The passing storm

Marek Handzel looks at how commentators view the current financial crisis and where trustees, still brave enough to look at equities, may find value

These are testing times for those in charge of pension scheme investment. The bear market that has decimated equity portfolios across the board does not appear to have quite shown us yet when it will reach its bottom – despite some short-term rallying after notable world events – and a global recession, having been talked up ever since the sub-prime crisis exploded, is now a reality. And it's not just equities that have suffered, all correlated asset classes have been hit by the volatility to a certain degree.

According to Standard & Poor's, world equity markets registered their worst month in history during October, with the index provider calculating that investors lost $5.79 trillion – the "worst ever month for global equity markets in modern history" said Howard Silverblatt, a senior index analyst at Standard & Poor's. Alarmingly, this came after the implementation of central bank rescue packages which, by all accounts, kept the financial system alive. The crisis is so deep that the Pensions Regulator decided to release a statement last month to trustees, many of whom are in a quandary, in an attempt to reassure them and put the global financial problems into context for schemes.

What's more, economic downturns that follow banking crises are, according to the International Monetary Fund (IMF) at least, usually longer and more painful then those not driven by breakdowns in the financial system.

In a rather bleak assessment of what the financial markets have in store for institutional investors in 2009 and possibly beyond, Keith Wade, the chief economist and strategist at Schroders, believes that two main factors can account for the fundamental weakness in global markets.

The first is what Schroders have called a "continuing lack of visibility" which has left the credit crisis looking like a "slow motion train wreck", with investors clearly able to identify the damage that is being done, but unable to see when it will all end. The second is market dislocation. As Wade explains, hedge funds are losing out as borrowing is reined in and asset disposal is weighing heavily on the markets. He says that this probably means better times ahead for the long-term investors such as pension funds once selling diminishes but warns that "there is a danger that falling prices cause others to start to sell either because they have hit levels at which they are obliged to reduce their holdings, or out of sheer panic".

Eying up opportunities in well-managed companies is the name of the game of course, but the wait for them to produce some substantial fruit for investors may take some time in the current climate. In the UK, many predict that the recession will be worse than the one experienced in the early 1990s. Chris Iggo, CIO of fixed income at AXA Investment Managers has suggested recently that GDP contraction could even reach the six per cent sort of levels seen in the 1980s as Thatcher set about re-structuring the country’s manufacturing base.

"The economy is likely to contract for several quarters before anyone can point to green shoots of recovery," says Iggo.

This has all led to UK pension schemes dropping their equity allocation levels. A recent survey carried out by Baring Asset Management has revealed that overall allocation to equities has decreased to 53.4 per cent, more than a ten per cent drop from last year. Pension funds taking part in the research also appear to be wary of global equity markets, with only five per cent stating that they planned to increase their allocation to equities over the next 12 months.

So although many managers remain optimistic that they can find value in the UK and nearby, such as Artemis (see pp32-33), all this means that investors may want to look elsewhere to build up some decent returns in 2009, given the smaller amounts of assets they are now working with.

Emerging markets
One area where optimism remains in large sections of the investment community is emerging markets. Gary Dugan, CIO of Merrill Lynch Global Wealth Management, points to a commodity price drop as a good reason to put faith in the BRIC countries as their governments would be able to reduce interest rates and help try to
re-create demand.

"In the short-term investors can buy UK or European equities and expect a return above ten per cent when markets recover. And they can get this without going further a field to emerging markets they understand less well," says Dugan.

"But in the medium and long-term the major emerging economies of Brazil, China, India and Russia will remain the engines of global economic growth. Even today we are seeing the Chinese government acting to maintain momentum with reducing interest rates, tax cuts and infrastructure spending. Russia has the potential to rebound strongly when equity markets there settle, and India and Brazil have huge emerging middle classes."

Wade's colleague, Allan Conway, head of emerging market equities at Schroders, agrees. He says comfort for those invested in the emerging markets can be drawn from the fact that the sector does not share a de-leveraging problem with the developed world.

As a result, he says the major problem they have to overcome is that of liquidity which he sees returning quite soon: "The outlook for emerging markets looks favourable given their strong fundamentals. Even though earnings forecasts are expected to be revised down emerging markets are attractively valued. Once the volatile market conditions we are experiencing settle down, we would expect to see emerging markets outperforming."

This view is shared by UK pension schemes, if the survey carried out by Baring Asset Management is to be believed. The firm found that trustees see emerging Asia as the region for the biggest potential for equity gains over the next ten years, with 65 per cent of the schemes polled saying that they had highlighted the area.

Marino Valensise, chief investment officer at Barings said that the findings were not a surprise, given that strong domestic demand and continued infrastructure spending would almost certainly help the economies there continue to grow.

BlackRock's fourth quarter investment outlook report, however, suggests that rushing into emerging markets is not perhaps the best policy. In it, the company states the long-term case for emerging markets remains strong but that it believes the "area will continue to struggle until there are clearer signs that the growth slowdown is bottoming out."

Recovery
So how long do pension funds have to wait until we see signs of a genuine revival in global markets and economies?

As far as Paul Niven, head of asset allocation at F&C, is concerned, the end of this crisis will only come once the banking system returns to a 'normal' status.

"We believe that policymakers globally are making the right steps in terms of what is required to restore confidence and unblock critical money markets," says Niven.

"More, however, is required, and in the short-term we are likely to see further cuts in global interest rates. It is our belief that authorities globally will go as far as is required to address the malaise but will now likely have to inject greater amounts of capital into banks than originally intended and take more direct control of banking operations."

AXA's Iggo says that the appropriate moves needed to stimulate a recovery have nearly all been taken, at least in the UK. He points to the Bank of England's monetary interventions, the Government's Keynesian-inspired economic salvaging plan and the lowering of interest rates as evidence that almost all that could be done, has been done.

"Yes, banks might not be paying dividends," says Iggo, "but buying a well diversified portfolio of stocks today may not be a bad idea if investors have the strength to stomach what could continue to be a lot of volatility."

- Pensions Age November 2008