Against a backdrop of geopolitical and economic uncertainty, which is unprecedented in my 50 years of market involvement, I shall focus on just one UK domestic issue – inflation.
Since the release of the latest CPI figures, no end of talking heads have delved into the entrails and one central point has emerged. Core inflation is proving very sticky.
It is not declining as rapidly as was hoped or priced by markets and remains much more elevated than in the other major developed economies. This latter aspect may be, in part, an effect of our post-Brexit world. This bout of inflation has its roots in the response of the Bank of England to the early pandemic ‘dash for cash’, and another large round of quantitative easing (QE). While the earlier rounds of quantitative easing had driven up asset and house prices, this had not extended to prices more generally.
This may explain the Bank of England’s rather strange stance with the Treasury Select Committee, which was to say that the roots of today’s inflation were not monetary in origin but could be resolved by monetary policy.
Demand and supply
The difference between these periods is that post the global financial crisis, the economic problem was a lack of demand while now it is a shortage of supply. It would appear that further rate rises are now to be expected from the Bank, and that contrary to the IMF’s prognostications, a recession in the UK is a distinct possibility.
The reversal of QE, quantitative tightening, brings with it a risk that was not present in the earlier phase. As Raghuram Rajan pointed out in his August 2022 Jackson Hole speech; the commercial banks large levels of reserves are reflected in large levels of retail demand deposits and corporate lines of credit, and as they are run down or utilised, liquidity strains are likely to appear.
We have seen with Silicon Valley Bank how these strains may escalate with disastrous consequence. Inflation increases the likelihood of such events.
Liquidity in markets
The liquidity aspect of the gilt market turmoil witnessed in September last year and liability-driven investment has received a lot of attention, but in all too many cases the analysis is poor as it lacks detailed analysis of the mechanics and as such is superficial, or worse, it is just pure opinion to defend some prior position which the empirical evidence simply does not support.
It is important to understand that liquidity has a cost; that there is a price for liquidity. It is not some innate, binary property of a security. Its price is strongly procyclical.
For a security or class of security, it is adversely affected by the degree of concentration of its ownership. This was a real problem for index-linked gilts, with 80% or more of them being held by UK pension schemes.
In the period prior to 2021, this manifested itself in ever higher prices and real returns as low as RPI minus 3.2% in the 10-year maturity. Then, in the crisis, we saw price declines of more than 80% in long-dated linkers and real returns shifted from RPI -215 basis points, to RPI plus 210 basis points.
One of the aspects of the crisis which has gone largely without comment is that some schemes were large active sellers of other securities in order to buy index linked and conventional gilts. This activity was responsible for most of the low net sales of linkers and conventional gilts reported.
The repatriation of overseas sales proceeds was also a significant contributor to the strength of sterling after September 26, 2022. It is a cruel fact that the most resilient investment class during the crisis was emerging market debt.
It is clear from the valuations and reports of many pension schemes that have emerged during the past few months, that the full costs of the LDI crisis have not yet been realised, and that many schemes still need to be rebalanced.
According to the latest monetary statistics (M4L), debt has been reduced in segregated accounts and pooled funds, respectively by £20bn and £55bn, but there is clearly much further to go, particularly given the new buffer requirements for pooled funds.
One final observation is that index-linked gilts are in fact poor hedges of the inflation exposures of UK defined benefit schemes. That said, with real returns now in excess of 1% above RPI, they may well prove to be the safest of havens and offer the highest returns to unlevered investors in these troubled times.
Con Keating is head of research at Brighton Rock Group.