There is a “meaningful” risk that Brexit negotiations will be unsuccessful, but pension schemes should be able to gauge this and react to the likely outcome, according to BMO Global Asset Management.
In the asset manager’s latest quarterly liability-driven investment (LDI) survey it asked investment bank derivative traders for their views on the probability that the UK and the European Union would fail to reach a deal on the former’s departure from the EU within the two year timeframe for negotiations.
The average view on the probability of a “no deal” outcome was around 40%, although views were spread across a range of 5%-100%, according to the asset manager.
It said this emphasised how much uncertainty there was in the market.
Rosa Fenwick, LDI portfolio manager at BMO Global Asset Management, said: “The risks of the UK failing to get a deal within the two-year window are meaningful.
“A transitional deal may be agreed but, given the political atmosphere, it is unlikely to morph into a permanent solution. The progress of the negotiations should be fairly well signposted though, giving time for pension schemes to react to the likely reality.”
Pension schemes could mitigate risks in several ways, she said.
One response could be to diversify risk assets away from the UK and Europe, and increase or accelerate hedging to reduce the volatility of liabilities.
A weakening of sterling could be positive for pension funds holding overseas assets, she said.
Pension schemes could also consider downside or tail-risk protection while it is available at relatively attractive prices, Fenwick added.
The asset manager’s LDI survey found that absolute hedging appetite fell over the second quarter of 2017. It attributed this to the surprise outcome of the UK election in June and a lack of index-linked Gilts available.
Total interest liability hedging activity fell by 18% to around £24.5bn (€26.9bn), while inflation hedging activity by 14% to around £21.3bn.
The majority of the quarter’s activity was in hedging using bonds either outright or by switching out of swaps, according to Fenwick.
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