Investing in a crisis: Where can the LGPS turn as inflation bites
Posted on November 18th, 2022
For many investors, the economic uncertainty over the last few months has come as a shock. Gilts, usually relied upon to provide a measure of stability in times of turmoil, became a big part of the problem. With market volatility heightened, the Local Government Pension Scheme (LGPS) has been presented with new challenges to address as they consider their long-term strategies.
The catalyst for the current wave of market volatility can be traced back to February this year, when the Russian invasion of Ukraine disrupted supply chains, pushing up the price of food, fuel and energy, causing a surge in inflation and a subsequent global rise in interest rates.
Add into this environment the now infamous UK ‘mini budget’, and the situation proved too much of a shock to markets. Particularly at a time when investors where already navigating an uncertain economic outlook, one that is dramatically different to low-rate, low-inflation world experienced in the previous decade.
What are the implications for market values?
Despite a steadying of market volatility following the appointment of a new Prime Minister and Chancellor, the situation is far from ‘back to normal’. With interest rates predicted to continue to rise into 2023, valuations are still adjusting, and many businesses will feel pressure on their margins if they have to borrow at unfavourable rates.
The fall in global equity markets this year has taken ratings relative to earnings below long-term averages, so prices look reasonable value to investors who are willing to stay the course. However, they could still be vulnerable if earnings fall dramatically, so the markets will need to be closely monitored in the coming months.
Bond yields are also less expensive than in recent years, but prices could fluctuate until fixed-income investors can gauge whether rising interest rates will bring inflation under control. While bonds are generally considered a less volatile option than equities in periods of market instability or when an economy enters a recession, it may be some while before the outlook is clear.
With the UK’s economic and political landscape shifting by the hour, market valuations may take time to readjust, and there will be a lag before changes in the wider economy feed into reduced deal prices.
“The challenge facing LGPS funds now is that they will need to adapt strategic asset allocations to an ‘new normal’ – a more inflationary environment with rising interest rates…”
What is the outlook for LGPS funds?
When looking at the direct impact of the recent volatility, the effect on LGPS funds has, thankfully, been limited. With little exposure to LDI (Liability Driven Investments), they have not faced the issues affecting private corporate pension schemes. In fact, the sharp rise in index-linked gilt yields has boosted LGPS funding levels by reducing the value of their liabilities, which includes future payments to members. Thanks to diversified global portfolios where the majority of earnings are from overseas, they also tended to benefit from the fall in sterling.
The challenge facing LGPS funds now is that they will need to adapt strategic asset allocations to an ‘new normal’ – a more inflationary environment with rising interest rates.
Rising inflation will result in higher pension costs, so generating income will be increasingly important in the coming years. Asset classes such as infrastructure, property, healthcare, and higher-income long-term real assets will likely be more attractive to tackle this growing risk. However, it is important to stick to a long-term approach, buying income streams at the best price, rather than reacting to short-term volatility.
Higher yields also provide more opportunity to generate income from bonds, and positive real yields on index-linked gilts might even enable some funds to hedge inflation risks, although not by using LDI strategies. Investors would be well placed to wait until prices have adjusted to reflect the impact of higher interest rates on the markets. They could also wait until the credibility of the government and Bank of England has been properly restored.
Ultimately, as most LGPS funds have investment portfolios that aren’t as vulnerable to short-term market volatility, they are already in a strong position and are well placed to be able to ride out the storm.