Investor concerns over the possibility of an economic slowdown, triggered largely by low oil prices and the Chinese stock selloff, weighed heavily on global equities in January. This led to negative equity returns for UK pension funds, but UK asset valuations nevertheless rose as bad stock performance was more than offset by falling government bond yields, boosting fixed income performance. Moreover, currency effects mitigated losses from unhedged investments in certain overseas indices (e.g., MSCI World) as the US dollar and the euro appreciated against the pound sterling. Despite this increase in assets, falling yields caused a more substantial increase in liability valuations for UK pension funds, thereby resulting in lower funding levels.
We believe that volatility and low returns will remain a significant concern going forward. As markets continue to second guess the policy actions of the People’s Bank of China, the European Central Bank and the Bank of England, we anticipate that we will experience more frequent episodes of heightened volatility, changes in correlations and intermittent liquidity. This places greater emphasis on effective risk management and achieving an optimal allocation across assets. The increased interest rate volatility over the recent months reiterates the potential impact of inadequately hedged liabilities and the importance of liability hedging to manage interest rate and inflation fluctuations. We suggest that investors with low hedge ratios should plan a hedging programme that is not solely dependent on improvements in current conditions.
In this environment of low returns, illiquidity premia and active management can both provide valuable incremental returns with a different risk profile to traditional listed assets. We believe that private assets such as real estate, infrastructure, mortgages and private equity can add material illiquidity premia. These additional returns reward a long term approach, where pension funds have an advantage relative to many other investors.
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