Updated with correction.
The threat of protectionism and a trade war between the U.S. and China are high on the watchlists of European asset owners, as the resulting return of volatility hit their investments in the first quarter of 2018.
Asset owners reporting portfolio updates for the three months ended March 31 watched a revival in stock market volatility eat away at returns. These negative returns followed positive, and in some cases stellar, investment returns for previous quarters and years.
The Cboe Volatility index jumped 81% in the first quarter, and was volatile within that period, rising 125% from Jan. 3 to March 3. Global stock markets, meanwhile, fell 3% in late February as talk ramped up of additional tariffs on imports and goods between the world's largest economies.
Pension fund executives are now watching closely for developments in conversations among world leaders and the impact on portfolios. Some also are looking to find opportunities.
"This heightening level of volatility is very positive in our opinion, because we think markets needed to consolidate. We would be worried if markets continued to rally," said Gregoire Haenni, chief investment officer of the 12.8 billion Swiss franc ($12.9 billion) Caisse de Prevoyance de l'Etat de Geneve, Geneva, Switzerland. CPEG's performance for the first quarter was -1%, following a 2017 full-year return of 9.5%.
Mr. Haenni said the fund's macro indicator "turned red" in February, and executives took profits. Following the market correction, "we bought some positions back — this is typical — (as we felt they were) supported by positive fundamentals."
Despite increased volatility, "the environment remains very healthy, supported by improving economic growth combined with strong corporate earnings." Mr. Haenni cited U.S. data, where the unemployment rate has reached a 17-year low and wages are rising at a healthy pace. Added to that, analysts expect 19.5% profit growth this year. "Historically, since 1980, in years when corporate earnings rose by more than 10%, the average annual return of the S&P 500 was 16%. For this reason, we think every market correction is an opportunity to rebalance the portfolio," said Mr. Haenni.
And more corrections might come. Mr. Haenni expects two catalysts to continue to weigh on equity markets: "The first is political uncertainty, and more specifically the trade war ... between the U.S. and China. We doubt a trade deal will be reached anytime soon."
The second, he added, is the normalization of monetary policies and fear of further interest rate hikes in the U.S. "We believe the Fed is determined to raise rates to have enough dry powder in case we experience another financial crisis," Mr. Haenni added.
Also noting the return of volatility were executives at the €46.1 billion ($55.9 billion) Ilmarinen Mutual Pension Insurance Co., Helsinki. The fund's first quarter return was -0.1%, with listed equities losing 1.6%. That followed a 7.2% full-year return.
Mikko Mursula, CIO at the fund, acknowledged the return of volatility from "surprisingly" low levels. "I would say the main reason behind volatility peaking in the listed equity market was exactly linked to geopolitical challenges and trade-war talks. Suddenly investors started to pay (more) attention to issues like that."
While short-term volatility "doesn't make us change our investment strategy … of course we do, every now and then, tactical trades in all these subasset classes. We can consider volatility as one of them. So we may have some tactical-type trades in place in FX or equity volatility," said Mr. Mursula. He declined to elaborate.
Consultants based in the U.K. also noted an uptick in conversations regarding trade war and protectionism concerns, and what investors can do about it.
"On a more tactical basis we have been talking to clients about and (have) implemented protection strategies using options," said Jignesh Sheth, head of strategy, investment consulting at JLT Employee Benefits in Manchester, England. "You have to pay away a little bit … but it will protect you from the more severe falls in equity markets. That's been the most topical, tactical switch we have been talking to clients about."
Tom Rivers, senior investment strategist at Cardano Risk Management Ltd. in London, agreed "the need for portfolio insurance is greater now than for the last couple of years." He said the use of protection through puts, or replacing some equity exposure with call options, is "a preferred strategy given that the market is so reactive right now to (U.S. President Donald) Trump policy."
Not calling the markets
Executives also highlighted the unpredictability of geopolitical events. While trade wars, protectionism and other macro elements are discussed at investment committee meetings, "they are more linked to our tactical asset allocation decision-making, and not … our strategic asset allocation," Ilmarinen's Mr. Mursula said. "One of the challenges with this theme or topic is it is very difficult to quantify them and 'guesstimate' what's going to happen next."
Also not keen to time markets is Kasper A. Lorenzen, chief investment officer at the 768.5 billion Danish kroner ($125.1 billion) ATP, Hilleroed, Denmark. The investment portfolio returned -1% in the first quarter, with international equities losing 2 billion kroner. ATP's investment return was 29.5% in 2017.
The question is how long-term investors respond. "We don't want to be too clever and predict where uncertainty will be, and if it will be higher next year. We believe in our portfolio construction, taking a balanced risk factor approach."
Executives also "still believe in the central banks' ability to take liquidity out of the market in a good, calm way. So we run risks the way we usually do, and just accept that we can't expect to make the same high risk-adjusted returns we've seen the past six to eight years," Mr. Lorenzen said. "Trade wars and protectionism are big themes, but also slow-moving. A potential negative supply shock from (those themes) is something you want to have on the screen for the investment strategy for next year, and the year after." The business cycle is also slow-moving, but "slightly quicker than trade wars, and you also want to have that on the screen," he said.
The €45.7 billion Varma Mutual Pension Insurance Co., Helsinki, also showed a negative investment return for the first quarter at -0.4%, following a 7.8% full-year 2017 return.
"We have had excellent returns the last years, and the feature of the markets and environment was low volatility," said Risto Murto, president and CEO at Varma. "This is a little bit back to normal — the first quarter we had clearly more volatility. (Our allocation) to hedge funds was good as it diversified the portfolio as planned," gaining 1.9%, while equity investments lost 1.4%.
Mr. Murto also cited trade wars as a cause of volatility. "We already have seen more policy-induced volatility in the market, mainly from the U.S. The latest thing is the trade war between the U.S. and China, which has also increased uncertainty, especially in some specific sectors — if you look at the China/U.S. trade relations, the hottest sector seems to be technology," he said.
As for the impact on the portfolio, "at the moment we are keeping our long-term view in place. It's still very hard to make definite conclusions regarding the underlying economy, policy and trade war risk," he said.
Dutch funds also felt the heat in the first quarter. The €405 billion ABP, Heerlen, Netherlands returned -1%, following a 3.6% return in the fourth quarter 2017. And the €196.6 billion Pensioenfonds Zorg en Welzijn, Zeist, Netherlands returned -0.6% in the first quarter, after a 3.7% return for the previous quarter. Statement from both funds cited uncertainty fueled by President Trump's trade stance among other factors.