The latest meeting of the Bank of England’s Monetary Policy Committee marks six years of a record low Bank Rate of 0.5%. Market pricing and economist expectations both suggest this will remain in place for a little longer and potentially much longer, with inflation below target, the risk of deflationary pressure spilling over from the Eurozone, and uncertainty about the interplay of the Bank Rate with the stock of bonds purchased under quantitative easing.
Since the nadir of the financial crisis, pension funds have benefited from strong performance on most assets. By contrast, the outlook for expected returns has fallen dramatically. In equities, we anticipate returns of 5% to 8% over the next five years (chart attached), compared to typical realised returns of 15% to 20% since the heart of the financial crisis. For the long dated bonds used to discount and match most pension liabilities, market pricing implies that yields will not settle above 3% at any point in future. We expect yields to increase faster than expected by the market, though the considerable demand relative to the supply of government bonds will limit the extent of this.
For pension funds searching for yield and growth, these market dynamics will require a shift away from traditional fixed income and equities and into an increasing opportunity set of alternative income generating investments that offer higher potential returns, such as property, infrastructure, renewable energy, alternative credit and private lending. Pension funds seeking to extend their hedging at attractive yields should ensure that they are positioned to exploit any short term yield opportunities, with any trigger levels set appropriately. Swaption strategies have recently been an attractive way to combine this view on yields with a desire to hedge.
High yield and emerging market debt have more attractive valuations than high quality bonds, relative to their history, and we are positive on these asset classes over a medium-term time horizon. However, investors need to be mindful of the additional default risk and volatility this may entail.
In an environment where low returns are expected to be the norm, successful active management can also contribute a greater proportion of the returns required by pension funds. Greater divergence in monetary policy, differing impact from the dramatic oil price changes and a wide variety of structural and social deviations across geographies offer opportunities for dynamic multi-asset strategies and alternatives.
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