Are EU ready?
14 March 2016
The EU Referendum, and impact of a "Leave" vote, is one of the the key risks facing UK pension strategy in 2016. It is impossible to forecast the outcome and, as we have seen from the Scottish referendum and the most recent General Election, sentiment and polling numbers are highly changeable. Sterling's recent decline suggests there is a lot of concern about the potential impact of a Leave vote, should that be the outcome and there could be further complications and uncertainty if the result is very close.
More uncertainty is never welcome, least of all to pension schemes which have been variously beleaguered in recent months by the slowdown in China, rising US rates, negative yields elsewhere, and gilt yields almost returning to their all-time lows. However, the Referendum is slightly different from these in that we know a great deal more about it (and I suspect we will grow weary with the ink spent debating it) - we know what it is, specifically when and generally what the outcomes (including various forms of "Brexit") might look like. The EU referendum is not a "black swan", but rather a "known unknown".
Regardless of any individual view on whether Brexit is likely or right, we can expect that there will be an immediate impact on markets driven by the perceived possibility of a Brexit, and the market perception of how Brexit might be achieved. This kind of uncertainty therefore presents an opportunity for pension schemes that are prepared for the possible outcomes, and nimble enough to take action during the expected wider market volatility.
So what can you do? This will very much depend on where your scheme's strategy sits today; some schemes may have every reason to be relaxed, but most will have a number of areas where they can be taking actions, or at least understanding what Brexit might mean for them.
- The most often commented upon financial market impact in recent days has been the decline of Sterling relative to the Dollar and Euro. We can expect uncertainty to result in a significant increase in market volatility, particularly as it relates to Sterling assets generally, but continued downward pressure if the odds of a Brexit become higher. This can be reflected in positioning by reducing currency hedging of overseas exposure towards neutral positions (i.e. 50%) or lower in the run up to the vote.
- Equities may suffer in the short term relative to bonds in the period up to the Referendum; this will be significantly exacerbated in the event of a "Leave" vote, focussing uncertainty around what the new relationship with the EU will be for key sectors of the economy and concerns about the impact of Brexit on the membership of the EU by some other Member States. Pension schemes can manage this risk by using more sophisticated techniques to manage the shape of equity returns, consider a tactical underweight to equities, reconsider the weighting to UK equities within the overall equity portfolios (the UK has a large index weighting to financial services, the services sector, the oil and gas sectors, and a particularly large number of multinationals), consider new ways to gain exposure to equity beta (though "smart beta" approaches are not without their own risks), and increased risk factor diversification within growth portfolios.
- Commercial property can be reasonably expected to suffer negative sentiment in the run up to the Referendum (because of uncertainty affecting confidence) and more so in the event of a Brexit if overseas buyers steer clear. Core property allocations, outside London, with focus on income yields are likely to outperform prime holdings.
- Bonds will probably outperform equities and property. This would suggest tactically positioning from equities to fixed income, and taking a careful look at construction of buy-and-hold cashflow matching portfolios where these are being built up in the coming months - though where such portfolios already exist one need only review allocations to individual issuers which may be at risk of heightened default risk in "Brexit" scenarios.
- Weakening Sterling can be expected to increase the cost of imports, potentially resulting in rising inflation expectations if "Brexit" occurs. Rising inflation expectation would be detrimental to pension schemes overall because this will generally increase the expected liabilities. Benefit indexation will also be higher (within the relevant collars) if inflation prints rise, whereas low realised inflation over the recent past has been helping pension schemes notably with lower benefit indexation.
- The Bank of England is unlikely to consider raising rates while there is particularly heightened market volatility - this would support an argument that lower yields would stick around for longer. That inflation could be imported and not wage driven would also give pause to the BoE regarding rate rises, or indeed spur greater easing actions. However, running up to the referendum and under the "Brexit" scenario, it is possible that overseas investors in gilts may prefer to reduce allocations in favour of other treasury markets (most probably the US given negative rates elsewhere). This could be combined with a downgrade of the UK's sovereign credit rating - two ratings agencies have already indicated as much. These would suggest upwards pressure on gilt yields.
- If the latter interest rate factors dominate, it would provide a fillip to UK pension schemes who have been unable to hedge their interest rate risks whilst yields have been near historic lows. This combination of volatile yields, potentially rising yields and increased trading activity by overseas gilt holders in the run up to the referendum should provide opportunities to increase hedging – pension schemes should be reassessing their triggers.
Clearly you can position a portfolio to take maximum advantage of a specific outcome if that is your strong conviction, but that is a somewhat binary risk view to take. We prefer approaches which seek to manage the risk of either outcome.
Are you ready?
Nikesh Patel FIA CERA
p: +44 (0) 207 804 5439