Another week, another struggle between the Bank of England and the government to arrest rising inflation and anaemic economic growth respectively.
This week there was some mixed messaging from the UK’s central bank – proving that it is not just the government that can confuse markets.
On Monday, it announced an increase in the daily buying limit of bonds from £5bn to £10bn, a move that encouraged markets into thinking that the Bank would do ‘whatever it takes’ to bring back stability.
Yet by Wednesday, governor Andrew Bailey told investors that pension funds had three days to get their affairs in order as the bond buying scheme would end as planned today.
As a reminder, this whole mess was brought about by the mini-Budget, which promised to pump up growth by reducing tax and injecting fiscal stimulus into the economy. This is an inflationary set of policies, however.
This led to a run on government bonds, with the market anticipating significantly higher interest rates, which in turn caused alarm bells in pension funds.
Tom Selby at AJ Bell summed it up best when he said that higher gilt yields were good news for defined benefit pensions because they push down the value of liabilities, which, all else being equal, should improve their funding position.
However, lots use liability-driven investment (LDI) strategies to hedge against interest rate risk. “This essentially means that when gilt yields rise and the funding position of the scheme improves, the scheme will need to pay money to the investment bank running the LDI fund,” he said.
In stepped the Bank to prop up the gilt market and prevent a liquidity crisis in pension funds, but this cannot last forever or indeed, it seems, even into next week.
While the outlook is bleak, managers told Trustnet that we have yet to reach “peak fear” and that things could get a lot worse before they get better.
Another dreary statistic this week was the news that the UK economy dropped back into negative territory in August, having surprised with some growth in July.
GDP contracted 0.3% but there are expectations of worse to come in September’s readings, when the mini-Budget was announced and the country slowed down for around half of the month to mourn the death of Queen Elizabeth II.
So if there is more pain to come, what should we be looking for? There is a whole generation of investors that have never experienced high inflation or seen this part of the cycle before.
There are already tentative signs of shock, with parcel delivery company Fedex removing its earnings forecast for the year, stating it expected a slowdown over the coming months to affect its full-year guidance.
One thing worth keeping an eye on is the amount of defaults. While there have been few rumblings about credit quality so far in this cycle, it may rear its head as the cost-of-living crisis bites.
Interest rates have risen from 2% to around 6%, which many people and businesses will be unable to afford and could lead to mass defaults.
Murray International fund manager Bruce Stout said: “People keep saying that the banks are in great condition and the balance sheets are really strong. We will see. They always say that. They have not had to pay a penny on deposits and have made money on loans at least, so I am sure they are in good condition.”
One option that may seem appealing is to look to the US. Stout noted that when everything goes to pot, investors will look to the dollar and US treasuries as a safety blanket.
It may not be a bad time to get into these assets, particularly for UK investors, where the currency effect will reap returns, even if yields keep rising.