Outline July 2013
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  • 1. July 2013
  • 2. 1 Clear Goals and Objectives 1 3 52 4 6 7 LDI and Overlay Strategies Liquid Market Strategies Liquid and Semi Liquid Credit Strategies Illiquid Credit Strategies Illiquid Market Strategies Ongoing Monitoring SEVEN STEPS Redington designs, develops and delivers investment strategies to help pension funds and their sponsors close the funding gap with the minimum level of risk. We take our clients through a rigorous 7 Steps to Full Funding™, which begins with laying out clear goals and objectives and assigning tasks and responsibilities. The second step is building an LDI Hub, or putting in place a risk management toolkit. Steps 3-6 involve crafting the right investment strategy to fit the need using a full range of tools and bearing in mind the goals and constraints of the scheme. Finally, ongoing high quality monitoring is essential to continually track progress against the original objectives and guide smart and nimble changes of course. Introduction 2 The 5 Global Challenges 3 VUCA – The Acronym Of Our Time 4 LDI: Hedge Your Bets 2 5 Inflation Risk: Mind the Cap (and Floor) 2 6 Don’t Discount the Effect of Discounting 2 7 Investment Grade Credit, Or Is It? 3 8 Setting Trends By Following Them 3 9 Saving Mean From Meaningless 3 10 Meeting Industry Challenges Head On 7 11 When Unconventional Becomes Traditional 1-7 12 Further Information and Disclaimer 13 Contents O U T L I N E July 2013Contents STEP PAGE
  • 3. Introduction Gurjit Dehl Vice President, Education & Research gurjit.dehl@redington.co.uk Welcome to the third edition of Outline, Redington’s quarterly collection of thought-pieces designed to help institutional investors make smarter and more informed decisions. The next ten pages feature articles on the key topics and opportunities we think institutional investors should be considering as they aim to meet their goals, including a big picture overview of the pensions crisis, the effect of caps and floors on hedging inflation risk, our thoughts on investment grade credit and trend following strategies, and some options for even more unconventional monetary policy. We hope you find the articles interesting and helpful as you consider how best to manage the risk-adjusted return of your portfolios. For more information on any the topics, please do get in touch. Kind regards, Gurjit Dehl OUT LINE 2O U T L I N E July 2013Introduction
  • 4. Pensions is one of the five global challenges we all face; it’s up to us to solve it. The first challenge facing the planet is global security. We are spending trillions of dollars trying to keep the bad guys at bay. Vast resources and effort are being deployed to keep ourselves safe. The second challenge is how to live sustainably; in other words, how to minimise and control the world’s ever-growing carbon footprint. Third, we face a global health epidemic. The four non-communicable diseases – Alzheimer’s, cancer, coronary heart disease and diabetes – are bearing down upon us like a steam train. And the tunnel remains pretty dark. Fourth, is the economy. Since 2008 and the global financial crisis, it has been obvious that the global economic eco-system is fragile and highly unstable. Anti-government protests in Brazil and Turkey are a stark reminder that this thing isn’t over. And finally, the fifth global challenge: inadequate retirement resources – a.k.a. the pensions crisis. We’re living much longer than our parents and grandparents. Some 40 per cent of girls born today will live to be 100 years of age. And, by 2060, the UK expects to have half a million centenarians. But we’re also contracting chronic illnesses in old age, and the cost of being elderly is high and climbing. In London you can expect to pay around £1,700 a week for full-time care for a parent with advanced Alzheimer’s. For the foreseeable future, the government is unlikely to be in a position to provide more than a bare minimum of assistance. After all, it is spending vast amounts trying to safeguard its citizens at home and abroad, keep a badly damaged economy afloat, and maintain the basic welfare of its citizens. Unsurprisingly, the nation’s public finances are in a desperate state. Time is running out. As Rudyard Kipling inscribed on his sundial: “It’s later than you think”. Many pension schemes are following a “Recovery Plan”, but success is far from assured. The markets have done them no favours, and the outlook remains one of continued pessimism. Some recovery plans are founded on assumptions that are beginning to look heroic. Underfunded pension plans are a global scourge: witness the bankruptcy of the City of Detroit. Detroit’s pension shortfall accounts for about $3.5 billion of the $18 billion in debts that led the city to file for Chapter 9 last week. A New York Times article quotes William Shine, a retired police sergeant: “Does Detroit have a problem?” he asks. “Absolutely. Did I create it? I don’t think so. They made me some promises and I made