The butterfly effect – How to take cover and control

An ancient Chinese proverb says: “Be not afraid of going slowly; be afraid only of standing still.” A powerful mantra perhaps, for the long-term funding objectives of UK pension funds in normal market conditions.

Many global investors will have longed to stop and stand still this summer. But on August 25, equity markets did worse than stand still, as the shock of an 8 per cent fall across Chinese stocks reverberated through trading floors.

But the volatility story is not confined to the heady days of August, nor to the Chinese domestic equity market.

Extreme market turbulence pushed the Vix volatility index to levels rarely exceeded since the global financial crisis, as the MSCI World lost 6.8 per cent over the month (see graph, below).

The Barclays Global Aggregate bond index returned just 0.1 per cent in August and is down 2.8 per cent for the year.

In a recent FT magazine article, Patti Waldmeir told the rags-to-riches stories of three Chinese billionaires: Zhou Chengjian, Liu Yonghao and Wang Wenyin.

Aside from the key to success being ‘work hard – then work harder’, the crucial take-away of the piece was an insight from agribusiness mogul Yonghao.

“Many traditional industries are facing huge pressures because of oversupply and rising costs. Tighter environmental protection is also adding more cost, and demand is slowing,” says Yonghao.

“Diligence and hard work are not enough for today’s youth to be successful.”

Yonghao, one of China’s most successful businessmen, has accepted an economic slowdown, but it is an alarming prospect for UK pension funds.

Market confidence

The China case may be an inevitable blip or correction. But ripples of uncertainty have hit global market confidence, with doubts growing about Chinese policymakers’ competence, says Paul Gibney, investment consultant at LCP.

“There are things that have happened, whether it’s the devaluation of the renminbi or the way they responded to initial domestic market volatility, that made people think perhaps they’re not as far sighted, calm and collected as we thought,” he says.

US Federal Reserve chair Janet Yellen’s nod to concerns about Chinese growth and the international environment as she announced the Fed’s hold on rate rises was a strong indication of the growing importance of China in the global economy.

“It was quite evident that was what was in [the Fed’s] mind. I’ve not really seen that before,” Gibney says.

But a shift in Yellen’s outlook in a subsequent speech provides investors with some hope for Fed rate rises by the end of the year.

The bigger story

Within this context the time-horizon for a UK rate rise remains ambiguous, with a cautious Bank of England at the helm.

Towards the end of September Andy Haldane, chief economist at the Bank of England, said it was “simply too soon” to gauge the potential for contagion from recent emerging market slumps for the broader global economy.

Haldane anticipates headwinds to emerging market recovery are unlikely to blow through quickly. “In my view, the balance of risks to UK growth, and to UK inflation at the two-year horizon, is skewed squarely and significantly to the downside,” he said, issuing a stark warning for pension funds across the UK.

“Against that backdrop, the case for raising UK interest rates in the current environment is, for me, some way from being made.”

Simon Hill, chief investment officer at Buck Consultants, says the bigger story for long-term investors is the failure of consumer spending to come though across developed and emerging markets.

“The growing fear is that we’re becoming entrenched in a deflationary psychosis now, there is a miasma of unease,” says Hill.

“For most of my working life, world trade has been growing faster than economic growth in the world but that has reversed… a key sign that the world is changing in not a particularly helpful way.”

Matt Tickle, investment consultant at Barnett Waddingham, says rising uncertainty has created divergent monetary policy, in turn exerting pressure on scheme funding.

“Yields are not increasing, nor do we expect them to do so significantly in the near future – an uncomfortable message,” he says.

The growing fear is that we’re becoming entrenched in a deflationary psychosis now, there is a miasma of unease

Simon Hill, Buck Consultants

Investors may have accepted the need to prepare for low growth, but Hill says longer-term inflation expectations suggest the market may be in denial.

“At the longer-dated end, 20-30 years and beyond, those inflation expectations have not dropped. This is different to how it was six or nine months ago,” says Hill.

“The inflation protection market is looking through the current drop in inflation rates and saying in the long term, we still have an inflation problem – the market is not buying into [it].”

But Hill does not think equity market volatility alone is anything to “write home about”.

“For some while we’ve been concerned, along with others, that the US equity market was looking fairly full valued and there was an old fashioned stock market bubble that had grown up in China,” says Hill.

“DC investors have certainly been reminded that equities are volatile, and they certainly will be when they get their annual statements,” he says, adding that DB trustees might see some shifts in funding levels.

