William Bourne on Room 151 - local pension Boards - practical steps towards effective performance

Local Pension Boards have the tools they need to function effectively; meddling should be discouraged. To read more please visit Room 151. 

A look at whether there really is an equity bubble yet

It is a commonplace today that equities are expensive by most historic standards. Whether the criterion be price to earnings, longer term Schiller ratios or the recently popular market cap to GDP measures, Developed Market equities are either at, or close to, all-time highs. The only precedent was the end of the 1990s and the eventual dotcom bubble. The explanation usually given to justify valuations, and one I would happily subscribe to, is the nine years of easy money which we have enjoyed since the last financial crisis. Because industry has found it hard to find profitable ways to employ this money in the real economy, much of it has flowed over into investment assets including financial ones. Prices of bonds, equities and property have all gone up. We have lacked, however, a way of quantifying how far prices have gone up relative to the level of liquidity – ie. how far the bubble has inflated. A recent article from CrossBorder Capital aims to do precisely that by looking at stock market capitalisation relative to the pool of available financial assets. It is effectively a measure of the size of the equity weighting within investors’ entire financial asset portfolio. In theory, much as with any portfolio, if the ratio becomes too high investors should react to reduce it. CrossBorder’s conclusions are that generally, on this market cap to liquidity basis, global equity valuations are at around the middle of the range pertaining since 2000 and well below the dotcom bubble peak. Even the US looks no more than a tad expensive while Emerging Markets, and to an extent Japan, look cheap. This is not an argument for complacency. There is clearly scope for a sharp fall in equity prices if the authorities choose to take liquidity, the ultimate denominator of this measure, out of the market by tighter monetary policy. But it does suggest that we are not really in a bubble yet and that if - admittedly a big ‘if’, given the noises coming out of the Federal Reserve - the level of cheap money is broadly sustained, valuation levels alone will not prevent equities from rising further.     CrossBorder's full article is available to purchase here.

Upcoming events

Please find below a selection of upcoming events William will be attending:  26th-27th June 2017 - Edinburgh visit 28th June 2017 - CIPFA - LGPS Local Pension Boards Conference - Barnett Waddingham, London 19th-20th July 2017 - LAPF Strategic Investment Forum - The Grove, Hertfordshire  30th-31st August 2017 - Helsinki visit     

Smooth sailing or stormy waters for the LGPS? William Bourne comments on the 2016 LGPS Annual Report

The LGPS 2016 Annual Report was published recently.  In many ways it shows a success story.  The number of employers is up 22% and, despite almost zero return in the year to March 2016, the long term investment returns show a healthy 3% real return annualised over 20 years.  However that is not a reason for complacency, on a whole range of fronts.    The rise in employers is largely driven by councils outsourcing jobs and the creation of academies.    The volume of the latter, which tend to be of relatively small size without dedicated HR departments, is undoubtedly putting pressure on fund administration departments.  The solution has to be some form of pooling, whether of academies into multi-trust academies, assets and liabilities into a single entity (as was done with The National Probation Service), or at the fund administration level. The 20 year investment return has, in contrast to private sector schemes, been driven by equities.     Some 35% is invested in equities directly, compared to 5% in bonds.  Pooled investment vehicles account for 44% and, while these cannot be categorised from the information available, the message is clear that equities comprise most funds’ major ‘growth’ asset class.  In contrast, private sector schemes have over 50%* invested in fixed income and, when LDI strategies are taken into account, the true number is probably closer to 70%.  In both cases, the level of return over the next five years is likely to be lower: government bonds yielding 1.5% over 10 years will by definition return that annualised figure if held to maturity; while equities would have to go to even higher valuation levels than at present to return more than their dividend (3% today) and the level of long term real economic growth (assume 2%). Paradoxically that may help funding levels.  Regardless of the precise discount rate valuation methodology used, either a fall in the valuation of bonds or equities, or higher inflation will lead to a lower estimate of the liabilities.  The 2016 Report, which used individual Fund valuations, gave an average funding level of 85% , whereas the Government Actuary’s Department’s Section 13 valuation of the whole Scheme based on standardised assumptions will, if we can judge by the anonymised 2016 valuations already published for each fund,  be closer to 100%.  If we allow for market movements between 31st March 2016 and today, the Scheme is almost certainly fully funded. However, funds are still going to have to make a choice between accepting lower returns from traditional asset classes such as bonds and equities, or branching out into newer asset classes in the search for higher returns.  It would be a mistake to be too complacent on the investment side. The 2016 report also shows that the cashflows from members - ie. contributions minus pension pay-outs - has, for the first time, tipped into the negative.  This has been long flagged up and has been delayed by the inflow of active members entering the Scheme from new employers.  However, the trend can only accelerate in the future.  In the near term, investment income (1.7% in aggregate) will comfortably cover the gap but not forever - now is the time for funds to plan for that eventuality. Finally, I turn to governance.  With less than a year until April 2018, when funds are supposed to turn their investment implementation over to the pools, governance arrangements will need to change.  Because Funds will effectively be outsourcing a large part of the investment management, they will need to put in place a clear framework to monitor and govern the arrangements between the various parties, including the Pools, the Section 101 committee, any connected body which has delegated responsibilities, the Pension Board, and outsourced service providers such as actuarial and investment consultants.    In my view, rather than trying to carve up the work between the 101 Committee and the Pension Board, clearer accountability will come from giving them separate functions.  The Section 101 Committee should be responsible for all functions including the governance of the various relationships, while the Pension Board’s role should be one of scrutiny and challenge.  They should ensure that appropriate governance processes are in place and followed, and provide challenge where they believe there are gaps. I haven’t even mentioned the General Data Protection Regulation, which comes into force in exactly a year’s time on 25th May 2018 but, while there is plenty of work to do, from a funding perspective the LGPS is not in a bad place.  Private sector schemes are reaping the consequences of de-risking: investing in low risk assets results in low returns and, except where schemes are sufficiently well funded or mature, sponsors are having to increase their contributions.  In contrast, the LGPS is beginning to look more sustainable in the long term.   * Source: Purple Book 2016, p. 42  