them some promises. I kept my promises. They’re not going to keep theirs.” Not every pension plan faces a Detroit style challenge, but every pension plan does need a strategy to become fully funded. So, what does that look like in practice? Are there particular assets to be avoided and others to be cautiously embraced? How do you measure risk and return? What is the latest thinking on asset allocation and manager selection? To what extent should the liabilities drive the asset strategy? In such matters, it is no longer sufficient to rely exclusively on the pension plan’s investment consultant. In today’s super-demanding and hostile investment environment, it is important for every trustee and CIO to form opinions and views. In my experience as an investment adviser, pension schemes that have prospered during the last decade, have mainly been those at which every member of the board has contributed meaningfully to this critical area: investment strategy. The 5 Global Challenges Dawid Konotey-Ahulu Founder & Co-CEO dawid@redington.co.uk 3O U T L I N E July 2013Overview
  • 5. VUCA – The Acronym Of Our Time For those managing personal or institutional money, the world is becoming more volatile, uncertain, complex and ambiguous. The globalisation of the world economy, combined with the acceleration of technology, means stock, bond and currency markets are more volatile than ever. The 2008 Global Financial Crisis has been followed by bouts of volatility on the back of economic or political bad news like the developments in Greece and Europe and question marks like QE tapering in the US. And the world is more uncertain, too, as a result of rapidly evolving geopolitical systems, rules and regulations that impact the countries we live in, the companies we work for and the markets we invest in. The challenges we face are increasingly complex; the products and services we need to help us solve them are increasing in complexity too. The result of this triumvirate of volatility, uncertainty and complexity is overwhelming ambiguity: the root of the quiet desire to bury one’s head in the sand and hope for better, easier times. Like the old days. These characteristics occur in so many areas of life, and so great are the effects of this concoction of four that the US military even gave it an acronym: VUCA. For us in pensions and finance, VUCA in 2013 refers to: Volatility - equity, bond and currency market volatility; the lack of stability and predictability. Uncertainty - the potential change in the inflation index calculation; the potential switch to “smoothing” for pension funds calculating their recovery plan; the lack of ability to foresee what major changes might come. Complexity - in understanding these financial markets in the era of the “new normal”. The proliferation and increasing complexity of new financial instruments and regulation to deal with increasingly complex markets, moving in ways experts have never seen before. Ambiguity - the resulting feeling. Is this the great rotation from bonds to equities? Or will bond yields stay low for longer? What is the best course of action? The volatility, uncertainty, complexity, and ambiguity inherent in today’s financial world is the new normal. And it is profoundly changing not only how organizations do business, but how leaders lead and how pension funds are managed. The skills and abilities of leaders once necessary to thrive are no longer sufficient or even applicable. Today, more strategic, complex, critical-thinking skills are required of business leaders to counter the effects of VUCA. In fact, what’s needed in pensions is a counter-VUCA: the Vision to imagine and design a long-term strategy that repairs the deficit; one that pulls all stakeholders together and unifies their goal and effort. Then the Understanding of all the options available to pension funds to reach those goals; through education, hard work and diligence, a level of comfort and understanding about complex financial products must be reached in order to capture the opportunities that lead to success. Third, let’s target Clarity in goals, constraints and accountability by using SMART principles in goal setting. And finally, pension funds must, if they are to reach their goals, achieve a level of Agility – speed and efficiency in decision-making; not haste. Together, these four characteristics design a better future for pension schemes, their deficits, and their members’ security. Robert Gardner Founder & Co-CEO robert.gardner@redington.co.uk 4O U T L I N E July 2013Overview
