DON'T OVERDO THE GLOOM
I last blogged two weeks ago under the headline ‘Two weeks is a long time.’ After two weeks of living under lock-down, I could say the same but in a different sense. Most of us are being good citizens, and we are all getting used to the ‘new normal’ of seeing little other than the walls of our house and video-conference screens. But it already seems like we’ve been doing it for a long time. And, of course, we are beginning to turn our attention to how we should react to the extraordinary events of the last few weeks. For pension funds the challenges are primarily about income and strategic allocation. Taking the second first, actuarial valuations are by statute done on a prudent basis. That means that the economic recession which is now inevitable should not of itself trigger a change in strategy. Downturns are part of the economic cycle and actuarial assumptions cater for them. It becomes trickier if the global economy does not re-start as governments are hoping, and the recession extends into a period of zero or negative nominal growth. We are now seeing some signs of a return to normality in China in terms of power usage in particular but the process of economic recovery is more akin to growing vegetables than flicking a switch. It takes time, requires some patient nurturing, and can be thrown off course by weather or pests. If the recession does turn out to be more L- than V- or U-shaped, governments will perforce end up supporting and paying for a much larger part of the economy. In turn they will want greater control. We are already seeing an element of dividend controls, for perfectly respectable reasons of course, but it is still a retreat from the market capitalism which has created such prosperity. And it could be much more invasive, again for entirely plausible reasons: trade restrictions, currency controls etc. It is far too early to predict that this is the future but this is the pessimistic scenario investors need to concentrate their thinking on because unlike other outcomes it will require a change in strategy. The lesson from Japan in the period 1990-2012, unpalatable though it may be, is that returns from most assets would be very low indeed. Japanese pension funds were able to make good returns from bonds, as Japanese Government Bonds yielded more than 7% in late 1990. With 10-year gilts yielding below 0.4% there is no such get-out-of jail card for western pension funds today. On the income front, the immediate problem is that, across a range of asset classes, income which had been confidently expected and earmarked to match outflows is now not going to arrive. Our estimates are that UK equities will see a fall of around 50% over the next 12 months, global more like 30%. Real estate funds in aggregate will receive between 50% and 60% of their first quarter income, though of course there will be wide variation depending on sectors. Corporate bonds, particularly BBB and below, will see substantial defaults. Companies were probably paying out too much before, so in some ways this is a needed re-set of yield levels. But that doesn’t make it more palatable to pension funds. And, going forward, many companies will rightly focus on reducing leverage before paying out dividends, so it is likely that future increases start from the lower base. Any investor who relies on income will again need to review their strategy in the light of this. Let me finish on a more positive note. Data from our friends at CrossBorder Capital shows that investor sentiment has sunk well below the levels reached after the Global Financial Crisis. They are the lowest since monitoring began in 1978. Historically that has been a crucial contrarian indicator indicating that the risks in purchasing equities are far outweighed by the potential rewards. And we know that the fiscal stimulus, particularly in the UK and the US, is truly unprecedented in scale. While it is important to consider the pessimistic scenario outlined above in considering long term strategy, it is equally important not to over-do the gloom. After wrong-footing investors on the downside over the past few weeks, it is very like Mr Market to do the same on the upside.