William Bourne warns of the approaching end of this bull market in risk assets

Our colleagues at CrossBorder have published their monthly Risk Update. It shows risk at the Global level at 74.6 (on a scale of 0 to 100) in April 2017. This is the highest level since October 2007, when the risk index stood at 80.6. The only other time when this risk indicator has been higher was in the early 1990s. However, as followers of my blogs in this area will be aware, there is a heavy skew within today's global risk aggregate. Risk is highest in the US and Japan, where the composite indexes stand at 86.5 and 79.5 respectively, but very low in the Eurozone at 16.2. The key driver has been investor ebullience - ie. greed is winning over fear or, as the optimists would put it, we are climbing the wall of worry. It is no surprise that Emerging Markets, where sentiment has improved most, have shown the greatest rise in risk. The level of this risk measure today is a clear indication that markets are generally heady. It is not necessarily prophesying a repeat of 2008's financial crisis and it is worth noting that it took nearly a year from October 1987's high reading before markets reacted. However, the benign conditions, for investors at least, of the past 25 years are unlikely to continue for much longer. Investors should begin to take their exposure off the table, the US and Japan first. Do not say Linchpin did not give you due warning! CrossBorder's full article is available for purchase here.​

Unequivocal flows of money back into china spell out higher bond yields in the us

Investors need to be alert about two things in 2017: the exit of previous ‘flight capital’ from US assets and the stance of Chinese monetary policy. The former determines the prospects for the US dollar and the latter prospects for global bonds and EM. Latest data, which confirm China’s PBoC is not tightening but 'flight capital' is clearly flowing back into China, reinforce our 2017 predictions that the US dollar has peaked and that G7 bond yields are progressively rising. Find out more here. 

japanese corporate governance

At a seminar a couple of weeks ago, I heard an ESG expert call the standard of corporate governance in Japan ‘extraordinarily low’.  I challenged him at the end of the session, pointing out that Japanese corporates tend to make decisions based on the very long-term, which was precisely the behaviour we are trying to encourage.  I also reminded him that in 2015, as part of the Abenomics reforms, Japan adopted a Code of Corporate Governance which is almost identical to the UK’s. The Japanese, unlike some nations, tend to obey laws. In the ensuing debate it was pointed out, quite correctly, that Japanese boards tend to have little diversity and rarely include foreigners; that shareholders are still some way down the pecking order, compared to in the US or the UK; but that governance in Japan is improving faster.  I would add that Japanese corporates do not have the same incentive to boost profits since corporation tax, rather than executive pay, is based on reported earnings per share; as a consequence that number tends to be conservative. The empirical evidence is in Japan’s favour too.  When we look at where the world’s major scandals and governance problems have come from in the past 20 years, they have almost all emanated from the US: Enron, subprime, the banking crisis… There will always be rogue companies, and Japan is no exception, but there has been an interesting shift over the past few years.  The Olympus scandal which broke in 2011 - where management had been misreporting profits over many years - was only uncovered when a gaijin (ie. a non-Japanese) manager took over.  It was an old-style Japanese governance failure, ie. management covering something up to avoid personal shame or embarrassment.  However, the Toshiba debacle this year was much more similar to bad governance in the West - poor decisions were made based on incomplete, ineffective or non-existent corporate governance procedures, but not for personal reasons. While an ‘extraordinarily low’ corporate governance standard is certainly not the case, how are shareholders treated in Japan today?  The level of buy-backs in 2016 at 5.3tr yen was some 60% higher than in 2015 and dividends at 11tr yen were 10% higher.  The buy-backs were generally done out of cash reserves and not via increased leverage, as is so often the case in the West.  It is also worth noting the increased level of mergers and acquisitions as zaibatsu slowly unwind the links of the last 70 years by selling or buying in quoted subsidiaries.  What’s more, these transactions tend to be done at premiums, which historically was not always the case. Japanese corporate boards tend to reflect the society, which is more male-dominated and certainly more homogenous (call it xenophobic if you prefer).  The corporate structure will always be closer to the European model where shareholders are one of a number of important stakeholders rather than the US one where shareholders are the top priority.  However, I would have more trust in the sustainability of a Japanese company’s earnings than its equivalent American one, simply because Japan still has its long-term culture in place.  I do also buy the argument that improvements in Japanese corporate governance are accelerating which, at the margin, is likely to lead to improvements in share ratings. 


From 15th-17th May 2017 William attended the PLSA Local Authority Conference at De Vere Cotswold Water Park Hotel in Gloucestershire​