The financial world is in crisis.
Once again, politicians and bankers are to blame, but sadly, it is investors who will pay the big price.
The trigger for the crisis occurred Sept. 23 when a new UK budget sent British government bonds reeling and pushed pension managers into a vicious circle of forced asset sales.
Investors across the globe should worry about contagion. Let me explain.
British government bonds, called 'gilts' because they were originally packaged in gilded folders, have been revered since 1694 by financiers worldwide for their safety. After all, gilts are essentially an IOU certificate from the British government, historically among the world's most stable.
The steadiness of the financial world was rocked in 2008 by the subprime mortgage crisis in the U.S. Pension managers from around the globe had been hoodwinked by international bankers and the financial alchemy of collateralized loan obligations. CLOs are securities created to acquire and safely manage pools of leveraged loans.
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The CLOs went bad when millions of low credit score borrowers unsurprisingly began to default on their mortgages. A financial crisis ensued as pension and investment fund managers everywhere raced to sell positions to very few bidders.
In the UK, the Bank of England — the equivalent of the U.S. Federal Reserve — eventually cut bank lending rates to near zero. The BoE also began furiously buying bonds to create liquidity.
The unintended consequence of zero interest rate policies put British pension managers in a bind. Gilts were not earning enough interest income to meet future payments for retirees. So, in 2011 the liability-driven investment was born. LDIs allowed pension fund managers to make riskier investments in stocks, high-yield bonds and especially CLOs.
Pension managers went all in.
Low interest rates propped up equity valuations, leading to steady growth for leveraged LDI portfolios. These trends were reinforced in 2020 when the global pandemic prompted central bankers, including the BoE, to double down on zero interest rate policies.
Investment in LDIs more than tripled from $400 billion pounds in 2011 to $1.6 trillion pounds in 2021, according to a report from Reuters.
Everything changed in 2022. Inflation surged to the highest level in four decades.
Russia invaded Ukraine, leading to higher energy and food prices. Russia supplies most of Europe with natural gas used to heat homes and power factories.
Ukraine is a significant supplier of wheat, barley, corn and sunflower oil. Zero COVID-19 policies in China also crippled the worldwide supply chain. Inflation is caused by too much money chasing too few assets.
The BoE has been raising its key lending rates all of 2022. In September, the central bank began reducing its bond holdings acquired since 2008. However, as interest rates in the U.K. quickly rose, fissures began to develop in the financial markets.
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Gilts were already down 45% in late September when the new Conservative government released its first budget.
The financial blueprint was a pro-growth mix of tax cuts and price subsidies. It rescinded planned increases in corporate tax rates, reversed a recent hike in payroll taxes and slashed tax rates for income earners over $150,000 pounds.
Another provision, funded entirely by new debt, earmarked $50 billion to freeze energy prices.
The reaction by traders was swift and negative. Thirty-year gilts plunged into a freefall. Yields, which move inversely to the gilts' prices, surged to 5.15%, the highest since March 2020.
And as gilts collapsed, pension fund managers began getting margin calls on their LDIs. They were forced into the vicious circle of selling gilts to meet capital requirements, which caused more weakness and additional margin calls. At one point on Sept. 23 the Financial Times reported that there were no bids at all for 30-year gilts.
The BoE did eventually intervene, pledging to buy $5 billion pounds of gilts every day to support the bonds; however, the frailty of the market had been exposed.
Investors are correct to worry the gilt crisis looks a lot like the American subprime mess.
Conservative portfolios have been contaminated with highly complex, leveraged derivatives. Bankers will force pension fund managers to sell liquid assets to meet collateral requirements. Those assets will include blue-chip equities.
Politicians are oblivious, especially to the consequences of their own actions.
The lesson? Derivative-inspired crises are rarely regional, nor are they asset class-specific. Global finance is interconnected. That is a big problem for investors all over.
Expect lower prices for stocks, bonds and other risk assets until there is clarity on gilts.
All the best,
Jon D. Markman
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