As we close the year of the Snake, and move into the year of the Horse, we are again reviewing the major asset class moves, from a UK pension fund investment perspective, in a similar way to what we did last year.
Long term inflation expectations increased, with the 30 year zero-coupon RPI swap ending the year around 0.5% higher than it started, at 3.74%, this compares to the lows of around 3.2% we saw in 2012 and recent highs over 4% we saw in 2008. Real yields generally fell over the course of the year back into negative territory.
The main driver of the inflation move occurred in January when the Consumer Prices Advisory Committee (“CPAC”) concluded its investigation into the formula effect gap between CPI and RPI. The final decision, contrary to market expectations, was for no change to the RPI index. Inflation expectations increased by around 30 basis points on the day this was announced, in January 2013.
UK & Global Fixed Income
You could hardly read an economics article during 2013 without seeing the word “taper”(referring to the Federal Reserve’s much-anticipated reduction in its asset purchase, or Quantitative Easing program), and many global fixed-income markets moved largely in step with the US over the course of the year as investors adjusted their expectations of the timing and size of tapering. Overall, interest rates in most major markets ended the year higher than they started.
In the UK long dated interest rates (measured by the 30-year zero coupon swap rate) ended the year close to their high’s at 3.4%, around 0.5% higher than they started. The yield on the 2042 gilt ended the year at 3.61%, rising by slightly more than the corresponding swap rate and highlighting the increasing attractiveness of gilts compared to swaps for long-dated liability hedging.
Benchmark 10-year interest rates in major developed markets all followed a similar path over the year, reacting to investor’s expectations on the tapering in the US. The US 10 year yield rose from 1.6% to 3%, the UK from 1.8% to 3% and the German bund from 1.4% to 1.9%.
Yields in the European periphery, having seen dramatic widening at times in 2012 all declined quite substantially as problems in Spain and Italy seemed to recede from investors’ minds and Ireland successfully exited its bailout program. 10-year yields in both Spain and Italy were around 4% at the end of 2013, compared to highs of more than 7% in 2012.
Economic fundamentals in most developed economies improved quite significantly, especially the UK and the US. In the UK we saw a significant uptick in indicators such as PMI surveys after the summer, which increased to multi-decade highs and resulted in economists’ revising up their 2013 GDP estimates. This enabled the chancellor to deliver an upbeat Autumn statement, with the latest forecasts from the Office of Budgetary Responsibility (“OBR”) revising up its earlier GDP forecast for 2013 to 1.4% and for 2014 to 2.4%. Sterling strengthened against both the dollar and the Euro during the second half of the year on the back of the stronger economic data, with the pound closing the year on its highs against the dollar of $1.66, having started the year at a similar level and falling to lows of $1.48 during the year.
Most developed equity markets experienced returns well above long term averages, and the highest annual return since the 2009 bounce from the market lows. There continued to be significant differentiation among markets. The MSCI World was up 24%, compared to 14% in 2012, with the Nikkei and S&P500 leading the way with a 50% and 30% return respectively, which took the S&P into new highs, some 30% above the 2007 peaks. The FTSE 100 index experienced a gain of 14% in price index terms, compared to a gain of 7% in 2012, a -2% return in 2011 and a +11% return in 2011. The DAX and Eurostoxx both experienced higher returns than the FTSE in 2013, with the DAX up 25% and the Eurostoxx up 18%.
A significant equity market story of the year was the underperformance of Emerging Markets, which generally reacted badly to concerns over tapering, with the MSCI Emerging index falling 5% in 2013, with Latin American markets and South Africa generally underperforming and other markets such as China and South Korea recording only relatively modest positive returns.
The experienced volatility among most equity indices during 2013 was low by historical standards, and the market pricing of option hedging against market falls reflected this. The VIX volatility index (which represents the implied volatility on 2-3 month maturity S&P 500 options) fell from a level of 17 volatility points at the start of the year to 13 at the end of the year, having been as low as 11 and as high as 20 during the year. This represents a fairly narrow range for the VIX which by comparison experienced a high of 27 in 2012 and 43 in August 2011. Similar indices now exist for volatility on the FTSE and Eurosotxx ( dubbed the VFTSE and VSTOXX respectively). These showed the same pattern as the VIX during 2013 of declining to low levels. The VFTSE declining by 6 volatility points to a level of 12 and the VSTOXX declining by 4 volatility points to 17.
The three main classes of credit all performed strongly for the second year in succession, with UK Investment Grade credit returning 4.7% in excess of swaps over the year compared to returns of 7% and 4% in the preview two years. Subordinated debt was up 10.5% in excess of swaps in 2013 and European High Yield returned 10% in excess of swaps. At the end of the year spreads on High Yield Debt were around 300 basis points, compared to c540 at the beginning of the year, and highs of 1500 in 2008-9.
Commodity indices generally fell during 2013, with the DJ-UBS index ending the year around 10% lower than it started, having been flat in 2012. The main driver of this was Gold which fell around 28% during the year including a 10% fall over the course of a single trading day in April. Crude oil finished the year around 7% higher than it started, at $98, having been as high as $110 during the year.
Last year in our review we highlighted the growing appetite for risk-based and risk-controlled approaches to investing such as Volatility Controlled Equity and Risk Parity. We continue to see interest in these approaches especially when they are combined with portfolio downside protection, and indeed we executed the first such transaction for a UK pension fund in 2013. Given the large divergence in returns this year between equity, commodities and fixed income (with equities substantially positive and both commodity and fixed income negative) multi-asset portfolios with an overweight to equities have outperformed those with an equal balance of risk among asset classes.
Happy New Year and best of luck in 2014!