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Co-Head of Investment Strategy Natasha Brook-Walters and Head of Macro Strategy John Butler discuss the implications of the recent sell-off in UK markets for global markets and investors. This article is based on a webcast held on 6 October 2022.
Last week we witnessed a historic move in both sterling and gilts. Cable, the GBP-USD exchange rate, hit a low of USD1.0350 on 26 September and two days later, on the 28th, the 10-year gilt reached a high of 4.59% while the 30-year moved above 5% from 3.5% earlier in the month. To put the scale and speed of these moves into context, it is worth remembering that 30-year gilts started the year at around 1.2%.
This multiple standard-deviation event was exceptionally painful for the UK pension industry, with many UK defined benefit schemes facing collateral calls on their derivatives used for liability matching.
As rates started to rise, impacted pension funds were required to post more variation margin to make up the mark-to-market losses they were suffering from their exposure to long-duration instruments. This created a vicious cycle as the assets sold included long-dated gilts and corporate bonds, which, in turn, added to instability in the long end of the UK yield curve, driving rates even higher. Unusually, there were also sales of assets that are not normally associated with liquidity buffers, such as equities.
This negative loop and market disruption was so severe that, on Wednesday the 28th, the Bank of England (BoE) stepped in to restore calm with a two-week emergency gilt purchasing programme.
By John Butler
A structural return of inflation — The events of last week in the UK need to be put into the context of a return of inflation across the globe due to structural supply constraints and external factors such as the war in Ukraine. This means that we now face a new regime with an explicit trade-off between inflation and growth, which has huge policy implications. As inflation has developed significant momentum, central banks cannot slow their tightening until they have absolute certainty that inflation has receded. This means that we will need to get used to more volatile and pronounced cycles with more frequent recessions. The central banks’ task is hugely complicated by today’s environment where, while most central banks are above their inflation targets, they contend with embedded supply constraints and the lowest unemployment rate globally in over 40 years. This requires a delicate balancing act between preventing inflation becoming entrenched as it did in the 1970s — which would de-anchor the long end of the bond markets — and ensuring that this tightening does not cause systemic damage in an environment predicated on persistently low and stable rates.
Hard-to-resolve policy imbalances — The UK is the poster child of these imbalances: having experienced the biggest negative supply shock of all developed economies, following its exit from the European Union, it still runs a monetary and fiscal policy that promotes demand. This translates into a high current account deficit that, since the Brexit referendum, is no longer financed by sticky inward foreign investment, but instead relies on attracting foreign demand for gilts. The announcement of a fiscal package potentially amounting to 7.5 % of GDP exacerbates this need for external financing. Therefore, the market response of needing a higher risk premium for owning sterling and gilts was, in my view, wholly appropriate. While the catalyst of the crisis was the poorly communicated fiscal response, the underlying tensions have been brewing for years, and were compounded by a perception that the BoE — relative to other central banks — appeared to take a softer stance on inflation.
The BoE has stabilised the situation for now, but the underlying situation remains the same, with unemployment at record lows, inflation reaching double-digit levels and the fiscal package still largely in place. Admittedly, household income will get squeezed by higher mortgage rates but that will be partially offset by the energy support package, which may also bring down nominal inflation to, I expect, around 4.5% by the end of 2023. However, with still strong wage growth and a rapid improvement in productivity unlikely — despite some positive measures in the new budget — inflation is likely to be stickier. This means that for the BoE to maintain the credibility of its inflation target, it will have to raise interest rates sharply, but that could run counter to the need for monetary stability as markets are now closely monitoring any sign of weakness. I think there are some key dates to watch.
14 October — When the temporary gilt purchase programme ends, there is a real risk that the markets may test the BoE’s resolve. I think the BoE still does not fully understand the impact on pension funds and their capacity to react.
Renewed market turmoil could lead to some further quantitative easing, albeit perhaps by a different mechanism such as direct liquidity lines. This would, I think, involve the Monetary Policy Committee (MPC), thereby clearly indicating that the BoE is prepared to sacrifice its price stability goals in favour of financial stability.
End of October/November — When we should get some greater clarification on the UK government’s budget package and longer-term fiscal policy path.
3 November — The next MPC Committee meeting, where the BoE will need to deliver a substantial hike, of 1% or more, to send a signal that it remains committed to price stability.
Markets are closely watching for signs of a potential pivot in central bank policies in response to monetary stability and growth concerns given the BoE’s return to temporary quantitative easing and the decision by the Reserve Bank of Australia to only undertake a limited hike. While it is not my base case, such a pivot could lead to higher inflation over the long term akin to what happened in the 1970s. Other countries running inappropriate policies also require close monitoring and here, I think, Italy could be a potential flash point if, as expected, the new Italian government announces an energy rescue package in line with those of France and Germany. If this fiscal loosening were to cause major spread widening between Italian bonds and Bunds, it could force the European Central Bank to sell Bunds, resulting in markets demanding higher Bund yields. In turn, this would impact gilt yields as the European institutions, which almost exclusively finance the UK’s current account deficit, would need higher compensation to invest in gilts relative to Bunds.
I think a durable positive change requires a more appropriate policy mix of tighter monetary policy and a fiscal policy that focuses on long-term growth. However, until policymakers are willing or able to stomach the significant reduction in demand and even the recession needed to beat inflation decisively, we are likely to oscillate between shorter cycles with a trade-off between growth and inflation and with sharp rallies and sell-offs of risk assets.
By Natasha Brook-Walters
This is an environment where markets are moving fast. While, to date, our investors have been able to navigate these markets, helped by the insights of our macro strategists, it requires a renewed focus on economics, policy and geopolitics. None of this is easy, but it also provides opportunity. For instance, through our daily Morning Meetings and other forms of internal investor dialogue, we have seen several of our equity and credit investors highlighting opportunities arising from indiscriminate price moves.
A key concern we had last week was about the potential of contagion, most notably in the US pension market. In discussing this with our US pensions expert Amy Trainor, we concluded that these moves in a highly liquid market of a G7 economy would prompt risk managers across our client base to re-assess their portfolios and risk exposures to ensure they also had ample liquidity to meet rate moves that might be larger than envisioned by their models. We also delved deeper into the differences between the UK and US systems and potential avenues for contagion and concluded that factors such as the greater use of physical bonds by US pension funds limited the contagion potential. In the event, some US funds needed to raise liquidity quickly, but the impact was not on the same scale as we saw in the UK.
Our overall view was that, for the moment, contagion was limited. Sadly, markets have witnessed multiple standard-deviation moves before, and while these are hard to deal with, they do not always lead to broad-based contagion. At the same time, these dislocations are probably a wake-up call that as we enter a more volatile and inflationary world stress will appear in the system. With that in mind, we think last week’s events should prompt a renewed focus on reviewing asset allocation and liquidity posture.
In the multiple conversations we had with clients since to assess the fall-out of last week’s events, three areas of focus stand out:
We are happy to share our expertise and support as we navigate these markets. Please do not hesitate to contact your relationship manager. For those with questions on funding ratios and the specific implications for pension funds, please contact your local Pensions Team.