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European pension funds skittish as more pain looms

European investors – and probably many others – are “understandably skittish”, according to Mercer Investment Consulting, as the risk of a double-dip recession has increased modestly, the consulting firm says in its latest medium-term valuation review.The review makes only a slight change to the recommended asset allocation for UK pension funds, signalling a slight warning about new investments in property. UK property has been upgraded from ‘undervalued/fair value’ to ‘fair value’.

The main concern from the report, however, remains with UK gilts. Over-15-year index-linked gilts, for instance are “extremely overvalued”.

The medium-term allocation review differs from the dynamic asset allocation (DAA) reviews that Mercer provides in some countries in two ways: it has a three-five-year time horizon, whereas the DAA review has a one-three-year horizon; and the UK-based review focuses much more on defensive assets for the high proportion of defined benefit schemes in the UK.

In Australia, for instance, which has the highest proportion of defined contribution pension fund assets in the world, the DAA report recommends a greater weighting to equities, including emerging markets. The UK report does not rate hedge funds or commodities, but, rather, provides separate commentary on those alternatives.

The latest review says: “Our views about the pattern of economic growth do not differ materially from the consensus. The most likely outcome is a slow, grinding recovery. Those countries providing exports to the more rapidly growing parts of the world are relatively well placed.

“The risk of a double-dip has increased modestly, particularly in the UK, if consumer confidence retrenches as fears of unemployment increase. Lack of capital investment remains a feature – but still has a reasonably low probability. Corporate profit growth forecasts are strong and companies are in better shape financially than they have been coming out of some previous downturns.

“Against this, banks are still shrinking their balance sheets and notwithstanding the expectation that interest rates will continue to remain low for an extended period, there is little sign of the private sector filling the gap that will be left by reduced government spending.”

Asset class ratings at June 30

All-Stocks fixed interest gilts overvalued
Over-15-Year fixed interest gilts overvalued
Over-5-Year Index-Linked gilts extremely overvalued
Over 15-Year Index-Linked gilts extremely overvalued
Non-Government bonds, all stocks undervalued/fair value
Non-Government bonds, over 10 years undervalued/fair value
UK equities fair value
Overseas equities fair value
Property fair value

The Mercer review says the firm believes that, on balance, yields are more likely to increase than fall over the medium term, absent a double-dip recession, but further stalling of the recovery could edge them lower in the short term.

“Looking forward, we believe that credit spreads will contract over the medium term, although we expect the contraction to take 12-18 months from here. We also expect that the narrowing of credit spreads might well be offset by a rising of underlying gilt yields, so absolute returns may be modest.”

(See chart showing the widening of credit spreads.)

On UK property, Mercer says it continues to believe the market is attractive over the medium term, however, there will be better points to enter the market over the next six-12 months.

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