Appendix 2
REPORT OF THE INVESTMENT ADVISER
PREPARED FOR
Dorset County Pension Fund
Pension Fund Committee
November 22nd 2012
Investment Outlook
Alan Saunders
AllenbridgeEpicInvestment Advisers Limited (AllenbridgeEpic)
AllenbridgeEpic Investment Advisers Limited is a subsidiary of Allenbridge Investment Solutions LLP
Risk Warning
alan.saunders@allenbridgeepic.com
www.allenbridgeepic.com
AllenbridgeEpic Investment Advisers Limited is an appointed representative of Capital Advisory Partners Limited
which is Authorised and Regulated by the Financial Services Authority.
This report has been prepared for the Dorset County Pension Fund and is for the Fund’s exclusive use. No liability is admitted
to any other user of this report. It should not be construed as an offer or solicitation to buy or sell any investment.
The value of investments and the income from them may fluctuate and may fall as well as rise. Past performance is not
necessarily a guide to future investment returns. Investments may involve foreign currency transactions (i.e. denominated in
a currency other than the investor's base currency) and may therefore be subject to fluctuations in currency values and the
value of such investments may fall as well as rise. The investor may not get back the original amount invested. Simulations
based on past performance may not necessarily be a reliable guide to future investment returns.
AllenbridgeEpic Investment Advisers Limited or an affiliated company may have an interest, position or effect transactions in
any investment mentioned. Any information contained herein has been obtained from reliable sources but we do not
represent that it is accurate or complete. Any opinions or recommendations are those of the author and are subject to
change without notice.
Appendix 2
Dorset County Pension Fund
November 2012
Report of the Investment Adviser
Investment Outlook
Summary
Market sentiment continued to improve during the third quarter and into the fourth. Equities
rose some 5% in Q3 while gilt yields bottomed during the quarter. Perhaps the main catalyst
has been a relaxation in the crisis atmosphere in the Eurozone which has led to a reduction in
risk premia for Spanish and Italian bond yields. At the same time, the US election is now out of
the way, removing some of the uncertainty, though not the pending “fiscal cliff”.
There is of course a long way to go. It was apparent early in the year that the global economy
had lost momentum and that global growth was slowing , led by the Euro area which is now
heavily in recession . Risk assets like equities retreated accordingly but have staged a credible
rally since the summer based on the assumption that policymakers in Europe, the US and
China will work their way through the problems. If there is a positive outcome, equities have
more upside but they are overpriced if the global economy continues to weaken into 2013. With
the risks in the Eurozone still evident, a cautious tone is appropriate at these levels.
Economy
The UK economy at least had better news in Q3 with a surprising 1% GNP growth rise,
reversing the contraction of the previous quarters. Even so, output is still 3% below 2008 levels
in comparison to the US which is 5% ahead. Inflation is falling back at last with CPI down to
2.2% recently but there are grounds for thinking it will start to rise again with higher food and
energy bills. The Chancellor’s twin targets are reducing the deficit and stabilising the debt/GNP
ratio which is still climbing. On both, he is likely to have to concede some slippage otherwise
he will have to impose further austerity which is politically challenging. Next year’s forecast of
GNP growth a little below 1%, followed by 1.5% in 2014 is not helping the budget arithmetic.
In the US, it is too early to forecast the outcome of the fiscal debate post- election but the
concern remains that mandatory tax increase and spending cuts could weaken the economy
badly if agreement is not reached between Congress and the White House. More positively,
Bernanke announced the commencement of QE3, a new programme this time buying $40bn a
month of mortgage bonds rather than Treasuries which has already had a positive effect on
markets. Obama’s fiscal stimulus and successive rounds of monetary easing have produced the
best relative economic performance of the developed world but the FED clearly is still
concerned about the lack of traction in the economy.
In Europe, the news-flow is not all negative but progress is very slow. The ECB has announced
its policy of Outright Monetary Transactions[ OMT}, ie unlimited buying of government
bonds, conditional upon countries making a request for help and putting in place a fiscal
adjustment process. It seems to have done the trick in terms of reducing the risk spreads on
Spanish bonds even though the Spanish government is reluctant to make the request. At the
same time, the German court approved the new European Stability Mechanism which will
provide further support though the German authorities are opposed to it bailing out banks’
legacy problems.
