(April 30, 2013) — Given JP Morgan Asset Management’s (JPMAM) assessment that QE cost pension schemes 16% in terms of their solvency, it follows that when QE is eventually unwound, scheme funding will receive a boost.
While clarity on when QE will be unwound in the UK is still anyone’s guess, JPMAM told reporters some of its better funded clients were already moving to a more risk-on position, so as to receive a greater benefit when it happens.
But what if you’re not in a position to take on more equities? And what if you don’t believe that QE will unwind anytime soon, and that actually, QE is more likely with Mark Carney‘s inauguration at the Bank of England (BoE) this summer?
QE3, or not QE3 – that is the question
James Klempster, portfolio manager at asset manager Momentum GIM, is among the many concerned about Carney’s influence. “He brings a history of being active and introducing measures to boost economic growth,” Klempster says.
“We expect, if necessary, he will pull the trigger (and introduce further easing). We should consider the political background too: we’re two years away from a general election, and while stressing the independence of the Bank of England, there will be a lot of pressure on them to get the economy in good shape for 18 months’ time.”
John Redwood, former director for NM Rothschild, an economist and current chairman for the Conservative Economic Affairs Committee, also believes the UK is unlikely to start unwinding QE soon, especially now Japan has announced a further major program of asset purchasing.
Even the European Central Bank is edging towards easier money, and with the UK’s new Bank governor in the offing said to favour easier money, it is more likely to ease further than to tighten this year, he tells aiCIO.
“Since the UK first lost its AAA credit status, yields on government bonds have fallen, not risen. Any new phase to the Euro crisis would attract more hot money into UK and US government bonds, away from the Euro area,” Redwood continues.
“Pension funds therefore face a cruel dilemma. On the one hand they know their liabilities are likely to remain inflated for longer by calculations based on very low UK bond yields. On the other they are worried that UK government bonds yielding less than 1.7% for 10 years do not offer a big enough income to meet future pension liabilities, and also pose a risk of capital loss.”
A strategy of diversified investments capable of generating a decent real return should be sought, Redwood says, but with future pension payments rising in relation to prices or earnings, low yielding conventional bonds do not match the actual liabilities.
“Shifting a pension fund’s investments into more bonds to match the bond element in the liability calculation would seem a risky investment thing to do. While there is no obvious end in sight to QE or very low rates, history tells us that these low rates are unusual in the UK, creating future capital risk.
“Buying corporate bonds that yield more than government bonds does not give a fund a lot of protection once government bond yields start to rise, though the extra running income is helpful. Property may prove to be a better asset for pension funds in these circumstances, as long as the properties are well located. The aim is to find property investments that give investors access to rising income from higher rents in well located, good buildings and international centres.”
Frances Hudson, global strategist at Standard Life Investments, told aiCIO in an ideal world where pension funds had the freedom to choose, risk assets would be a good option, but “most schemes don’t have that freedom”, thanks to pressures from Solvency II and an ageing closed DB population resulting in glidepaths pushing CIOs into bonds.
“There hasn’t been much pain associated with holding bonds as they’ve performed well recently, but I don’t know if this is a sustainable position,” she says.
“Real estate has become popular, but you have to be incredibly selective about it. The real message coming through from our real estate managers is that the returns are primarily income, not capital.”
Can we prepare?
Whatever happens in the short-term, most are of the consensus that QE will be unwound at some point. Mark Allan, senior economist at AXA Investment Managers, was one of the few to tackle a possible date for fiscal tightening.
“Given the weakness of the economy, we believe tighter monetary policy is a long way away — 18 months ahead is the earliest possible conceivable date,” he tells aiCIO.
“Sometime in 2015 is significantly more likely, and 2016 cannot be ruled out. We would not expect the BoE to start to shrink its balance sheet until at least nine months after it begins raising interest rates.
“Carney has been pretty clear that he believes monetary policy should be looser. Most of the attention has been on commitment strategies, but more QE later this year is certainly not impossible: perhaps a 1 in 3 chance.”
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Shedding some light on how schemes might be preparing, Stefan Dunatov, the chief investment officer of the Coal Pension Trustees Investment, believes what truly matters is not whether QE is unwound, but why it is unwound.
EU, UK, and US central banks are clearly going to do all possible to ensure inflation expectations and inflation outcomes stay positive, but when an economy has weak output growth, there is a good chance of QE being larger for longer, he says.
Central banks know how to deal with inflation: unwind QE and raise interest rates, but central banks can afford for inflation expectations and outcomes to drift upwards for quite some time before having to take action — the risk for schemes is they mis-time the QE reduction and interest rate rise and that higher inflation becomes a problem.
The implication of this is that QE is only going to be unwound as a reaction to increased inflation outcomes, as opposed to expectations, which are caused by two things: a substantial demand jump or substantial supply shock, such as an oil crisis.
“Supply shocks are not on the horizon — these are most likely to appear from a political crisis, such as the current Syrian civil war spilling over into neighbouring countries. So you are left with a significant demand jump — which is precisely what QE is aimed at generating,” says Dunatov.
“There is an in-between scenario, where supply is slowly ‘eaten up’ by poor productivity and slow supply-side destruction, but this is unlikely, in my view. This means that you can end up with a very constructive view on growth/risk assets, especially if they are bolstered by attractive valuations. Preparing for QE withdrawal means owning these already.”
There is a scenario whereby QE could be gently unwound though – and it’s doesn’t necessarily need inflation to run wild for the BoE to turn the taps off.
Momentum’s Klempster believes it’s naïve to assume the BoE’s primary focus is deflationary worries. “You could see inflation stay where it is now, and QE still be unwound,” he says.
“QE is a harness – if the need for it reduces, if there’s less of a risk of poor GDP and poor growth, if the economy starts to recover on its own, the corporate sector will become more confident.
“That leads to more mergers and acquisitions activity, more recruitment and more growth.”
To prepare for each eventuality, Klempster reports a surge of defined benefit schemes entering into multi-asset arrangements and diversified growth-type fund ranges, which adjust their risks on the basis of what’s attractive as well as increasing diversity.
“British schemes used to be very UK-centric — now we’re witnessing an explosion of multi-assets,” he adds. “A lot of diversified growth fund managers are reducing their durations to take account of the extreme volatility highs at the moment too.”
The consensus seems to be that January 2015 will be a key date for UK CIOs diaries. Economists agree this is the earliest we might see meaningful signs of recovery, and with a general election a mere six months thereafter, you can bet Carney will be under pressure to act if it isn’t.
Related News: Did UK Pension Funds Pay Too Much For QE1? and Japan Moves the Needle on QE