It has been quite a week (and counting) in the UK. On the 23rd of September, the new UK government delivered their first recipe to revive the UK economy and it was received worse than a foreigner asking for a capuccino-and-steak for dinner in an Italian restaurant.
TILS opinion on the UK economy, a primer
Before moving in the UK, the British economy has always been a mystery for me. I mean, I had a naive idea about London, sort of NYC equivalent on this side of the ocean, but what about the rest of the country? What do they do to earn a living? Being born in Italy, it was conceptually easy for me growing up to link the economy of a country to its manufacturing activity: people get paid to work in that factory that produces that brand. Italy’s economy is quite ‘tangible’.
Did I ever cross into anything “made in UK”? For 30 years, there were only four things I could associate to the country: finance, music, drugs and football (ah yes, when I was teenagers also videogames). If it was not for the football teams and, for example, the actual evidence brought by people sitting at Anfield during games on tv, I was close to believe that life in England outside London was an urban legend.
Every single video material, mainly movies, coming from there contained a decadent and darkish story, with some cynic humour sprinkled on top. The narrative ark was always on the way down, set in a scenery of grey sky and anonymous high streets with the same architecture and same shops no matter where the story was taking place. Can you blame me? Trainspotting, The Full Monty, Lock and Stock…
Then you come here…and you realise that yes, nothing is actually made here. Other than buildings. First time in my life I met so many people that work in property construction/development and are not the ones lining the bricks.
In my mind, England is (could be) a great “platform” built on two pillars: English (the language) and the rule of (business) law. It is the best place to start a global business, it is even so conveniently placed that you can talk with 90% of the globe, from Australia to Chile, without having to set an alarm clock during the night. There are Oxford and Cambridge, great research hubs. It is not the US but it can be a great number two in that. Think about the Premier League and expand the concept: teams have worldwide supporters, are backed by foreign capital and welcome foreign talent.
Mini-budget rant
[I should avoid writing these news-based posts. I am mid-way through it and the UK Gov already changed its mind about the 45% tax. My opinion is still the same though]
In this context, the idea of eliminating the 45% tax bracket makes sense. Forget for a second that Brexit drove the country in the opposite direction. If your only economic hope is based on your platform, you want to attract the best talents on it. But if you are an entrepreneur planning to start the next unicorn, you might think twice before setting it up in a place where almost half of your earnings go to maintain someone else’s corgis. Or maybe as a founder you can even be fine with it, since by the time you will realise your gains you would be gone in Dubai or Singapore; but it is definitely a pain in the ass for whoever is part of the journey.
The issue is not the 45% itself but the fact that we (still) live in a world where there are alternatives. Instead of thinking in absolutes, what is the right amount a “rich” (let’s not even go there) person should contribute to society, you have to think in relatives: at which point the tax level in the UK becomes a disincentive to attract talent? A race to the bottom would not help anyone but neither does living on the Communist cloud so many Labours planted their tent on. Plus, Roman Abramovich was paying way way less than 45%, so it is not even a tax on the rich…is a tax on some high earners that cannot make arrangements around it.
You do not have to, or want to, be Dubai but you have to offer at least a better alternative than other European countries. And compensate for the terrible weather, the driving on the wrong side of the road and a superiority complex that stopped to be justified at least two centuries ago. The Nordics model, high taxes for free state-sponsored services, would be hard to replicate for any country with a large population anyway. At least, that’s my quite superficial idea, I am definitely not the expert here but…look at France. The European model of welfare state was, unfortunately!, a fluke, something that has never been sustainable in the long term. For sure, high taxes are hard to digest when what you get back is very poor in terms of quality. Essentially, you are asking anyone coming to England to subsidy with their taxes the life of someone living in Leicester, or Cornwall, or…basically any place outside London. It is a legitimate ask but only up to a certain point.
Read the room
The problem of having debt is that you are not anymore 100% in control of your destiny. What you can do in the future depends on your lender(s) willingness to continue to lend to you. The more you borrow, the less you are in control.
I talk a lot about leverage, and therefore debt, on this blog. I do not consider it bad in absolute terms: it is a tool and, as such, it can be useful if managed properly. The main issue in managing debt is that there is not a clear threshold on how much is too much, the point where you lose control. In the context of public finances, this incentivise Governments to try to get closer to the limit as much as they can: their tenure on the Iron Throne is so short anyway, compared to debt maturities, that they can reap the benefits and be long gone once the bill come due. Unless you are the “unlucky” one who hit the reverse-jackpot while in command, like KamiKwasi.
