Have British pension funds missed the lesson of the MBS collapse?

It was her promises to revitalize the British economy by passing massive tax cuts that gave Liz Truss the opportunity to move to 10 Downing Street. However, its supply-side economics (cutting taxes, less regulation, and allowing free trade) could not operate in a vacuum, isolated from the realities of monetary policy. The markets therefore hated his plan. The pound fell to record lows as it became apparent that its proposed tax cuts were unfunded and the UK government was not serious about tackling inflation. Persistent and substantial inflation risked causing instability and stagnation in financial markets. After considerable outcry, Truss is now the ex-Prime Minister with the shortest term in British history.

The aftermath has been felt across British political and economic spheres, with Finance Minister Kwasi Kwarteng being sacked after just six weeks in office. The turmoil has also led to a massive explosion in liability-driven investment management. Many of the UK’s biggest pension funds were big buyers of ratings-approved derivatives, but as the markets quickly reversed course they suffered massive margin calls.

As Yogi Berra would say, it’s deja vu all over again and analogous to the mortgage-backed securities crash of 2007-10. It appears that to keep yields at a level that would allow them to meet future liabilities, UK pension funds have been buying rated securities (in this case, secured loan bonds). Today, many of them are forced to quickly unwind their positions in response to turbulent markets and have suddenly become forced sellers. If they had just bought these titles, the problems would be bad enough. But it appears they did it with derivatives and relied on the ratings agency’s conclusion that they were highly rated securities – the maneuver freed up additional cash so that they can bet other bets. However, when interest rates soared and the UK currency fell, there was a sell-off with margin calls for pension funds across the UK. Thus, the Bank of England was forced to step in and provide temporary liquidity.

Although the funds may have called what they were doing “liability-driven matching,” these underwater pension schemes essentially speculated in derivatives to hedge their exposure to changes in bond yields and used the excess funds generated by “risk reduction” to earn even more. aggressive investments elsewhere. This is one of those ideas that may look good on paper but in practice fall apart due to excessive leverage. In this case, there wasn’t a sane adult in the room who was asking, “wait a minute, how is that reduce risk?”

It’s a big story with implications that remain to be seen, but Kwarteng’s replacement, former foreign secretary Jeremy Hunt, has done an about-face and will now allow corporation tax to rise from 19% to 25% as expected. However, this series of events has already caused serious damage. The government had already scrapped its plan to cut tax rates for the nation’s top earners from 45% to 40%, along with Truss’ energy plan and promise not to cut spending. Hunt recently indicated that the UK government will need to save billions of pounds and is expected to present a medium-term budget plan by the end of the month.

These political announcements alone shouldn’t be enough to cause a run on the banks, but behind the scenes there was massive derivatives speculation. Of course, it makes no sense to pretend that you’ve matched your debts by canceling them with long-term fixed income investments at a time when the fixed income market was experiencing its biggest bubble ever. The other side of this trade included billions of dollars of smart borrowers who wanted to lock in ridiculously low interest rates for as long as possible to fund extremely risky business plans.

UK policy makers, legislators and the Bank of England need to be very careful now. They must carefully manage this developing crisis as their entire plan to fight inflation through tighter monetary policy is now in jeopardy. Who knows what this will do to their currency and ultimately the UK economy? This throws a spanner in the works of managing their economy for good results, including high employment and low inflation. Of course, the UK is suffering like most countries in the region due to soaring energy costs from the war in Ukraine, supply constraints and a nascent Covid recovery. However, it has already undergone another dramatic reset, having gone through BREXIT just a few years ago. And now we have seen its currency plummet despite higher interest rates.

The implication for US-based investors is that these overleveraged UK pension schemes have gotten rid of leveraged loans and bonds of all kinds. Although these markets have already been chilled by uncertainty, pension funds that bought high and are now unloading could throw them into real panic. As we often see with market reversals, new trends can continue beyond what most rational people anticipate. The Bank of England acted with urgency when the first wave of selling hit, but empirical analysis and data trends indicate a second wave is brewing as the fixed income market continues to slump. adapt to ever-higher interest rates. Investors, including pension funds who should have been more savvy, bought long-term paper at the 4,000-year high in the fixed-income market and are now being forced to take big losses.

And while things aren’t quite as bleak domestically, there are still plenty of areas of concern for investors. For example, in June last year, the US 30-year Treasury note traded at a yield of 1.6% to maturity, indicating that investors were attributing virtually no risk to owning this security – neither the risk of inflation nor the time value of money. risk, and certainly not interest rate risk. But the world has changed dramatically over the past year, and that same stock is now earning 4.2%! However, that still isn’t beating inflation, which is running at 8-9%, so something has to give.

Global inflation is at levels not seen in 40 years, and central banks appear unified in their efforts to combat it. At the same time, structural challenges, such as China’s zero-COVID on-and-off policy, are causing supply chain disruptions. Similarly, the war in Ukraine and its impact on energy and other commodity markets is driving inflation.

The impact of energy on the European economy will be enormous, as will the rapid depreciation of currencies in the Eurozone, the UK and emerging markets, as the cost of borrowing in US dollars has just increased considerably. There could be a lot of suffering this winter in Europe as electricity costs soar for basic necessities like home heating if Russia cuts off supplies.

Based on these factors, we should expect many more corporate bankruptcies, not only in the US, Eurozone and UK, but also in emerging markets where the same trends are occurring then as currencies depreciate against the US dollar as the Fed takes the lead. raise rates.

It’s a difficult time, yes, but sudden changes often reveal new opportunities. Historically, fixed income securities were a safe, low-risk component of most portfolios. Now you see benchmark fixed income securities selling off so much that the entire world of investors has to revise their expectations, causing major turmoil and distress.

Going forward, the best course for investors is to increase short selling and be patient with long positions. Since you need to invest in long positions, your best bet will be to focus on short-term stocks to return money to shareholders and selectively buy distressed stocks.

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