  • 6. LDI: Hedge Your Bets When playing roulette and putting everything on Red, the odds of winning to losing are not 50:50. It is, in fact, 47:53. The odds are always ever so slightly tilted against the gambler. Similarly, if we imagine playing pension liabilities roulette with interest rates, it is not as simple as winning when interest rates go up and losing when interest rates go down. What happens when rates stay flat, right where they are? Typically, the present value of a pension fund’s liabilities is estimated based on the current yield curve and consequently the implied forward rates (red line). Currently, the yield curve is steep implying that the forward rates are higher than the current interest rates (black line), as shown in Chart 1. This means that current yields need to move up as projected by the forward rates, just for the liability value to stay constant. In other words, should these higher forward rates not materialise but simply stay constant, the liability value will rise (assuming other factors remain constant), because discounting happens at a lower rate than expected. Redington’s research has found that the simple situation in which interest rates stay constant translates to an approximate annual increase of 2.5% in pension fund liabilities one year from today. Chart 2 shows what happened in 2012 – short and medium term rates failed to rise as much in 2013 (red line) as was priced in the forward curve in 2012 (dotted red line). With little or no hedging, the expected deterioration of a pension fund’s funding position should rates remain at current levels is what we refer to as the rolldown effect. Roll this up over the ten years or so of the fund’s recovery plan, and this is the pensions equivalent of trying to run up a downward escalator; sweating your assets just to stay in the same place. Now if we factor in market volatility, imagine there’s a guy at the top of the escalator throwing rocks at you. Similarly, when a pension fund is interest rate hedged, the hedge in place would earn the 2.5% carry on the rolldown of the yield curve. A partial hedge would at least lower the incline of the upward climb to full funding. An interesting term called “Financial repression” has emerged recently to describe the current environment with some compelling reasons as to why rates might stay lower for longer. However, as sure as one can be that rates *will* go up again in the future, as John Maynard Keynes once so succinctly put it, “the market can stay irrational longer than you can stay solvent”. Alice Cheung Associate, Investment Consulting alice.cheung@redington.co.uk Chart 1: 2013 Spot v Forward Rates Chart 2: 2012 Spot and Forward Rates v 2013 Actual STEP 5O U T L I N E July 2013 2 Source: Bloomberg, Redington Source: Bloomberg, Redington
  • 7. Inflation Risk: Mind the Cap (and Floor) Protecting members’ benefits from inflation leads to added complexity for pension schemes, even with the RPI-CPI debate closed (for now). UK Pension funds and inflation UK defined-benefit pension funds tend to have liabilities linked to inflation, due to the contractual revaluation of benefit payments for active and deferred members each year, and the annual increases granted on pensions in payment. Historically this risk exposure to (rising) inflation, and inflation expectations, was one of the largest risks facing pension funds, which has over time led pension funds more and more to consider investing in assets linked to inflation in order to best hedge this risk. Enter the inflation caps and floors When a pension fund starts to build a hedge for its liabilities it quickly discovers a subtle but important feature of its liabilities - while inflation itself can (and has) been negative from one year to the next, in a lot of cases the pension benefits that are paid out cannot decrease from one year to the next. In the language of the capital markets, the benefits contain inflation floors at 0%. Most also contain caps at 3% or 5%. Why caps and floors complicate the hedging process The presence of the caps and floors changes the behaviour of the true market valuation of the liabilities, compared to a situation where they are not present. The theories relating to option pricing help us understand how, but the key outcome is that the change in value of the liability will not be quite “one-for-one” with changes in inflation, but somewhat less than one. As a pension fund begins to build an inflation hedge from scratch, this level of detail is not paramount – the most important thing is acquiring more inflation hedging assets. As the hedge becomes larger, and begins to approach (in percentage terms) the scheme’s funding ratio, it becomes important to take this effect into account. Typically pension schemes have three alternatives: (1) Invest in instruments which exactly match the behaviour of the inflation floors (“LPI” swaps) (2) Only invest in “pure” inflation-linked instruments and accept the mismatch between that and the liabilities (3) Only invest in “pure” inflation-linked instruments, and attempt to match the behaviour of the caps and floors – this is often the most popular approach, but requires careful modelling of inflation caps and floors, and hence inflation volatility. While the cost of instruments that precisely match the liabilities has fallen recently, there remains a substantial difference between the implied volatility of the inflation floors, and the realised volatility of the expected inflation rate which schemes can continue to benefit from by using a dynamic hedging approach to the inflation risk in their liabilities. Dan Mikulskis Director, ALM & Investment Strategy dan.mikulskis@redington.co.uk Chart 1: The relationship between inflation- linked assets, and liabilities which have inflation subject to annual caps and floors, is not one-for-one – but a clear pattern emerges Chart 2: The implied volatility of the 0% inflation floor continues to be substantially in excess of the realised volatility of the inflation rate STEP 6O U T L I N E July 2013 2 Source: Bloomberg, Redington Source: Bloomberg, Redington
