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Negative rates don't suit everybody

Friday, 6th September 2019 07:23 - by Shant

These are tough times to look ahead for any fund manager, and no more so than for those mandated to pension funds who are dictated by liability-driven investments.  In the current economic climate, central banks across the world look set to embark on a concerted program of fresh easing, with a mutual task of trying to bolster growth and inflation.  The latter is a double-edged sword for pension funds, but with nominal yields dropping into negative territory like lemmings, attractive income-driven investments are dwindling by the day. 

 

This goes in part to explain the trajectory of the bond market rally in the last 6-9 months - a period when the US 10 year Note has seen its yield plummet from a peak of 3.25% (in October 2018) down to circa 1.50% a few weeks ago.  It did not escape my attention that either side of the new year, certain market pundits were warning of a rush to import attractive yields and despite stopping ahead of ideal 'normalization levels' (from a central bank perspective), a sudden bout of realization within a global context saw market participants from all quarters piling into US fixed income.  

 

For pension funds, regulatory pressures have somewhat forced their hand in continuing the purchase of fixed income products, with cash flow requirements forcing regulators to insist on investment levels in cash and liquid securities.  Once again, this all backs up the price action seen in recent months, and may well have been instrumental in the broader shift into negative real yields.  This is where the problems lie and a widening of the spread between nominal yields and inflation prompts further expectations in a subsequent widening in funding deficits.  

 

In contrast, equities have realized some very impressive gains over the longer term.  Over a 100 year period, the annualized rate of return for US equities has exceeded 10%, well over half that of government bonds.  However, a peak in the economic cycle has also led to a de-risking process which has reduced their exposure to equity markets, alongside prudential regulating, adding to the flow into bonds, further leading to the subsequent collapse in yields.  

 

Aging populations and lower birth rates further add to the income/liability mismatch, though as with the current dynamic in global interest rates, fund managers seem comfortable - for now - to accommodate for underperformance in the near term.  Historically, this has worked out well in what have been well-patterned business cycles, but there is a fear that since the actions in the aftermath of the 2008 financial crisis, policy direction has veered the global economy of the future into unchartered waters.  

 

One can argue that central banks have little choice but spur growth with monetary policy directives as seen over the past decade.  However, there is an unnerving inevitability in the level of correction in equity market valuations which is an inescapable function of mean reversion.  The question is whether this will be, and to what degree this will be  compounded by central bank action.  Asset purchases out of Japan have long been a contributing factor in the resilience in US stock markets - I have spoken about this before - so it is now a question of whether their counterparts in Europe and North America go down the same road.  If so, then policy normalization could be a long, long way off, and this is something that pension fund administrators will be monitoring and discussing from some time to come.

 

 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.

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