June 30th, 2017
The second quarter of 2017 ended with a less favorable environment for pension plans, as the Ryan Labs Asset Allocation Model returned +2.61% versus the RL PPA liabilities’ return of +4.24%. This underperformance of 1.63% decreased the RL PPA funding ratio model by approximately 1%, falling from 85% to 84%. The key drivers to underperformance were the Bloomberg Barclays U.S. Aggregate index and S&P 500 as they returned 1.45% and 3.09% versus the liability return of 4.24%, respectively.
Year-to-date, funding has improved from 82% to 84% lead by the rally in domestic and international equity markets, with the S&P 500 returning +9.34% and the MSCI EAFE International’s +14.24% return. The trailing 12-month period provides a more meaningful funding improvement of 10%, from 74% to 84%. Similarly, this increase is linked to domestic and international equities rallying by 17.9% and 20.84% during the period. As a result, many pensions were able to pull glide path triggers and take advantage of the opportunity to further de-risk their plans.
Fixed income provided low-digit returns in the second quarter with long duration bonds being the top performer. The yield curve flattened modestly as short-term rates rose, while tighter spreads boosted corporate credit returns. As of June, the spread between the 2 Year and 10 Year Treasuries was 92 basis points (bps), a decrease of 31 bps from the December 2016 level of 123 bps. Within high-grade fixed income, credit spreads in the Barclays Aggregate Index tightened to 103 bps in June from 118 bps in December 2016.
Domestic equities provided modest gains in the second quarter due to an improved earnings season and optimism in upcoming earnings despite weakening economic data. Non-U.S. equities rallied for the second quarter in a row given a weakening in the dollar, although there has been a softening in global manufacturing sentiment.
In June, the Fed overlooked mixed economic data and lowered inflation expectations by raising the Federal Funds target rate by 25 bps, from 1.0% to 1.25%. The Fed also seeks to “begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated” (1), which would effectively decrease the amount of reinvestment in Treasuries and MBS over time.
Another highlight and implication for pension funds from the second quarter is the historically low volatility experienced by most asset classes. Typically, such low volatility encourage risk taking and rather aggressive investment strategies given the perception of calm markets. Pensions should consider this low volatility environment along with the current themes of lowered inflation expectations (given falling commodity prices led by oil), possible changes to monetary policy by the Fed, and a possible maturing U.S. business cycle.