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Last year produced a pretty mixed bag of results for pension funds. Overall, the results turn out weaker than in the previous years but they vary a lot between pension schemes. Volatility in financial markets has strongly increased. The Vix index, for example, has moved from levels around 10 to 20-30. Not only asset returns but also liability valuations of pension plans are on a rollercoaster, as their discounting factors are swinging around with market rates.

 

Volatility

Investors were initially unimpressed by the problems in the US sub-prime sector. Yet in the first months of 2007, financial markets believed in the continuation of the ‘goldilocks scenario’ with stable economic growth. Liquidity was abundant, fuelled by the excess supply of the monetary authorities for half a decade.

In spring, however, inflation worries took the upper hand. That development was interrupted by the news from the US mortgage sector, leading to a liquidity squeeze in the financial sector in summer and a more widespread credit crunch in the autumn.

Central banks reacted with liquidity injections but struggled to find accord on how to best respond. Not surprisingly, the US Fed cut its rates most aggressively, by 1%, last autumn. At the other extreme, some emerging countries, most notably China, continue to hike rates to counter overheating.

The ups and downs in consensus opinion also push the bond markets around. The US long bond yield, for example, has moved from peaks over 5% and troughs below 4% in the last half year.

One of the most striking features of the new investment environment is the substantial widening of credit spreads, even in the money markets. There are wild gyrations also in other markets, such as commodities with gold rising to $800 and oil to $100. The US dollar fell to new lows of nearly 1.50 against the euro.

 

Second round effects

The majority of European pension funds escaped the negative first-round effects because of low exposure to US mortgage-related securities. That brought some relief to trustees, but the second-round effects in the financial markets are being more strongly felt, in particular, through higher credit spreads, even for good quality.

There are also enormous performance differentials in the equity markets - for example between financials/property-related stocks versus commodity stocks; small caps versus large caps and developed versus emerging markets. The performance of pension funds varies a lot not only depending on their asset mix but also on the specific exposure within asset classes.

Given the volatility of asset prices and currencies, it is not easy for pension fund boards to keep a clear view on the bigger picture. Nor is there much agreement among strategists about the medium-term expectations.

The deflationary camp predicts a continuation of the credit crunch. The loss of trust between banks, and towards banks, is more damaging the longer is lasts. They see the real estate crisis spreading to the UK, Spain, Ireland and beyond. The US is moving into a recession and this will lead to a global economic downturn.

The inflationary camp expects the troubles in the financial system to be temporary and any spillover into the real economy to be limited. Furthermore, BRIC and the energy-exporting countries are now strong enough to weather the storm. The major risk is central banks cutting rates too aggressively to help the bankers, thereby putting the seeds for more dangerous inflation in future.

 

Third round effects

Most international bodies, including the IMF and OECD, only forecast a mild slowdown of the global economy, but their list of risks and caveats has become longer. First the sub-prime crisis, then the troubles in the financial system, now the worries about the business cycle. Is there a third round of risks, working through to a much wider contagion of the world economy?

q Stagflation: As if things were not confusing enough, an unloved friend of the 1970s is re-emerging on the scene: stagflation. Even some European central bankers have started to talk about inflationary and contractionary forces being at work simultaneously.

q Politics: Another risk is clearly political. In the face of voters’ problems with debt repayments, the temptation for populist interventions is high. At the same time, food prices (and energy) prices are rising strongly, and this has never been popular with folks.

q Currencies: The US dollar has almost halved its value against the euro since 2001. The effect on pension fund performance varies, of course, on net exposures and hedging policy. Could the trend be reversed in the coming years, or will the euro remain on a structural uptrend?

At the turn of the year, there is a lot to discuss for pension investment committees with their fund managers. The focus has so far been mainly on bonds and equities, but it will increasingly turn on other asset classes that are valued differently, and where there is often less experience within pension plans.

Real estate. Property has been one of the most rewarding asset class in recent times, certainly in risk-adjusted terms. In fact, many pension funds have increased their allocations to property, or intend to do so. However, price expectations now seem to be changing fast, at least in some market segments.

Property has been one of the most rewarding asset class in recent times, certainly in risk-adjusted terms. In fact, many pension funds have increased their allocations to property, or intend to do so. However, price expectations now seem to be changing fast, at least in some market segments.

Private equity. Conditions for debt finance have significantly changed. Pension boards are interested to learn from their (fund of) fund managers, how their buyout and venture capital holdings are affected. Have the long-term prospects for private equity changed?

Conditions for debt finance have significantly changed. Pension boards are interested to learn from their (fund of) fund managers, how their buyout and venture capital holdings are affected. Have the long-term prospects for private equity changed?

Derivative strategies. Wide and volatile spreads in money markets strongly affect the workings of derivative markets. Difficulties for pension funds arise in a number of ways, for example when setting up swaps-based LDI structures, or via ‘absolute return’ products that are structured around capricious LIBOR rates. Need to re-think?

Wide and volatile spreads in money markets strongly affect the workings of derivative markets. Difficulties for pension funds arise in a number of ways, for example when setting up swaps-based LDI structures, or via ‘absolute return’ products that are structured around capricious LIBOR rates. Need to re-think?

Commodities. Commodity prices have risen strongly in recent years. However, the path has been very uneven. What is the experience with the investment approach to commodities of your pension fund? Is the benchmark and diversification right?

Commodity prices have risen strongly in recent years. However, the path has been very uneven. What is the experience with the investment approach to commodities of your pension fund? Is the benchmark and diversification right?

Risk premia. In the bull market over the last years, investors accepted unusually low risk premia for their investments. More and more money was chasing smaller and smaller spreads for taking additional risks, in particular credit and illiquidity risk. More than one warning shot has now been received.

In the bull market over the last years, investors accepted unusually low risk premia for their investments. More and more money was chasing smaller and smaller spreads for taking additional risks, in particular credit and illiquidity risk. More than one warning shot has now been received.

Historic statistics, credit ratings and quant models may not necessarily provide a good guide for the future. Even so, crises tend to produce good opportunities for long-term investors: are pension funds still able to capture them?

Georg Inderst is an independent consultant based in London

(georg@georginderst.com)

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