Risk On? Maybe Not For Much Longer

The recent equities rally could come to an abrupt end, according to some banking analysts.

(February 4, 2013) — A lack of positive data from the United States and other large economies could see the recent equities bull run hit a brick wall, analysts at Societe Generale said today.

The French bank’s team said US equity rally had been impressive – the S&P500 rose 5.4% in January – given the slow pace of the economic recovery.

Some market commentators had been predicting – and even announcing – the “Great Rotation” of investor sentiment over the last few months. A surge towards equities in the first weeks of the year helped to propagate the idea as equity markets rose on the inflows.

However, the note said: “Fourth quarter GDP contracted by an annualised 0.1% [quarter-on-quarter], while sales forecasts remain weak and earnings growth has slowed down since summer 2011. With the lack of positive economic data, the S&P500 looks overvalued and therefore the ‘risk on mode’ could come to an end in the near term.”

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The analyst note said the risk of a Chinese “hard landing” had dissipated, which was helping to fuel confidence in equity markets. But at the start of the second quarter investors should be ready for the nation’s recovery to slow and impact markets more generally, the note said.

More positively, Jim Reid, global markets strategist at Deutsche Bank, said the encouraging start to February had been boosted by other economic signs in the US.

“US equities began the month of February on the front foot as the Dow Jones (+1.1%) closed above 14,000 for the first time since 2007 and the S&P 500 (+1.0%) forged new post-financial crisis highs,” Reid said.

This was due to positive news on non-farm payroll numbers, he said, but added that more generally unemployment had edged up to take the sheen off the day’s achievements.

Both banks’ analysts were relatively positive on the movement of the Eurozone, though Reid highlighted potential political issues in some of the countries that were struggling with their debt burdens.

Related story: Risk Averse Pensions Open Doors for SWFs.

Longevity Hedging Risk: One Area the Market Fails to Deliver

Despite aging populations, the market for longevity risk products is underdeveloped, according to a study.

(January 31, 2012) – Hope is poor strategy for pension fund managers to rely on when faced with any risk, whether tail, interest rate or inflation, but perhaps especially so with longevity. 

An interdisciplinary study by four researchers, including finance and accounting specialists, has compared the two most common longevity-hedging strategies in the context of defined benefit pension plans. The ground-up hedging strategy transfers a portion of all future retirement payments, often in the form of a bond. 

Excess-risk hedging, in contrast, involves offloading longevity risk at a certain level. The most prominent example of the latter occurred in 2008, the insurance company Canada Life orchestrated a “survivor swap” with owners of insurance-linked securities. The researchers used historical data and a model to determine the optimal approach to longevity hedging for DB plans specifically, considering both cost and risk. 

Their conclusions, based on how pension plans have used the strategies and how they could optimize them, called for better options: “First, the market should design appealing longevity securities that can attract pension plans. As our results indicate, the pension plans are inclined to transferring more longevity risk with the excess-risk hedging strategy since it is less capital intensive and more cost effective.” 

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Again, unlike most other risks facing pension funds, the authors argued that insurance companies and asset managers are failing to provide sufficient products to defray risk. Those that are available, are simply too expensive to justify. “The current high transaction costs in the capital market discourage the plans from transferring longevity risk,” the authors wrote. “This problem can be mitigated by standardizing longevity transactions. For example, we can promote consistent best market practices and publish tradable longevity indices. Such efforts will provide greater transparency and confidence for this market, and increase transaction activity.” 

Longer life spans are posing an acute problem in Japan particularly, which has both an aging population and widespread pension coverage. 

Read the whole article, “Managing Capital Market and Longevity Risks in a Defined Benefit Pension Plan,” here.

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