  • 8. Don’t Discount the Effect of Discounting STEP 7O U T L I N E July 2013 2 Tom McCartan Vice President, Manager Research tom.mccartan@redington.co.uk Changes to the swap discounting methodology have created an additional risk for many pension schemes, thankfully there is a way to understand and mitigate it. There is a new market standard for discounting swaps. Pre-financial crisis, all interest rate swaps were projected and discounted using a LIBOR curve (the reference rate for swap fixings). Following the crisis, market participants realised LIBOR did not truly reflect a risk-free rate. The significant jump in LIBOR versus Overnight Index Swap (OIS) rates in 2007-8 (see chart) was due to fears over the creditworthiness of banks. Market participants realised that LIBOR was not an appropriate rate to discount a daily collateralised swap. Since the mark-to-market movements resulting from changes in swap rates are effectively a fully collateralised loan, LIBOR was never the correct rate to use – swaps are dealt on a ‘secured’ basis while LIBOR reflects ‘unsecured’ bank funding rates. So the market sought a discount rate which more accurately reflected the economics and risks of a swap, ie. its collateralised nature which mitigates credit risk. The new methodology to discount swaps, under a clean Credit Support Annexe (CSA) which permits cash and gilts to be posted as collateral, is to use an OIS curve. This discount rate needs to reflect the collateral terms in the CSA, so a swap that is collateralised daily under a cash and gilts CSA should be discounted on a sterling OIS curve. Why does it matter? Clients who are discounting their liabilities using a LIBOR swap curve want the swaps they buy (their hedge) to match the sensitivity of the liabilities. Under the old methodology, swaps and liabilities both referenced LIBOR so the value of each moved in tandem. The new methodology projects swaps using LIBOR but discounts them using OIS curves. Since liabilities do not reference OIS at all, there is a new basis risk which comes into play, ie. the difference between movements in LIBOR and OIS rates. As the chart shows, this LIBOR-OIS spread has been extremely volatile in times of bank funding stresses. How to mitigate this risk There are a number of things that can be done. Firstly, the scheme has to decide what the risk is and just how significant it is. LIBOR-OIS only becomes a problem when there is a large mark-to- market on the existing swaps. Mark-to-market can be reduced by regular re-couponing of the swap, but there is a cost to this. The risk to the scheme is that if there is another blowout in the LIBOR-OIS spread due to renewed bank funding pressures, the swap’s value will not move in line with changes in the value of liabilities. This would create a divergence between the value of the hedging asset and the liabilities being hedged. As the chart shows, both 2007/8 and late 2011 contained periods where LIBOR was rising (due to an increase in banks’ credit risk) while OIS rates fell (as market priced in rate cuts and priced out rates hikes respectively). Should this occur in the future, the performance of pension scheme liabilities and hedging assets could diverge. Source: Bloomberg, Redington
  • 9. Investment Grade Credit, Or Is It? The tightening of liquid credit spreads means they are no longer attractive against many schemes’ required return to full funding, however, other attractive credit opportunities do still exist. The chart shows how spreads have tightened across the liquid credit universe, which has particularly affected higher credit beta instruments. The hunt for yield in a QE world has led to institutional investors globally chasing the same assets, particularly where the securities offer contractual cashflows with underlying security in case of default. Many assets which seemed to offer “excess” returns have rallied to levels which now discount an awful lot of good news. Examples include investment grade credit, loans, high yield and asset-backed securities. These assets provided handsome returns in 2012, as did most asset classes. Ordinarily, this would have improved all schemes’ funding ratios but the grind lower in real yields meant underhedged schemes saw little improvement in their financial health. Looking forward, the combination of lower expected returns from liquid credit and worsening funding levels means that the return required to reach