By Noel O’ Halloran
Over recent quarters we have seen global equity markets hitting all time highs while at the same time there has been extensive media coverage of pension fund deficits blowing apart pension schemes. While they seem quite contradictory, both of course are correct because equity market levels affect the assets of a pension scheme, while its liabilities are calculated with reference to government bond yields – the lower the yield, the higher the liabilities. With government bond yields at historic low levels until recently, liabilities rose more quickly than assets, pushing up deficits to levels that in some cases have become unsustainable.
As a result defined benefit pension trustees are under pressure to buy government bonds. I strongly challenge this and indeed increasingly over recent quarters there are trends I highlight that are dominating thinking and investment flows that make me nervous:
– The advice to de-risk pension schemes by selling equities to buy government bonds to reduce deficits
– The move from active to passive equity management
– Buying yesterday’s winners
This dominance of these trends make me nervous and lead me to the old phrase – “If everybody is thinking the same, then nobody’s thinking!”. Just as trees don’t keep growing to the sky for ever, many market ‘winners’ do reach a crescendo of hype which means that it’s time to get nervous and take action as an investor. Remember the great investment trends such as buying dot com stocks as they soared in the early 2000s, the move into Irish property during the mid 2000s and other such ‘winning’ trades? As we all know now, it turns out they were classic investment bubbles.
Thinking the unthinkable reminds me that this month, for the second time in six months, the world has seen a dramatic political outcome that completely caught consensus off-side. And for the second time in six months, global equity markets have not only survived the aftermath, they have thrived which is the exact opposite of what the consensus would have expected.
‘Thou shalt not worship false gods’ and so what about this recommended buying of government bonds — buying yesterday’s winners? Over recent weeks we have finally witnessed a material rise in bond yields and in my view there is a strong possibility that we have begun to finally burst the global bond bull market (bubble?). Will the election of Trump be recorded in the annals as the catalyst to burst the 35-year bond bull market?
Some arguments that make me believe that a further increase in bond yields is likely to happen include an increase in growth and inflation expectations and an increase in fiscal spending which will push up government borrowing. It makes, in my view, much more sense for pension trustees to wait and see for a period whether these factors themselves reduce pension deficits via higher bond yields, rather than buying government bonds at their current, very expensive, levels.
It’s been a peculiar world since the global financial crisis in 2008, one where investors are constantly worried about something! Nonetheless it has been a strong equity bull market, since the first quarter of 2009. This bull market has been a difficult one for many active asset managers who have struggled to beat their index and we have therefore seen a massive redirection of investor money towards indexed equity funds – again buying yesterday’s winners?
In my view the bull market has created significant valuation dislocations in large cap stock indices today. I believe strongly that buying the index is buying the highest risk and most inflated elements of the market right now. I remember active managers making similar anti-consensus arguments about technology stocks in the early 2000s and Japan in the late 1980s—they were right and I feel similarly today. Passive management is buying yesterday’s winners. Active management is aimed at buying tomorrow’s!
Noel O’ Halloran, is chief investment officer at KBI Global Investors
