Our viewpoint

The irony
of market volatility and how trustees can prepare

Phil Boyle

In this blog, Phil Boyle discusses some of the main drivers behind the current market volatility and provides tips for Trustees who are deciding which investment risks to continue to run and which to take steps to manage.

There was a strong hint about one of the main drivers of current market volatility at the end of January when TASS (the Russian news agency) reported that OPEC and Russia could meet in February to cut oil production.  This caused a temporary rise in oil prices and a spike in equity markets.  And the converse of this appears to be true as well; falling oil prices are driving down equity markets.

This is ironic.  Low oil prices are usually great news for consumers and companies but they have fallen so low that they are creating enormous losses for oil companies and any business that provides services to them and this is enough to drive down stock markets in the US and the UK.  A good example of the scale of these oil company losses was reported in the Guardian recently where they reported that profits for the S&P500 would be down by around 5.8% in 2015 so it is not surprising equity markets are falling but that profits for the S&P500 would be up by 5.7% in 2015 if you exclude energy companies from the calculation.

But falling profits are not the only issue.  In addition to fears about falling growth rates in China and pressure on the European banking sector, investors are probably also concerned that the sharp falls in many commodity prices (not just oil) are a leading sign that global growth is really slowing down.

Two possibilities for the global economy

So this volatility in equity markets is either a rational response to an underlying problem in the global economy or the global economy will actually keep trundling along fine and it is just a temporary problem in equity markets.  Lots of market commentators will have a view on which of those two possibilities is correct. 

Interestingly, when comparing the global economy and equity markets, it is important to understand the disconnect between the two because of the difference in their make-up.  Public equity market are weighted to capital intensive industries (like oil, mining and motor industry), whereas developed market economies are service sector orientated and many service sector companies don’t have quoted equity so it is hard for investors to benefit from their success (I’m thinking of partnerships, accountants etc).  This is not a new issue but investors should consider how to get better access to these markets through venture capital and private credit markets perhaps.

A double whammy for UK pension schemes

While other investors may be focussing on market volatility, UK pension schemes have suffered a double whammy as market expectations for the Bank of England to start raising interest rates have now been pushed into 2017 causing bond yields to fall even further and increasing the measures of pension scheme liabilities by around 6% since the start of 2016.  So whilst equity market volatility is grabbing all the headlines many UK pension schemes will have suffered bigger losses from falling bond yields than falling equity markets.

So what should Trustees be doing?

The most important role for a Trustee in the current volatility is to review and confirm which investment risks to continue to run and which to take steps to manage (even at the risk of missing out on potential returns in the future).

We suggest that you should put three issues on the agenda for your next Trustee meeting: 

  1. Review your “hedge levels”
    This is jargon for the amount of protection your investment strategy provides from movements in interest rates and future inflation.  Should this level be increased? Many trustees have already increased their hedging levels, and whilst they may have thought it was an even bet at the time, in the past 8 years, no Trustee has regretted that decision.  Some will question whether yields could fall any further, but it’s worth noting that the UK is in the middle of the pack of G8 countries, with four others (Canada, France, Germany and Japan) currently having yields which are significantly lower than the UK.  So Trustees should be aware that there is scope for UK yields to fall further.
  2. Carefully manage any transactions
    Whether that is selling assets for cash flow needs or switching from one asset class to another.  In particular, it is important to try to avoid selling your growth assets at potentially temporarily depressed levels.
  3. Review whether you have enough genuine diversification in your portfolio of assets and is the diversification that you have working properly? 
    Individual asset classes have seen dramatically different returns over the last few years.   For a Trustee, now is a dangerous time to have too many eggs in one basket. My colleague Kevin Frisby has created a video “Understanding diversified growth funds” which provides some insights on DGFs.