full funding by a given date will have risen for all but the best-funded of schemes. Effectively, this makes liquid credit unsuitable for many schemes. Alternatives to Liquid Credit For clients looking at suitable credit opportunities, there remain a number of alternatives: 1. Rely on more alpha generation by taking the shackles off your active credit manager 2. Move down the credit spectrum by taking more credit risk 3. Seek increased illiquidity premia by investing in illiquid credit assets Alpha generation (1) may be suitable but it is important not to have unrealistic expectations of the returns achievable. The recent upheaval across all markets makes us wary of recommending more credit risk (2) as the economic climate remains uncertain. Both are viable options but should be assessed against each scheme’s requirements. Illiquid credit assets (3) certainly offer an attractive alternative. They allow investors to lock in returns at more attractive credit spreads, as well as benefit from illiquidity premia which are more than equal to any anticipated alpha generation. The greater certainty of cashflows, often linked to inflation, and a claim on assets in case of default mean institutional investors are taking a closer look at this asset class. Banks have been the natural home of illiquid assets until the financial crisis. For pension schemes with a long-term investment horizon, it is vital to be cognisant of the liquidity requirements to pay members’ benefits as they come due. Before embarking on an illiquid credit allocation, a framework for calculating and spending your illiquidity budget may well make all the difference. pete.drewienkiewicz@redington.co.uk Pete Drewienkiewicz Director, Head of Manager Research STEP 8O U T L I N E July 2013 3 Source: Bloomberg, Redington, Credit Suisse Chart 1: Evolution of Credit Spreads 2004-2013
  • 10. Trend-following strategies’ ability to provide attractive risk-adjusted returns in a systematic way with meaningful diversification benefits can make them an attractive candidate for pension schemes. Trend-following strategies (a subset of the “CTA” or Managed Futures universe) aim to capture the return premium associated with buying or selling assets that are demonstrating a particular price trend, either up or down. These funds are active in the most liquid global markets – equities, bonds, currencies and commodities – and seek to exploit the tendency of markets to trend. As simple as this approach sounds, there are established behavioural reasons why trends exist and why they are likely continue to do so. Assessing the opportunity Over long periods, trend-following strategies have achieved strong performance whilst exhibiting low to negative long-term correlation to traditional asset classes and alternative investment strategies (see table) although correlations can vary over shorter time periods. They have also shown evidence of tail risk protection; strong performance in 2008 demonstrated some of their diversification benefits within portfolios. More recently, returns for these strategies have generally been milder due to the risk-on/risk-off nature of markets, although equities and other risk assets have gained over this period, highlighting again the diversification trade-off. A key focus for most trend-following managers is downside risk control. Many strategies use various techniques to control risk, with volatility targeting being fairly common - a typical volatility target is 10% but anything from 6% to 25% is feasible. Setting Trends By Following Them Karen Heaven Director, Investment Consulting karen.heaven@redington.co.uk STEP 9O U T L I N E July 2013 3 Source: Bloomberg, Redington Trend-following managers use a wide variety of technical signals to guide their trading decisions, with many also using fundamental and non-price data. Compared with a global equity index, over long time periods these strategies have displayed significantly higher excess returns for lower volatility levels and thus better risk-adjusted returns along with more favourable “worst year-on-year” drawdowns. The majority of managers share four traits: 1. Decisions primarily based on technical analysis; 2. Seek to profit from trends in markets; 3. Highly diversified portfolios; 4. Mostly or fully use systematic investment processes. Managers mostly use futures to implement the strategies as futures are very liquid, highly regulated with low transaction costs and they use clearing houses which mitigates counterparty risk. Although fees have been considered high for this type of strategy, we are seeing greater availability of managers at much more competitive fees including, more recently, funds without the performance fees usually associated with them. Like other return-seeking strategies, they do carry risks – how to preserve capital when markets fail to show exploitable trends, and how to minimise losses associated with the ending of trends? To address this, it is important to put in place a robust framework to monitor and mitigate risks.