But David Curtis, head of UK institutional at Goldman Sachs Asset Management, says many pension fund investors are on top of their equity exposure and have been making reductions over the past five to 10 years.

“Recent ONS figures show UK pension funds’ exposure to the equity market is at its lowest-ever level and the volatility that has been experienced should serve to continue that trend,” says Curtis.

Staying calm

Consultants and managers have not seen reactionary shifts in response to the summer’s events, a result in part of scheme boards’ quarterly meeting schedules entering recess over the summer period.

Curtis says changing investor sentiment should not have a significant impact on schemes’ longer-term strategic asset allocation.

“That said, some schemes are looking at the sell-off, especially in emerging market debt, and wondering whether this could be an entry point to build new strategic asset allocations,” he says.

Tickle has seen a few schemes cautiously reallocating to equities, but the vast majority have not made immediate changes to strategy or allocation.

“Schemes in general were aware that the smooth, low volatility of returns couldn’t continue forever and had therefore set strategy with the more ‘normal’ levels of volatility in mind that we have seen more recently,” he says.

Bulls and bears

Scott Edmunds, investment consultant at Quantum Advisory, says the summer storm has polarised the risk appetites of pension scheme investors across the DB and DC arenas.

“The bulls [are] perceiving recent market movements as a buying opportunity and the bears [are] fleeing for safety,” says Edmunds.

However, he acknowledges recent market moves have been extreme, testing the nerves of even the most seasoned investors. “We would caution engaging in knee-jerk reactions,” he says.

Yields are not increasing, nor do we expect them to do so significantly in the near future – an uncomfortable message

Matt Tickle, Barnett Waddingham

Euan MacLaren, head of institutional for UK & Ireland at Natixis Asset Management, sees strong buying opportunities coming to the fore in developed markets.

He says: “We’ve seen good quality companies and markets dropping, you are able to buy quality at a much cheaper price.”

Schemes have also been looking at volatility across their portfolios. “Larger schemes are exploring ways they can decrease volatility within their global equity portfolios while continuing to add alpha.”

David Hutchins, senior vice-president and head of manager Alliance Bernstein’s multi-asset pension strategies, says investors will have to be smart about how they access opportunities.

“We see an awful lot of opportunity but not a broad beta opportunity,” he says. “People will have to be smarter about the way they invest in the market for the next three to five years.”

Hutchins also envisions reviews of smart beta implementation after version 1.0 left some investors disappointed.

“The evolution of strategies into version 2.0 – smarter smart beta – a bit less of a back test and more of the fundamentals,” he says.

Diversification pays off

LCP’s Gibney says well-diversified schemes will feel reassured by earlier decisions to branch out and diversify their return-seeking assets.

“For many it’s really confirmed that what they were already doing was sensible, primarily making sure they’re properly diversified so they’re not relying on one source of returns,” he says, adding it is important for schemes to look beyond equities for returns and include sensible credit and illiquidity exposure within their asset mix.

Hill says property has continued to deliver good returns, particularly long-lease property and income funds, which he says have maintained value and delivered good yields, but that pension funds may be disappointed with alternative investments over the past two to three years, even though the asset class has fared well through tough conditions.

“Although they’ve delivered slightly disappointing returns and equities have been booming… they have delivered low volatility and have continued to do that this year.”

Time-based triggers

LCP’s Gibney says where they have not done so already, schemes must address economic realities and consider replacing funding-based derisking triggers with simple time-based shifts out of risk assets.

For some schemes this will require a time-horizon readjustment, while others may need to garner additional sponsor support, he says.

If there is a sell-off I think pension schemes will move pretty rapidly... you’ll see a wall of money come at the bond market via LDI

Barry Jones, KPMG

Alliance Bernstein’s Hutchins says schemes that have not yet hedged liabilities against interest rate risk for fear of locking in current low levels now face a tough decision.

“The worry for them is that they capitulate at the wrong point in the funding cycle,” says Hutchins.

KPMG’s June 2015 liability-driven investment survey found overall mandates increased by a quarter to 1,033 in 2014, up from 825 the previous year, showing that despite historic lows for yields available, demand for LDI remains strong.

Barry Jones, head of LDI research at KPMG, says “huge demand” for LDI has continued through 2015, predicting a surge of interest should the Fed raise rates later this year. “That might spook the market into a bit of a bond sell-off,” says Jones.

“If there is a sell-off I think pension schemes will move pretty rapidly, whether that be via triggers or consultants advising clients, you’ll see a wall of money come at the bond market via LDI.”

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