Investment Market Briefing for UK Pension Schemes

Hello and welcome to our review of the first quarter of 2020, focused upon the state of the global economy and investment markets over that period. Now, this has of course been an unprecedented period, it's been an exceptional period that we're looking at, all caused by the global pandemic that we've seen, caused by the coronavirus COVID-19.

Now of course, it has to be said that this is a horrific position, obviously for the world from a humanitarian perspective, with many thousands of people, hundreds of thousands of people potentially having been killed across the world. But what I'm focusing upon here is to look at what the impact of that has been in terms of the global economy and upon investment markets.

Now, at the start of the year and the start of this last quarter, markets were very much focused on other geopolitical events. But all of those things have been superseded and dwarfed by COVID-19 and the question is, of course, how is this now going to play out? Well, of course, if we look at Asia, Asia is probably our lead indicator for how things are going, but even there, things are very uncertain and at the present time, with the number of deaths still rising within certain parts of Europe, including the UK as well as in the US, there's a huge amount of uncertainty out there in terms of when this is going to end or how we are exactly going to tackle it.

Now, most governments around the world have reacted to this by basically taking very aggressive action to curtail both economic and social activity, basically following a policy of suppression, hoping that that will resolve the issue as we move towards getting a vaccine. Now, in effect, what governments are doing is accepting that there's going to be an economic cost in the shutdown, but that is better than obviously what would be an even worse position from a humanitarian perspective in terms of the virus. In response to that, we've also then seen a coordinated approach being taken by central banks and also by governments around the world to try and do basically whatever it takes to provide the appropriate level of support that's going to be needed to stabilize and help the economy around the world get back on track.

So exactly how bad could this be? Well, quite clearly, we have now already entered a global recession. We saw growth actually slowing at the end of this particular quarter in March and now as we enter the second quarter, we're expecting this to go very, very severely downhill. The recession is going to be very severe and it's going to be very deep. Hopefully we can then recover from there reasonably quickly. But we know that this is going to be a very, very severe hit and it's probably going to take us into a situation which is significantly worse than even the financial crisis of 2008. Now, there are all sorts of figures being put about by a number of economists, the IMF have recently announced their revised forecasts. And looking the IMF forecast, for example, it suggests that growth in the global economy will shrink by about 3% over the course of this year, then hoping it will recover towards the end of the year into next year. And by next year we'll be looking at growth of around 5.8% before it then stabilizes to normal around three, three and a half percent as normal. But those are clearly very uncertain figures at this stage. In the UK the position is potentially even worse. We could be looking at a shrinkage in the economy here of about 6.5% over the course of this year. And although then we might get to recovery next year with growth of, say, 4%, once again, that's a very severe hit that we're going to take. And the honest answer, as I said, is this people just don't know what the situation is. 

Another important economic consequence, however, of this, and one that could be longer lasting, is the question of unemployment. Because however steep and quick the recovery might be from the recession, unemployment is likely to linger for some time. We've seen in the US where unemployment is down all the way at 3.5%, that that's peaked very quickly up to about 10%, and it could go as high as about 15% over the course of the next couple of months. Now, in response to that, obviously, as I say, governments and central banks have taken action. And the action that they've taken needs to be strong for governments, the fiscal stimulus needs to be sufficient to provide a genuine boost to the economy, and we then need the central banks to be fully supportive of that and effectively to provide the backstop to that fiscal policy. And we have seen that.

We have seen that around the world. We've seen it in the UK, certainly in the US. In terms of the level of support. We've seen central banks cutting interest rates to close to zero. We've seen massive amounts of liquidity put into the market, and those central banks saying that they will purchase assets pretty much of any sort in order to keep the economy on track. Likewise, governments have been applying a very strong fiscal stimulus, $2.2 trillion in the US in order to try to stimulate the economy, as well as some temporary tax cuts and also significant support for both businesses and individuals. But if that's economic position, what have markets been doing through that period of time?

Well, initially, markets didn't react too much to COVID-19 when it was over in China. There wasn't a great deal of movement in markets in the early months of this quarter. But the shutdown in China then led to a fall away in demand for oil. And when that fell away, so the price of oil fell and we quickly developed into a price war for oil between Saudi Arabia and Russia. When that happened, we saw the oil price fall from just under $70 a barrel down to as low as $20 a barrel and markets started to take much more notice at that stage. Likewise, it became clear that the virus was going to spread and this was in fact going to develop into a full-blown pandemic. As a result, markets collapsed and we saw stock markets right around the world fall and fall very sharply. 

