Corporate Europe Is In great Shape, Say Analysts
Apr 05, 2006
Eric Chaney (London)
The synthetic index derived from our quarterly Analysts survey rose from 54.6 in early January to 61.5 at the end of March, that is, more than one standard deviation above 50, its long-term average. The added impetus came from Industrials, Materials and Consumers Discretionary, joining forces with Technology, Financials and Healthcare.
A conundrum: why are soft and hard data diverging? This piece of news is important in the current context, because the unexpected rise of the German Ifo index to a level unseen since 1991 triggered a substantial sell-off in EMU bond markets. Taken at face value, the Ifo index is suggesting that German GDP growth might be currently accelerating to 3.5% to 4% from one year ago. Because German data such as retail sales continue to disappoint, the gap between “soft” and “hard” data is widening. The debate is far from over and is likely to be a key theme for investors this year: Is German domestic demand really taking off, after nine years of stagnation, or are there new biases in business surveys, possibly linked to globalization? Bonds and also currencies and equities would behave very differently in each case. We might have to wait further to get definitive answers. The Analyst Survey is on the side of Ifo-like surveys At first sight, the 12th edition of our Analysts’ Survey is leaning on the side of other business surveys. Our London-based equity and credit analysts turned much more positive on business conditions in general, found that financing was easier than three months ago and reported an incremental upgrade of capex plans, the fourth one in a row. Easier financing might seem at odds with the rise in interest rates, however, it is consistent with the healthy business environment reported by analysts covering the financial sector and with the acceleration of credit reported by the ECB. The capex recovery is gathering steam Apart from Energy, Telecom and Utilities, which have been big capex spenders for some time, major upgrades to capex were reported in Consumers Discretionary and Media. From a broader perspective, the uptrend in capex plans reported in the last three surveys is a sign that European companies are weathering well the increase in energy bills. The survey provides some clues to explain that. First, restructuring is continuing: the net balance of analysts reporting headcount reductions vs. additions rose from 14% to 16%, the first rise since December 2004. Insurance and Banks join Telecoms and Consumer Staples in the headcount cut camp. Only the Property sector intends to hire personnel, not a surprise. Second, pricing power improved: the median increase in producer prices accelerated from 0.7% to 1.2%, a sign that companies are able to pass a part of the rise of input prices onto customers, the other part being borne by cuts in compensation costs. Cost outsourcing is far from being completed Although depicting a healthy picture of corporate Europe, our survey is not fully conclusive regarding the European economy at large. First, large companies are admittedly more sensitive to global factors than others. They might thus benefit from growth in global markets. Second, they have outsourced a larger share of their production than others, and this trend is not over: we asked analysts a particular question: “What is the share of outsourceable costs that have already been outsourced”. The answer was unambiguous: 86% of analysts thought that less than 50% of such costs had been moved in their sector. The most “outsourced” sectors seem to be Consumer Staples, followed by Energy and Financials, but even in these sectors, a lot of room is left. With many industries entering into a period of consolidation, the outsourcing trend might even be accelerating. That is why we suspect that the Ifo index, largely influenced by manufacturing companies that are moving platforms toward Eastern Europe and now China, might be upwardly biased. In the end, evidence of the recovery in the heart of the euro area will have to come from domestic demand indicators. This has yet to come, but be ready for surprises.
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A Framework for Making Pension Fund Investment Decisions
Apr 05, 2006
David Miles (London) and Melanie Baker (London)
In the UK and the US, more and more defined benefit (DB) pension schemes are closed to new members. Roughly one-third of UK DB schemes members are active but two-thirds are either deferred members or members already receiving pensions. Investment decisions regarding the portfolio allocation of existing assets will become ever more important relative to the significance of new contributions coming into funds. Trustees and advisors face a tough set of decisions and, because of the size of existing liabilities, the decisions they make have potentially major consequences for asset pricing. In a recent report (“A Framework for Making Pension Fund Investment Decisions” D Miles and M Baker, April 3, 2006) we analyse — in a simplified and abstract setting — how the many factors that affect the future balance between assets and the cost of paying pensions should influence investment decisions today. We take account of many sources of uncertainty: the pattern of future asset returns, longevity risks, strength of the corporate sponsor. Crucial factors are also the levels of current funding and the asymmetry in how upside and downside risk to fund performance are regarded. We develop a calibrated model which — given assumptions about key inputs — generates explicit answers about the optimal structure of assets. The model can be thought of as a tool to help the thought process behind investment decisions. What the model does … Multiple sources of uncertainty (including longevity and asset price volatility) help make pension fund investment decisions very hard. These sources of uncertainty become larger the longer the investment horizon is. Once the trade-offs between different types of risk are clear, we can better assess how far pensions should match debt-like liabilities with assets that share those characteristics The pension problem we analyse is one where the results of asset allocation decisions today will be known several years down the line. The resultant asset values will be judged against the value of the pension liabilities at that point. Both asset values and pension liabilities in the model are uncertain. Some of the factors that influence them are common (e.g. bond yields) while others are assumed to be distinct (e.g. longevity). Attitudes to Risk We describe the risk preferences of the trustees with a utility (or payoff) function that allows for asymmetry between the effect of having a deficit or surplus, and also for more rapidly rising pain from larger deficits. The right investment decisions today depend on how painful deficits are when pensions have to be paid. It also depends on how valuable might any surplus be. Trustees face a difficult job in assessing which risks are acceptable for a pension fund. But they cannot avoid that choice. Key features of the results Under a wide range of scenarios, we find that a substantial hedging of shifts in yield is likely to be optimal. In the simplest interpretation of this result, it means that long-duration bonds are likely to form a substantial part of pension portfolios. But the same end can be achieved by less direct means — through swaps and other derivatives. Many view pressures on trustees and advisors to hold more bond-like assets as pushing them towards decisions that on economic grounds are not very sensible. In general, we find that this is not the case. Our findings do not reflect pension regulations or accounting rules. In fact, the question we pose is: what is the right portfolio of assets based on economic factors, and in isolation from any constraints from regulations and accounting? But the appropriate asset allocation will differ across funds. Key results include: 1) The volatility of returns on equities (our shorthand for alternatives to bonds) matters a great deal. One would probably need to believe that such volatility was a good deal lower than has been typical in the past to warrant equity weights as high as 60%. 2) More longevity risk — which we assume cannot be hedged, and certainly not with bonds — does NOT mean that a more conservative investment strategy is optimal. 3) Whether bond yields are likely to rise (or fall) may be more important than whether they are low (or high) relative to returns on other assets. 4) The right investment strategy may not be very sensitive to the current funding level when the appropriate horizon for judging performance is long. 5) Risk tolerance is central to investment decisions. Our analysis provides a way for decision-makers to quantify their risk tolerance so that it can be appropriately reflected in investment choice. Whether such a switch towards more long-duration bonds means that yields will stay at their current low levels — or indeed move lower — is far from obvious. It depends critically on sources of new supply of long-duration bonds. It is perfectly possible that greater supply can match the greater demand from pension fund re-balancing. In fact, a switch from equities towards bonds achieved through companies buying back their shares held in other corporate pension funds, and financed through issuing bonds, is neutral. It creates as much new bond supply as is demanded and as much new equity demand as is supplied. We remain sceptical that pension fund re-balancing means that real bond yields have to stay at recent, unusually low levels.
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