Market Thinking

making sense of the narrative

Danger UXB

Danger UXB was a British TV series about a company of soldiers dealing with UXBs, or Unexploded Bombs, left in London after the Blitz. Made in the late 1970s it will doubtless be familiar to BoE governor Andrew Bailey and certainly the former Deputy Governor Andy Haldane, whose presentation given back in 2014, highlighted the problems of regulations like FRS 17 moving risk back from those most able to take it (the financial system) to those those least able to – pension fund sponsors and pensioners. In particular he discussed how asset allocation was being driven further and further out of equities and into low yielding bonds and how the tendency would be to buy more bonds as rates fell, creating an overshoot. Of course now, as rates are going back up again we are finding the reverse happening, with the added excitement of previously under-appreciated leverage and illiquidity that has caused the distress in the LDI market (see Leveraged and Dangerously Illiquid.) After the ‘less than helpful’ remarks this week by Governor Bailey, many in the City are wishing that the former Deputy Governor had got the job and it was him, rather than Andrew Bailey now hovering the pliers over the red wire and the blue wires.

There is in fact a real risk that, thanks to a decade or more of completely inappropriate monetary policy (only now beginning to be acknowledged) the plumbing of the financial system has become so distorted with hidden leverage and illiquidity that there are going to be a lot more of these landmines going off.

The rules-based system, that sees volatility as one of the only risks, continues to be the gift that keeps on giving, especially in the ruinous environment of zero interest rates and a frantic chase for yield. You suppress volatility and everyone is happy, especially as apparently it can be done for little or no cost – at least according to your friendly investment bank or asset management company – because it means you now aren’t taking any risk. Except of course risk is never removed, it is simply moved around, and usually hidden – until it rises to the surface, as now. Zero Interest Rates, along with Zero Covid and Zero Carbon was one of the deadly trinity of Zeros imposed from the top down by the Globalists that not only failed to produce the intended consequences, but largely achieved the opposite and now that it is being reversed is revealing a whole lot more unintended consequences.

As discussed last week, the LDI is a relatively simple issue – the industry had been led down something of a garden path by the financial sector offering a product that was packaged as ‘low risk’ but turned out to have embedded leverage and illiquidity. As with any of these financial products – from Portfolio insurance in 1987 to junk bonds in 1990, split cap and property investment trusts in the 2000s, CDS in 2008 and many others, the story is always the same. The measured risk (volatility or benchmark) is suppressed and returns are generated by taking risk elsewhere – almost always with leverage and often with poor liquidity, although the reality is that even the most liquid markets freeze when there is distressed selling. It is under these circumstances that those enforcing the selling, in this case the BoE, have to step in to provide that liquidity as buyer of last resort. The FT continues to offer the best coverage on the issue, with Tony Nangle in particular providing clear and insightful analysis (behind paywall). Importantly, as the Algo driven clickbait headlines continue to erroneously make this all about the UK mini Budget and government policy (egged on by the Globalists desperate to keep their failed triple zero policies in place), the positive aspect of all this is that, as Tony Nagle points out and as the FT graphic shows, most of the Pension schemes now have assets ahead of liabilities and are now back in surplus.

The journey is painful, but the end result is desirable. UK Pensions back in surplus

Source FT

Less Leverage, more liquidity, please.

With Gilts now up at 4.0% – having hit 4.5% this week – the long term investors unencumbered by the need to get out of their LDI structure are clearly starting to lock in some genuine risk free return. Going forward, it looks likely that pension funds will be looking to reduce leverage and also lower their exposure to the higher yielding illiquid assets they had bought in the zero rate environment. As Tony Nangle put it

Illiquid assets that don’t get repriced with everything else will be a larger component than planned for or desired. Trying to reduce these in a hurry might be tricky. And good luck originating (or rolling over) infrastructure assets, private equity, private debt or venture capital for UK pension funds anytime soon.

Tony Nangle, the upside of a Gilt Market Crisis, FT

The key message is that, while they won’t necessarily be sellers of Alternatives, they are going to be a lot more reluctant to take on any more illiquid assets, a subsector of markets alreay facing issues from a return on cash approaching 4%. And it won’t just be pension funds. For while according to a June study by Blackrock, the biggest concerns among the CIOs of the multi-trillion $ life insurance industry are Inflation, liquidity and volatility, and yet (somewhat confusingly) their apparent key change to their Strategic Asset Allocation is going to involve using more derivatives and buying more alternatives, we suspect that, having seen the events of the last two weeks, they too are going to want to avoid any UXBs of their own.

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