What does this mean for other markets?

Markets are closely watching for signs of a potential pivot in central bank policies in response to monetary stability and growth concerns given the BoE’s return to temporary quantitative easing and the decision by the Reserve Bank of Australia to only undertake a limited hike. While it is not my base case, such a pivot could lead to higher inflation over the long term akin to what happened in the 1970s. Other countries running inappropriate policies also require close monitoring and here, I think, Italy could be a potential flash point if, as expected, the new Italian government announces an energy rescue package in line with those of France and Germany. If this fiscal loosening were to cause major spread widening between Italian bonds and Bunds, it could force the European Central Bank to sell Bunds, resulting in markets demanding higher Bund yields. In turn, this would impact gilt yields as the European institutions, which almost exclusively finance the UK’s current account deficit, would need higher compensation to invest in gilts relative to Bunds.

Are there any upsides?

I think a durable positive change requires a more appropriate policy mix of tighter monetary policy and a fiscal policy that focuses on long-term growth. However, until policymakers are willing or able to stomach the significant reduction in demand and even the recession needed to beat inflation decisively, we are likely to oscillate between shorter cycles with a trade-off between growth and inflation and with sharp rallies and sell-offs of risk assets. 

What does this mean for investors? 

By Natasha Brook-Walters

This is an environment where markets are moving fast. While, to date, our investors have been able to navigate these markets, helped by the insights of our macro strategists, it requires a renewed focus on economics, policy and geopolitics. None of this is easy, but it also provides opportunity. For instance, through our daily Morning Meetings and other forms of internal investor dialogue, we have seen several of our equity and credit investors highlighting opportunities arising from indiscriminate price moves.  

A key concern we had last week was about the potential of contagion, most notably in the US pension market. In discussing this with our US pensions expert Amy Trainor, we concluded that these moves in a highly liquid market of a G7 economy would prompt risk managers across our client base to re-assess their portfolios and risk exposures to ensure they also had ample liquidity to meet rate moves that might be larger than envisioned by their models. We also delved deeper into the differences between the UK and US systems and potential avenues for contagion and concluded that factors such as the greater use of physical bonds by US pension funds limited the contagion potential. In the event, some US funds needed to raise liquidity quickly, but the impact was not on the same scale as we saw in the UK. 

Our overall view was that, for the moment, contagion was limited. Sadly, markets have witnessed multiple standard-deviation moves before, and while these are hard to deal with, they do not always lead to broad-based contagion. At the same time, these dislocations are probably a wake-up call that as we enter a more volatile and inflationary world stress will appear in the system. With that in mind, we think last week’s events should prompt a renewed focus on reviewing asset allocation and liquidity posture.

In the multiple conversations we had with clients since to assess the fall-out of last week’s events, three areas of focus stand out:

• For UK pension funds, discussions centred on either how best to meet their liquidity needs or how best to gain access to the long-duration corporate bond market given that many schemes are now able to reduce leverage on the back of improved funding ratios.
  
• Opportunities for allocations — Across our broader client base, several clients are looking for opportunities to add risk based on developments not just in the UK, but also other markets and are asking us where we see value. We have seen interest across all areas, but most notably in high-yield credit, emerging markets and longer-dated credit.
• We have received numerous questions on risk management, liquidity, asset allocation and portfolios more generally. This includes reviewing of asset allocations and sizing of overlays given the significant moves in risk models and/or risk-management preferences. Understandably, clients are also looking to assess the composition of the liquid portion of their portfolios.

We are happy to share our expertise and support as we navigate these markets. Please do not hesitate to contact your relationship manager. For those with questions on funding ratios and the specific implications for pension funds, please contact your local Pensions Team.