Investment Market Update for UK Pension Schemes

Hello and welcome to our review of quarter two focused on the global economy and investment markets.

First, the headlines. Following one of the most difficult quarters of living memory, quarter two was an incredible quarter, with some of the largest rises in equity markets seen in decades. At the same time, many economies shrank sharply, particularly during April. Despite rising unemployment and much uncertainty regarding the chances of a resurgence of the COVID-19 virus, a V-shaped recovery is now being forecast by the bank of England's chief economist.

For UK pension schemes, what does this all mean? In general, funding levels improved over the quarter as asset performance outweighed the increase in liabilities.

Now we'll delve a bit more deeply into the economic background for the quarter before looking at the impact on the main equity, bond and currency markets. We'll finish by highlighting the impact this has had on Defined Benefit pension schemes in particular.

During the quarter, most developed countries saw declining rates of new COVID-19 infections. The main exception to this was the US, where infection rates initially followed this trend, but then picked up materially in June. The reopening of economies and the resumption of business activity has provided some further grounds for optimism among investors that economic activity may be rebounding quickly. Other economic headwinds that could threaten a recovery include a ramp up of US China tensions, in part driven by China's Hong Kong crackdown, the stuttering progress of EU UK transition talks, and the ripple effects that rising unemployment and corporate bankruptcies from the crisis are likely to have.

The stark reality of the impact of lockdown was confirmed by economic data around the world showing the extent of the market contraction during April in particular. More recently released data in June, however, while still relatively poor, exceeded market expectations. A good example of this is the UK economy, where the GDP contracted by 20% over April, but a V-shaped recovery is now being forecast by the bank of England's chief economist. And GDP forecasts for the first half of the year have now been revised upwards from a 27% contraction to only a 20% contraction. The human cost of this economic downturn was reflected in the major job losses announced during the quarter, which have continued into July. We've heard seemingly daily announcements of redundancies in the press from different industry sectors such as retail: Boots, 4,000 job losses; travel: BA, 12,000 job losses; and hospitality, casual dining and restaurant groups, between them, 3,400 jobs. Indeed, City Am recently estimated that 85,000 job losses have been announced in the UK since the onset of the pandemic. This is despite government incentives for companies to maintain full staff through until next year.

The economic picture then was pretty bleak, so how did markets react? Perhaps surprisingly, we've seen some of the fastest rising markets for decades rebounding from the lows of late March to the extent that global equities, UK corporate bonds and high yield bonds are now in positive territory for the first half of 2020.

Looking at the equity numbers in more detail, the FTSE ALL WORLD returned a staggering 19.8% for sterling investors only just beating the emerging markets index which returned 18.9%. US stocks in particular posted their best quarterly returns this millennium, driven by technology stocks such as Apple up 43%, Microsoft up 29% and of course Zoom Video up 77%. Utilities and staples were weaker and financials underperformed as investors worried about the impact of the COVID fallout on the potential for defaults to increase.

European equities were buoyed by the various government's responses to the COVID crisis and in particular anticipating the 750bn euro recovery fund that was eventually agreed after the quarter end in July. The UK market also shared in this rally, but not by as much. The 10.2% return included the impact of dividend cuts not only by the large banks, but also by the oil majors such as Shell, who cut their dividends for the first time since the Second World War.

So how did credit markets fare? Well, corporate bonds also recovered strongly over the period, with investment grade credit spreads tightening by 100 basis points, or 1% from the highs near the end of March as bond prices rose. In the UK market, the return UK corporate bonds was 9.0%, whilst global high yield returned 12.5% percent to sterling investors as spreads fell by some 350 basis points, or 3.5% in that market. This spread tightening has benefited from many of the factors that drove the positive sentiment in equity markets. But in addition to this, market liquidity has improved significantly as a result of the large scale monetary measures that have been introduced by governments and central banks around the world.

On to government bonds now and official data published show that the government's debt exceeded the size of the UK economy in May for the first time in 50 years. The UK government bond market has also now experienced prolonged negative yields for the first time, with the yield in nominal bonds now negative up to seven years maturity. That means for terms of up to seven years, investors now need to pay the government to lend to them.

This continued fall in yields had happened across the curve, resulting in another quarter of strong returns for holders of UK government gilts, in particular index length gilts which had lagged their fixed interest cousins in the previous quarter, this time posting a return of 10.3% as inflation expectations rose from the lows seen back in late March. In currency markets we saw the euro gaining ground on sterling, breaching the one pound ten mark towards the end of the quarter against the dollar. Sterling initially fell back only to rally towards the end of the quarter on dollar weakness, to end broadly unchanged as we can see in the chart. In Asia, the yen remained range bound, whilst the renminbi was weaker relative to the dollar earlier in the quarter only to rally once the strength of the Chinese economic recovery became clearer and COVID measures relaxed. 

So how did this impact a typical pension scheme's funding position? This will clearly vary by scheme, but well-hedged schemes will have seen strong asset performance of the growth assets improve the funding position and even those with limited hedging we think will have seen that growth asset returns outweigh the increase in liability values, leading to an overall increase in the funding. We estimate this to be in the region of 4% for a typical scheme as shown in the chart.

So what should trustees be thinking about as a result? Well, we've got three questions for you to consider. Firstly, have you got your hedging level right? And did this protect you as expected?

Did your growth assets perform as expected during this period? And if not, are there other assets available that could deliver the return you need with lower variability?

And finally, has the scheme's sponsor strength changed as a result of the extraordinary six months we've been through? And if so, what should be done about it? To discuss any of these aspects further, please get in touch with your XPS Investment consultant. Thank you for watching.