At the worst point, equity markets around the world were down around 35% or more. Since then they've recovered a bit because obviously the fiscal stimulus that we talked about has been put in place and we've seen markets move back up a bit. So that in the UK over the course of the quarter we actually saw markets fall by about 25%. For other global markets the decline was about 20%, so slightly better. And for UK investors, there was another significant impact. We actually saw sterling fall quite sharply during the quarter. Again, at its worst it fell by about 10% against major currencies before reverting slightly to finish down around five or 6%. Now for a UK investor with overseas investors, that helped to mitigate some of that loss that we saw in those overseas equity markets. So that the return for a UK investor in those overseas markets was down closer to -15% but whichever way we look at it those are some pretty horrific figures.

Now the flip side of that is of course government securities, government gilt, where we've seen a flight towards that level of security and there was a significant movement downward  again in terms of gilt yields. Right across the duration curve, we saw about 50 basis points being taken off the yield. So that for example, the 15 year gilt yield fell from about 1.2% down to about 0.7% over the course of the quarter. Within that, it was very volatile, but that's a very dramatic movement that we've seen once again. Now that's not true just for all bond markets, however, because although government gilt saw yields fall quite so significantly, it was not the case for corporate bonds. The spread, the gap between gilt and corporate bond yield actually widened out quite dramatically and that's because investors are concerned about the potential for defaults that could happen in the corporate bond market. So that hasn't had the same level of benefit that we've seen in the gilt market. And then finally turning to property. Property itself had its own separate issue. A number of the property funds in the UK gated, by which I mean that they closed to redemptions because they're unable to get the external and independent verification and valuation for their underlying assets. So this has been a really tough time and it's been a very difficult quarter as far as the assets and investment has been concerned. So if that's what's happened, where might things now go? Well, obviously how deep this recession will be will dictate what is going to happen to investment markets and how deep and how long the recession and the shape of the recovery that we might see post-recession is going to depend upon exactly how the virus plays out and how we manage to deal with that. And that's still, as I say, very much uncertain at the present time.

There are certainly some significant downsides there. There is the potential for reinfection and we could enter a second or even third phase of this. It doesn't mean just because we've dealt with it first time that it's then resolved. Likewise, it could be that valuations in stock markets currently haven't priced in enough of the recession and then we could see corporate earnings fall even further than anticipated, which would push markets down further. Then when we get to the recovery phase, it's not going to be plain sailing, there's going to need to be full recruitment taking place again, there's going to have to be an element of corporate restructuring. All of that means that there could be difficulties ahead for companies coming out and of course some companies won't be around and as a consequence there'll be some disruption to the supply chain as well.

On the potential upside, what we could see of course, is that valuations now look relatively cheap, things have fallen a long way and if things do recover, those valuations may look very good. At the same time, if the central banks keep interest rates so low and with the fiscal stimulus that's been provided by governments, we might very well see that corporate earnings take off much more quickly and therefore the recovery is quicker. But there's a huge amount of uncertainty as to what that will mean.

Now here at XPS in our investment newsletter we've contained in there a number of potential scenarios as to what could happen. We've based it around a central case that there will be some more bad news yet, there'll then be some potential pickup in the market, but it will be relatively slow, and we've tried to put those scenarios together to show what it would actually mean for the assets of a typical pension fund in the UK and what that might mean for funding. So having established that central base case, we've then considered what would happen if things were worse than that in a number of scenarios and also what would happen if it's better than that in a couple of scenarios. And if you'd like any information on that then please speak to your consultant.

However, trustees generally for pension funds do need to consider the current position and what action could they take. Well certainly there's no need to panic at this stage. Trustees are planning for the long term nature of the pension fund and you need to continue to plan on that basis. However, you should review where you currently are. Firstly, you need to assess what has actually happened and consider what that now means for your asset values. Also what the movement we've seen in gilt yields will mean for the value of your liabilities and consequently how that has changed the deficit in the scheme. You then need to engage with the employer that sponsors the scheme to understand what impact the virus and the shutdown will have had on their business. Is that going to change the strength of the employer covenant that sits behind the scheme? And indeed, is it going to restrict in any way the level of contributions which the employer can pay across into the scheme? And then with that information on board, consider whether you need to act. Do you need to review the investment strategy in light of a potential change to the strength of the employer covenant? Or because the level of risk that you're able or willing to take has now changed? These are the considerations you now need to make. 

Further information is available on our website and in our other newsletters which we have issued to you. Or once again, please feel free to speak to your consultant. Thank you for watching.