionist policies in order to soothe their unhappy electorates.

Gibney says: "At both a national and supra-national level, European politicians are listening much more closely than they have been to their voters." Objections to both globalisation and immigration are being heard.

The days of the agreements between trading blocs may well be numbered - both Trans-Pacific Partnership trade pact and the Transatlantic Trade and Investment Partnership appear to be dead in the water. "It looks like trade will be more fragmented in the future with more bilateral agreements," says Gibney.

Outlook

The combination of protectionist policies and stronger dollar look negative for emerging markets. Gibney says: "This has taken the gloss off the asset class as a whole."

However, there will still be individual countries, sectors and companies which perform well within the emerging markets. Gibney says: "Pension schemes might benefit from a more active approach."

But while it looks like there might be a protectionist agenda in the future which could penalise emerging markets, there are no guarantees this will come to pass.

The current level of political uncertainty demands a different approach from pension schemes. Cardano client director Tony Baily, says: "At the moment investors try to determine the most likely political outcome and plan for that eventuality."

A better approach is to determine a range of plausible futures and then ensure the portfolio is robust enough to ensure the scheme will be able to cope, whatever the outcome. Baily says: "Rather than use a rear-view mirror, we try to be forward looking and ask a series of ‘what if?' questions.

Typical questions could include what if the UK has lost decades like Japan? Or what if interest rates stay lower for longer? Or what if this is the end of the bond bubble and interest rates head higher?

This method will only work, however, if every possible scenario is captured. Cardano achieves this by imagining how each asset would react to different combinations of growth and inflation. Baily says: "By running through all the different combinations, it's possible to cover most of the eventualities."

In addition to these steady state scenarios, Cardano also examines the impact of major growth and inflation shocks on the performance of different assets. Baily says: "We then look for those managers which will perform well in these circumstances."

It is also selects managers which can deliver good returns in any environment. Baily says: "This is particularly difficult - there's a lot of hard work needed to identify these managers."

The likelihood of different outcomes is constantly reviewed. Annalisa Piazza, investment strategist at Cardano, says: "We take a dynamic approach and constantly re-visit the probabilities assigned to each scenario." Specific risks are also identified and then hedged.

Now is the time for pension schemes to consider whether their investment processes and portfolios are robust enough to survive further political tumult. The swathe of European elections in 2017 mean next year could prove to be just as disruptive as 2016.

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• Topics
• Investment
• LCP
• Hermes Investment Management
• Cardano
• Mitul Patel
• Henderson Global Investors
• Paul Gibney
• Neil Williams
• Annalisa Piazza
• Patrick Thomson
• Tony Baily
• Charlotte Moore