Be prepared! Who knows what’s next in these volatile markets

Following the end-May bank holiday global markets were dominated by Italian political developments as the political crisis intensified. Misery loves company as the saying goes and that is definitely the case for crises in Southern Europe – the Spanish prime minister Mariano Rajoy has also left his position following a corruption case involving his party. Though in grand scheme of 2018 risks, these may in fact turn out to be overshadowed by greater market volatility triggered by a China/US trade war, Russian sanctions, Brexit uncertainty, Argentina volatility or a myriad of other geopolitical and broader risks that may surface.

It’s interesting to note the significant market reaction in the UK as the long weekend’s developments were digested (with an understandable focus on Italy). 20-year gilt yields initially fell by almost 20 basis points (bps), FTSE 100 fell 1.5% and EuroStoxx 50 fell 2.5% from their previous day close, although they also all recovered to different degrees in the subsequent days. Given this level of reaction to the weekend’s news, the risks mentioned above could lead to further volatility for investors.

So what are defined benefit pension scheme’s doing to prepare and/or adapt to market volatility? Some of our clients consider strategies that are designed to protect/be less influenced by volatile market conditions, for example:

• Funds that target a more absolute return and are therefore designed to be able to perform and offer a safe haven for capital preservation through changing market conditions including the current volatile ones!
• Some absolute return funds invest in one asset class while they utilise derivatives to remove broad market risk and instead focus on areas such as relative value and stock selection. An example of this is absolute return bond funds
• Other funds achieve this through diversification, such as diversified mutli-asset funds, where correlation is carefully monitored between the constituent assets. With these multiple sources of returns this spreads the risk so the fund is prepared to perform in a range of market conditions and returns are less dependent on equity markets alone

• Option strategies that can put a strategic framework in place that ensures schemes adapt to/are protected from evolving market conditions:
  • Equity option strategies can help DB schemes reshape their equity returns, for example providing some protection against falls, paid for by relinquishing some of the upside of equity markets
  • Swaption strategies - where a scheme sells an option to enter into a pay-fixed interest rate swap with a counterparty at a pre-agreed fixed rate (i.e. the strike) at a specified date in the future. In this example the scheme is paid (it receives the swaption premium) for agreeing to increase its interest rate hedging if interest rates rise above a specified level on a specified date

One of the key drivers of equity options and swaption pricing is the underlying asset’s volatility, so depending on the exact strategy, timescales, levels etc these can be designed and tailored to adapt and capture opportunities of market conditions.

So if you find your DB pension scheme on this rollercoaster of market volatility, perhaps consider whether there may be a place for a more stable ride on the Ferris wheel, or invest in a waterproof to protect you from the unexpected splash that might be round the next corner.