A market that typically moves just some basis point per day went parabolic:
Not only the UK has to import everything, it runs a current account AND a fiscal account deficit. The UK economy is borrowing from foreigners in exchange for foreign-made goods. Not exactly the position where you should feel 100% at the steering wheel but then…do you remember when I mentioned the superiority complex?
Bondholders and speculators had enough and decided that the UK has properly lost the plot.
The LDI accident
Should I explain what a defined-benefit (from now on, DB) pension plan is? It is a plan that pays retirees a fixed amount per month irrespective of what the retiree has put into the plan. Like the “state pension” your parents get (if you are 40 or older?). Still not clear? Google.
For reasons beyond my understanding, decades ago in the US and the UK someone thought it was a good idea if firms would offer their employees DB pension scheme. Yes, countries that embraced capitalism and the concept of “creative destruction” thought…firms would live forever?!? After some defaults (duh), this plan was put aside for new employees and now patiently waits to be joined by Brexit in the “who could have realised it in advance, uh?” drawer. But these pension schemes were legal contracts, so they will still be ‘alive’ as long as the people who signed them (and firm sponsors) are.
In UK, those plan liabilities are huge: they match like 40% of the institutional asset management market and they almost equal the size of the government total debt (net of bonds held by the Bank of England)! The present value of those liabilities is driven by two components: interest rates and inflation. While the latter should be self-explanatory, the former is relevant because future liabilities are discounted using GILT yields.
As bond prices determine the valuation of pension liabilities, moving pension assets into bonds will effectively hedge the volatility of liabilities. This strategy presents two issues:
- as of today, few pension schemes have enough assets to cover their liabilities
- even when they can, bond yields have been too low to generate enough income to match inflation
It is Financial Engineering time! (again)
Sorry, before I go there I owe an explanation. What is LDI? LDI means Liability Driven Investment, an investment strategy that focus its attention to the liability side of a pension fund’s balance sheet, the assurance made to employees. Instead of having a portfolio that maximises returns for a given level of risk (or takes risk in order to generate a target return), in this case focusing on the asset side of the balance sheet, here your target is a portfolio that goes up and down with liabilities and requires the lowest possible amount of contributions from its sponsor.
Yes, all this circus started because companies that signed those pension commitments do not want to pay for them, or they want to pay the least possible amount. They can match liabilities 1:1 with purchased GILTs, but that would be too expensive. As I said, financial engineering time!
The ‘standard’ LDI portfolio should look like this:
You want 100% of the portfolio to match the risk movements of a 100% bond portfolio but you do not want to invest as such because returns would be too low. Here is where leverage comes to help. Option 1 is what is more commonly used: you invest 60% in “growth assets” (here represented by stocks) and you use derivatives to increase the portfolio bond exposure from 40% to 100%. This way, stocks will provide the higher returns and derivatives will make sure that any movement in the liability portfolio is matched with an equal movement on the asset side.
Derivatives have typically very long maturities because they have to match the dates when the employees in the scheme will die. The other side of the derivatives wants to be sure the pension scheme will be there at the maturity of those contracts, so it demands to exchange collateral from now until the end of the contract. The collateral is basically a proxy of the mark-to-market of the derivative. If today the derivative is worth £100 in favour of other side, they demand the pension scheme to ‘deposit’ £100 with them. The pension scheme is still the owner of the £100, and it gets interest out of that deposit, but the cash now sit on the other side account. This way, if the pension scheme defaults, the other side can cancel the derivative but keeps the cash.
If you look at the pension scheme asset allocation, there is no mention about cash. So how the scheme manage above mentioned collateral exchanges? In theory, the growth asset bucket (the 60% invested in stocks) has three caracteristics:
- high returns
- high liquidity
- low correlation with interest rate movements (and therefore with bonds)
In the dream scenario, when bonds goes down and the scheme has to post collateral, stocks went up. The pension portfolio also deviated from 60/40 and now is something like 65/35. The scheme does not really care about the fact that bonds went from 40 to 35 because also the liability went down. So it can sell some stocks (remember they are going up, so selling them is easy peasy) and use the cash as collateral. If the scheme was starting from a fully-funded point (asset value = liability value), now the scheme is overfunded and the scheme sponsor can keep the gains for itself: party time!