  • 11. Saving Mean From Meaningless Alexander White Associate, ALM & Investment Strategy alexander.white@redington.co.uk STEP 10O U T L I N E July 2013 3 Let’s open with a question - what is the mean excess return earned by US equities (over short-term interest rates) since 1870? The simple answer is to take the average, which is 5.4%- this is the arithmetic mean (AM). The trouble is, that’s not what you’d have earned. An investment that returned 5.4% excess every year would have earned 7.5 times as much as the equities over the period. The equities earned the same as an investment that returned the much lower 3.9%- this is the geometric mean (GM). Clearly, which you use makes a big difference. What do they mean? The AM of some data points is the sum of all of them divided by the number of them; in context, it is the average of the different returns earned every year. The GM of n data points is the nth root of the product of those values; in context, it is the total return earned over the period, expressed as a constant annual rate. Given n years’ returns r1, r2, ..., rn, then: and To illustrate the difference, suppose a fund doubles in value every year for three years, then goes bankrupt. The returns are then 100%, 100%, 100%, -100%. The two mean return values are: No matter what you earned before, if the fund goes bust the GM will be -100%; it is simply a reflection of what you earned over the whole period, whereas the arithmetic mean reflects what happens in between. Now, consider the following 4 scenarios, with 2 years of returns: Two things become apparent: firstly, the GM is lower than the AM; it can be proved that the GM will always be lower, unless the returns for every year are the same. Secondly, the larger the moves are, the bigger the difference. This leads us to the natural insight that the higher the volatility of returns, the greater the difference between the AM and the GM. In fact, one commonly used approximation 1 is So, for equities with a volatility of around 20%, an AM assumption of 5% is roughly the same as a GM estimate of just 3% (in our example, the volatility was 17.5%, which leads to an accurate GM estimate of 3.9%). As might be guessed, this is one of the biggest causes of difference between quoted estimates of the equity risk premium; without knowing which mean is estimated, the figure is arguably of very little value. Ultimately, any long-term investor should be more concerned with GM returns, since they are what the asset will actually earn. Either way though, whichever you choose, anyone who uses an expected return assumption should be very clear about exactly what they mean. 1 Although other approximations are also used- such as. See “On the Relationship between Arithmetic and Geometric Returns”, Mindlin, 2011
  • 12. The last five years have been difficult for pension funds, and the next five are set to be unpredictable too. The right reporting tools, combined with SMART goals, can meet industry challenges head on. Mountains of the Mind is a report on the pensions industry’s greatest challenges, based on the results of a Redington survey carried out this year. Decision-makers on pension fund boards gave their responses in a number of categories, revealing the items highest on the agendas of those shaping the future of the industry. In the next five to ten years, the greatest challenges they believe they face are: 1. Managing the ‘End Game‘ All pension funds face an end-date and an ultimate goal. Managing progress towards those goals is the greatest challenge on pension fund agendas. 2. Governance and decision making A long-time challenge for pension funds is in implementing ideas and making timely decisions. 3. Deficit funding and management Stakeholders must not only find the balance between investment risk and return but also understand a changing landscape of investment opportunities. 4. Investment returns In an environment of low interest rates pension schemes face the challenge of attaining adequate investment returns to consistently pay future liabilities. 5. Economy Economic conditions have been hard. Pension funds must navigate their way through events like the Eurozone Crisis and Quantitative Easing. Clear objectives, coupled with regular monitoring, can help meet these challenges. In Managing the End game, regular monitoring of scheme performance against long term objectives lets stakeholders act in an agile way, without needing to “take views” on market conditions. Good governance and effective decision-making can be achieved by establishing clear goals, progress towards which is regularly monitored by the board through effective reporting. A set of goals plus a clear idea of a decision’s impact renders decision-making a much simpler affair. Deficit funding and management, the third greatest risk pension funds perceive that they face, is only solved by using the right ingredients for an effective investment strategy. Many investment solutions are available to overcome this challenge, the choice of which is bespoke to schemes; however, it’s only with regular and precise monitoring that schemes are able to grasp the benefit of opportunities on their path towards their goals, and make decisions quickly enough to capture them. Similarly, the challenge of investment returns is only overcome by stakeholders who monitor their required returns to reach full funding so they can take advantage of investment opportunities as and when they arise. Lastly, the challenge of the Economy is faced by checking regularly the vulnerability of the scheme to significant market moves, like those of the Eurozone crisis, by simulating ‘what if’ scenarios and assessing their potential impact on assets and liabilities. Unsurprisingly, pension funds that agree clear objectives, and couple them with objective based monitoring, create clarity and accountability, and post better results. Teresa Ngone Vice President, Investment Consulting teresa.ngone@redington.co.uk Meeting Industry Challenges Head On STEP 11O U T L I N E July 2013 7