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Appendix 2
Meanwhile France and Germany are opposed over banking union , which France wants and
fiscal union, which Germany wants. The economic situation in Europe is very serious and
Germany is now feeling the effects of the general recession. Little by little, though, Germany
appears to be coming round to a more constructive position.
Elsewhere, the China slowdown continues to weigh down on global exports and the
appointment of the new leadership may lead to fresh initiatives to stimulate the economy. Japan
is still struggling but has limited policy weapons to use while the spat between China and Japan
over disputed islands needs watching. Commodity prices remain subdued, except food prices so
that hopefully subdued global economic growth next year will not mean global stagflation.
Markets
In Q3, equities and corporate bonds outperformed gilts while index linked produced negative
returns. This mirrors the performance of the year to date returns, demonstrating the recovery in
sentiment for risk assets against defensive assets , the reverse of the outturn for 2011 when we
had double digit returns for gilts and negative returns for equities. Property has been closer to
gilts than equities with a good outturn last year and fairly flat returns this year.
Although gilt yields are off their lows, they continue to price in an extreme deflation scenario
which still looks unlikely so it remains an expensive asset class. Index linked yields are equally
well below long term averages with real yields mostly in negative territory .This reflects the
path of nominal yields essentially for at least inflationary expectations have fallen back and are
closing in on the Boa’s target .To that extent, index linked look rather better value than
conventional gilts. Much the same could be said of corporate bonds which look dear in absolute
terms as yields are low but still carry attractive spreads over gilts compared to history Default
rates remain low so spreads should really be lower.
In contrast, global equities are on undemanding valuations provided corporate earnings hold up
and the European recession does not spread. Forward P/E ratios are around 12.5, below long
term averages though, on a cyclically adjusted basis, allowing for the recent recovery in
corporate earnings , this widens out to around 16.0. That means equities are vulnerable if
macroeconomic conditions deteriorate again or if there is bad news on the Eurozone. Emerging
markets look best value around as valuations are similar to developed markets but underlying
growth should still be better. China is still lagging but Brazil and India have started to rally
.European markets , perhaps surprisingly, have also started to recover and could have some
way to go.
After a fairly significant relief rally, it is probably time for equities to mark time until we get
greater visibility on issues like the “fiscal cliff”, Eurozone developments and China as
sentiment could easily reverse .Longer term returns may also have to be shaved in view of the
likely reduction in long term economic growth projections.
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Appendix 2
Property
Property too looks attractive against gilts with a yield averaging some 6%. The market though
is going through a slowdown with capital values falling modestly. In that sense, it is not a
cyclical downturn but a reaction to the rather sharp recovery in values that took place after the
crash of 2008/9.
Rental values are falling reflecting the broader economic slowdown and there continues to be
the broad disparity between London and the south east versus the rest of the country.
Increasingly, funds are looking for long lease , upward only or inflation adjusted rent reviews
which have more of a liability matching asset characteristic than that of a growth asset but these
are hard to find. After the disappointment of 2008/9,, property has acted as a stabiliser in
portfolios thankfully.
Alternatives
The suite of products jostling in the alternatives space is quite wide but they all attempt to
capture more of an absolute return approach rather than a benchmark or relative return
approach to investing. In that sense, cash is probably a suitable benchmark for most products
which should offer diversifying returns against equities and with a greater emphasis on limiting
downside. Hedge funds failed to do this in the market crash and their participation in the
subsequent rebound has been disappointing, with the exception of some managers. For that
reason, our review of Alternatives will cover a wider range of sources of alpha .
Asset Allocation
Last quarter , we reported that risk assets looked reasonable value while safe assets looked very
expensive. Over the last three months, that call has proved correct but such is the wide range of
uncertainty still that it would be unwise to extrapolate the recent trends short term though they
should play out in the longer term.
Meanwhile, the bond portfolio has been split into a credit portfolio investing in corporate bonds
and a liability matching portfolio intended to hedge out inflation risk, the starting point of
which is a portfolio of index- linked bonds. While this is also used as an overlay to match the
duration of liabilities represented by our 20% allocation to bonds, its real purpose is to hedge
out the uncapped inflation exposure the scheme faces with its future pensions. With inflation
numbers beginning to fall, this may be a good time to start locking in inflation to protect
against the risk that inflation will start to rise again.
Alan Saunders
Senior Adviser
AllenbridgeEpic Investment Advisers
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