The problem using stocks is their short to mid term volatility. You can use leverage to hedge your interest rate risk but you cannot use leverage to pay off your debts. Before employees reach their retirement, you need a sort of glidepath to reduce the scheme exposure to stocks; by the time, hopefully stocks have generated enough returns to cover any plan shortfall you had before.
In real life, a DB pension portfolio looks more like this:
- the LDI portion cover the interest rate and inflation risk with leverage (this is not complicated in UK because the Treasury issue long term inflation-linked bonds)
- the growth-asset part avoid going all-in with stocks, due to their volatility, and prefers investments that can either produce alpha while staying liquid (absolute return bonds). either they trade illiquidity for higher yields (private equity, private loans, infrastructure debt…this type of s**t)
In regulated industries like insurance, stocks are also avoided because the regulated capital charge is too high compared to other types of investments (it is a boring topic, what is relevant is that real life portfolios are driven by the Government choices as much as investment manager ones).
Which bring us to the following consequences:
- each investment strategy in the portfolio is managed by a different manager. This makes sense because you want to diversify along that line but introduces complexities when you need to move cash around. This is one of the main issues DB scheme had in the last week of September. The movement in rates was so fast that even if they could liquidate another investment (say the Absolute Return one), it would take them days to collect signatures, send instructions and move cash between different custodians. Even if they had the cash to meet collateral calls, they could not send it fast enough to the other side of the trade.
- Some investments in the scheme trade liquidity for returns: the scheme manager has fewer opportunities to generate cash in a short period of time.
- The asset side is more correlated to the liability side. While this would be great absent the use of leverage, it means that to generate cash the scheme has to potentially sell an asset that is already losing value. In the past 40 years, it has not been a problem because the heuristic was “interest rate up = the world is in a good place”. Interest rate sensitive assets were losing value while the world was in risk-on mode, no one had a problem taking the other side of your trade. That’s not the mood in today market.
- Some managers had to sell what they could sell fast: GILTS. Here we are vicious circle: let’s sell GILTS to meet margin calls because GILTS value went down; oh s**t, now I have a new margin call, let’s sell more. Rinse and repeat.
- Absolute Return funds, the main liquidity provider of the strategy, generate that 1.25% return above GILTS mainly employing Relative Value strategies. “When Genius Failed” explains really well what happens to those strategies when markets are in risk-off mode.
How to build a nuclear bomb
There are two final ingredients that brought us were we are.
Managing margins and collateral is not easy (and I can tell you since I spent way too much of my life doing it). Set aside too much cash and your returns will suck. Set the cash reserve too low…and hope everyone else would be as stupid as you, so the Bank of England will bail you out.
Since someone invented VaR (Value at Risk, not the football thing…I just realised now how both sucks, maybe the name is cursed?), the finance world tacitly agreed to manage risks…up to a certain point. Assuming the past is a good proxy for the future (it is not), the world is prepared for risk events that falls in the 95th, sometimes 99th, percentile of the distribution. If a 1-in-200 years event happens, just cross your fingers and pray you collectively created a mess so big that someone has to intervene.
This LDI margin mess was not a surprise, it was a consequence of choices, a trade-off between risk and return. DB schemes decided that it was fine to be exposed to that margin call risk because it was better to achieve some additional returns than being fine if something unprecedented would happen.
Everyone was more or less in the same boat because there are only two investment consultants in the UK that cover the whole market. And both suggested the same strategy to every fund. Sounds a bit crazy but that’s it, really.
Before you ask, yes $NTSX run a similar strategy. But they do not run the same risk because all their assets sit under the same umbrella. WisdomTree manage both the stock and bond parts of the fund, they can move around stuff quickly; maybe they can even use stocks as collateral. Seemingly small differences…that can create quite divergent outcomes.
In this sense, LDI seems like a Return Stacking strategy. They key difference is exactly how collateral is managed, how liquid and correlated the components are and how easy is to move funds between them. If you have a margin account on Interactive Brokers and think you can manage margin calls with liquidity sitting somewhere else, there is maybe a lesson here for you as well 😉
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