  • 13. When Unconventional Becomes Traditional A new governor is in town and there’s talk he is bringing new monetary tools. What’s facing him and what might be in his toolkit? The new Bank of England Governor has arrived. Mark Carney’s first meeting of the MPC left a fairly clear message – markets were pricing in rate hikes far too soon. Interest rates fell across the whole curve, giving back some of the gains following the Fed’s over-hyped taper talk (the US is looking at slowing down the amount of purchases, not stopping or reversing them just yet). Market reaction to the surprise UK and US central bank statements were significant, highlighting the fragility that still underlies the rise in both equity and bond markets in recent years – talk of stimulus and both markets rally, talk of taking stimulus away and they both sink. Is the economy on the road to recovery? Positive signs for the UK include renewed expansion in manufacturing, house prices displaying a recovery, current rates being supportive of growth and borrowing. There are also some headwinds, such as renewed austerity policies, negative real wage growth, political and economic issues in Europe and the Middle East, Chinese slowdown fears and current rates reducing the profit margin on lending activities. Trying to predict what’s going to happen is a near impossible thing. There are just too many variables from both home and abroad. The economy may turnaround, so long as rates do not rise too far too fast. Expanding the unconventional toolkit If current monetary tools are unable to revive growth, the new governor might well consider the following: - Forward guidance: it seems likely this will begin in August, with the ECB also looking to follow the Fed’s lead in providing guidance - Reduction in base rate: 6.25% reduction in the base rate since 2007 has helped but not cured the economy, still, there’s 0.50% left - Negative deposit rate: If printing new money did not work existing cash piles could be put to use by charging those leaving cash on deposit, encouraging cash holders to invest and not hoard - Overt Monetary Finance: QE but on a permanent basis, for example, by sending principal as well as interest receipts to Treasury - Widen scope of QE assets: Extend purchases from gilts to corporate bonds or asset-backed securities, potentially even equities - Cancel the debt: If all else fails the BoE could cancel the amount owed to them by Treasury, with QE money left with banks. Implication for pension funds The economy is far from out of the woods. Policymakers may have taken their foot off the monetary stimulus accelerator but it still too early to apply the brakes. Mean reversion in rates is not a sensible strategy to rely on to repair funding deficits. Deflationary threats still lurk despite the continued above-target inflation prints. Unless growth turns around soon, the biggest danger is that we move from a low yield to no yield world. Gurjit Dehl Vice President, Education & Research gurjit.dehl@redington.co.uk STEP 12O U T L I N E July 2013
  • 14. If you would like more details on the topics discussed, please contact your Redington representative, the author or email enquiries@redington.co.uk Stay up to date with our latest thinking www.redington.co.uk Download the Red App More Redington Publications Disclaimer In preparing this report we have relied upon data supplied by third parties. Whilst reasonable care has been taken to gauge the reliability of this data, this report carries no guarantee of accuracy or completeness and Redington Limited cannot be held accountable for the misrepresentation of data by third parties involved. This report is for investment professionals only and is for discussion purposes only. This report is based on data/ information available to Redington Limited at the date of the report and takes no account of subsequent developments after that date. It may not be copied modified or provided by you, the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipients to any other party without Redington Limited’s prior written permission except as may be required by law. In the absence of our express written agreement to the contrary, Redington Limited accept no responsibility for any consequences arising from you or any third party relying on this report or the opinions we have expressed. This report is not intended by Redington Limited to form a basis of any decision by a third party to do or omit to do anything. “7 Steps to Full Funding” is a trade mark of Redington Limited. Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is a company authorised and regulated by the Financial Conduct Authority and registered in England and Wales. © Redington Limited 2013. All rights reserved. RRRRR 13O U T L I N E July 2013Further Information and Disclaimer