Surviving the QE roller-coaster

With so much discussion within the Local Government Pension Scheme (LGPS) about governance, structural reform and collaborative initiatives, it’s easy to overlook how volatile funding levels have become and what this means for investment strategy.
The last few years have seen unprecedented monetary policy measures, or Quantitative Easing (QE).
We have all become so familiar with this central bank toolkit we forget just how extraordinary it is.
Interest rates have been cut close to zero and followed with purchases of government debt on a level that was inconceivable prior to the 2008 financial crisis.
Every step has been taken to stimulate economic activity by making money as cheap as possible.
It is a policy that appears (finally) to have worked in the US and UK, and is now being aggressively adopted in Japan and Europe.
QE has also had a large impact on LGPS funding levels. Initially, this was undoubtedly negative.
The Bank of England’s buying of gilts drove yields lower and caused actuarial calculations of pension fund liabilities to rise sharply.
Most LGPS funds have little exposure to gilts (certainly far less than is typical for private sector schemes), preferring instead to focus on riskier assets with higher expected long-term returns, such as equities and property.
With “safe” gilts rising faster than risk assets, funding levels deteriorated quite quickly.
Recently the impact has been more benign as easy money flooded markets and drove up the price of risk assets.
Since May 2013 there has been a growing recognition that QE will eventually end, particularly in the US.
Government bond yields have moved a little higher. Funding levels have therefore improved.
LGPS funds in England and Wales will have seen actuarial valuations in March 2013.
Typically, these show a rise in their deficits since 2010, higher than in 2007.
The average funding level for the sector, calculated on a consistent and conservative basis, would probably be around 75%.
Roll that forward to the end of 2013, with risk assets having risen and gilt prices fallen, and the funding level could have been up to 10% higher.
Some of this gain will have been lost in the first three months of 2014, but the volatility of funding levels is clear.
Pension fund investment strategies need to prepare for coming volatility as the Quantative Easing tap is turned off This volatility could soon become relevant to investment strategy.
While the funding shortfall is large, strategy will focus on return generation to close the gap, with little attention paid to liabilities.
However, we may now be in an environment where funding levels swing sharply up and down, and some funds may want to adopt strategies that lock-in at least part of what could be short-lived improvements.
Liability focused investment strategies are a logical response to such an environment.
QE has also changed the nature of risks facing LGPS funds. The flood of money into markets means there are no “cheap” assets any more.
In equity markets, for example, US shares are priced at historically high multiples of historically high profits (relative to the economy).
There has been little earnings growth in the last year, but investors have been willing to pay higher prices, so the scope for disappointment is growing.
In property, valuations have started to rise sharply and it is increasingly difficult to invest quickly.
In bonds, high yield and other credit spreads are returning towards the low levels seen immediately before the financial crisis.
There is little margin of safety in almost any asset type.
Even “safe” assets are now at “risky” valuation levels and running to cash is not really an option because it is guaranteed to deliver returns well below inflation. How will this play out? The only certainty is that QE is not permanent.
At some stage monetary policy will return to normal and the tide of liquidity will go out.
Policy makers will make strenuous efforts to avoid destabilising markets during this process, as has been seen from the actions of the US Federal Reserve.
However, eventually the QE drug does need withdrawing.
What is far less clear is how markets will react as this unfolds.
Will bond yields continue to edge higher? Will risk assets continue to sustain higher ratings? Will inflation be allowed back into the economic system as a means of reducing the burden of public sector debt? It is likely that swings from optimism to pessimism and back will continue for some while.
LGPS funds would be well advised to start monitoring their funding levels more regularly and to create a strategy framework that enables volatility to be used as an opportunity rather than a threat.

John Harrison is a senior adviser with AllenbridgeEpic and independent adviser to four LGPS funds