Flash market update - September 2022

Since the start of 2022, markets have been behaving in a more volatile way. The emergence from lockdown (and changing demand dynamics) along with the Ukraine crisis have led to a sustained period of higher prices and heightened published short-term inflation. Bond yields globally have risen as high inflation has hit global growth, and central banks have sought to address the position.

Year to date, in order to control rising inflation, the Bank of England has continued to increase interest rates, but has been relatively cautious in doing so, as it runs the risk of raising rates too quickly which could result in a sustained period of recession.

On Thursday 22 September 2022, the Bank announced it would be raising interest rates by 0.5% to 2.25% (the highest level since 2008) and in a further inflationary tackling move, it announced it would start selling c£80bn of UK government bonds (around 10% of those purchased historically via Quantitative Easing). The market reacted moderately to this news and bond yields rose. When the price of bonds fall, yields rise – and the expectation of more bonds coming to market meant bond prices fell and subsequently yields rose.

On Friday 23 September 2022, the new UK Chancellor, Kwasi Kwarteng, announced his emergency budget. The Government’s spending plans will require significant additional borrowing (c£400bn over the next two years), as a result the UK Government will need to issue more debt than ever before in order to meet this need.

Over the last few days it has become apparent that the Government and Bank of England have different and opposing objectives – as a result, UK gilts and Sterling have been negatively impacted as the global market have struggled for clarity over how this will play out.

Ultimately markets dislike uncertainty, and this juxtaposition has caused volatility. What will happen to UK politics, the economy and financial sector remains unclear – more recent comments from the Chancellor intimating that he wasn’t focused on market moves, has led global markets to act accordingly.

Market Reactions

Against the US Dollar, Sterling fell nearly 4% on Friday 23 September, and hit a record low on Monday morning. This would suggest that these moves are reactionary and are about market confidence and have little to do traditional rate differentials.

Since the Chancellor’s announcement, yields on 10-year bonds have risen to around 4.5%, (the highest level since the 2008), increasing by around 3% since the start of the year.

Clearly, the Bank has a more difficult challenge to control inflation. On 28 September 2022, it announced it will again start buying government bonds to restore some stability and has backtracked on the plan to sell bonds it originally owned. The Bank now hopes to lower bond prices by stepping in as a buyer. Yields on 10-year bonds fell back around 0.5% after the Bank’s intervention.

Impact

The quantum of such movements has been unheralded and the impact on pension schemes has in some cases been extreme.

In the light of rising yields, leveraged liability-driven (LDI) investments have come under pressure. For those schemes with high leverage and limited liquid assets, LDI managers and investment consultants have been in a tailspin trying to find additional capital to shore up the depleted collateral. Well governed schemes with more moderate leverage and clear plans and processes to access additional capital have managed their way through the volatility with relative ease, taking comfort from the fact their liabilities and deficit were decreasing.

The intervention on Wednesday 28th September by the Bank of England has reversed some of the positive news being experienced by schemes, but at the same time taken off some pressure for those struggling to source collateral.

Finally, it has been important for trustees to be considering what else is happening in their portfolios, so that they can continue to take a balanced and strategic approach to their investing.

Conclusion

Good governance really pays off and particularly in a crisis. Trustees need to understand the risks within their asset strategy and, as has been evidenced by this crisis, the risk of interest rates rising needs equal attention to the risk of them falling. Leverage needs to be employed with care and wherever it is employed there needs to be clear plans to manage the full range of possible outcomes that may emerge. Having professional trustees who understand technical investment issues, put in place appropriate processes to manage emerging issues and who are available at all times to engage with advisers and providers is, we believe, a superior model. It protects members and sponsors as well as providing comfort to both, and it also provides the best opportunity to focus on strategic priorities and adding value rather than firefighting.