Transcript
Speaker: Welcome to HSBC Global Viewpoint, the podcast series that brings together business leaders and industry experts to explore the latest global insights, trends and opportunities.
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Speaker: Thanks for listening.
Speaker: And now onto today's show.
Speaker: You're listening to the HSBC Global Research Macrobrief, our weekly review of the key reports from our economists and strategists across the globe.
Speaker: Coming up this week, we take an in-depth look at what's going on in the UK bond market following another week of turbulence and intervention by the Bank of England.
Speaker: And we look at whether there will be any respite for emerging market assets after yet another tough quarter.
Speaker: Before we begin, just a reminder that this podcast was recorded on Thursday the 13th of October 2022.
Speaker: Our full disclosures and disclaimers can be found in the link attached to this podcast.
Speaker: Hello, I'm Aline Van Dyne.
Speaker: And I'm Piers Butler.
Speaker: It's turning out to be another eventful week for bond markets.
Speaker: In the UK, the Bank of England has stepped up its emergency measures and warned of material risk to financial stability following huge market moves.
Speaker: We're going to take an in-depth look at what's going on with our head of UK rate strategy, Daniela Russell.
Speaker: Dani, welcome to the podcast.
Speaker: Thank you very much.
Speaker: Very happy to be here.
Speaker: Before we sort of talk about what's currently happening in the bond market, I think we need a little explanation about what is LDI or liability driven investment.
Speaker: Can you give us a bit of an explanation on that first?
Speaker: Yes, it seems everyone's been trying to become an expert in LDI over the last couple of weeks.
Speaker: But to put it very simply, LDI is an investment strategy which is used by a lot of defined benefit pension schemes in the UK.
Speaker: So those are the pension schemes which we refer to as the gold-plated ones, sometimes called final salary, where the retirees promise a guaranteed pension by their employer, which is based on their years in service and their earnings during their career.
Speaker: And so to do that, pension schemes invest in long-dated gilts.
Speaker: And those provide a predictable stream of income.
Speaker: And it allows the pension scheme to buy assets which closely matches with their long-dated liabilities.
Speaker: But a lot of schemes use a strategy called LDI, which basically involves increasing leverage.
Speaker: And that means that they can effectively try to match their liabilities, but by using relatively less cash.
Speaker: So that cash can then be used to invest in higher return assets like equities, and that enables them to provide higher returns overall.
Speaker: But there's a but, and that's what we've seen recently.
Speaker: When you use leverage, it means that you need to post what we call collateral, which is essentially security against any losses.
Speaker: And that's why the recent problem has emerged.
Speaker: So let's talk about the recent problems.
Speaker: What sparked them?
Speaker: Why did the market all of a sudden get very concerned about this leverage and these LDI pension funds?
Speaker: Well, the challenges actually started mounting many, many months ago.
Speaker: Bond yields have been rising throughout this year as inflation has been rising and central banks have been raising interest rates.
Speaker: But the move really accelerated when the Chancellor announced his fiscal package back at the end of September.
Speaker: And the speed and surge of that rise has been problematic for pension funds.
Speaker: because as I say, they own a lot of gilts using leverage and they found that the value of their gilt holdings have fallen.
Speaker: So those pension hedges, which were designed to protect against falling yields and higher prices, went the wrong way.
Speaker: So they have been forced to post what we call, as I say, collateral.
Speaker: And in order to do that, some of them have been forced to sell government bonds
Speaker: because they sell what they can, which they obviously own a lot of gilts, so they sell those.
Speaker: And so what we then saw was an uncontrolled rise in yields.
Speaker: And that was showing no signs of stopping.
Speaker: And that was what prompted the Bank of England to intervene.
Speaker: So talk to us about this Bank of England intervention.
Speaker: It seems to have temporarily calmed the markets.
Speaker: But as we know, there's a lot of confusion as to whether they're going to continue with this intervention or not.
Speaker: Yes.
Speaker: So if we rewind back, the Bank of England announced back on the 28th of September that it would buy long-dated gilts.
Speaker: And that was chiefly to reassure pension funds that if they needed to sell gilts, there would be a buyer out there.
Speaker: So at the time, the Bank of England said that they would be spending up to five billion pounds per day.
Speaker: So a maximum of 65 billion pounds by the scheduled end of the gilk buying program, which is tomorrow, the 14th of October.
Speaker: Now, has it worked?
Speaker: Well, initially it brought some relief and yields fell very sharply after the announcement at the end of September.
Speaker: But then in the days after that, we saw yields starting to rise again.
Speaker: And earlier this week on Monday, we saw quite an uncontrolled rise in yields.
Speaker: So on Tuesday morning on the 11th of October,
Speaker: The Bank of England announced that they would also be buying index link yields and they have been doing that over the last few days.
Speaker: And as you say, you know, the purchases are due to end tomorrow and there's a lot of uncertainty as to what might happen next.
Speaker: Why do you think the markets were not sufficiently reassured by the Bank of England's intervention?
Speaker: In a way, how do we break away from this vicious downward spiral?
Speaker: Well, the aims of the Bank of England's intervention is to buy time for pension schemes.
Speaker: And people are worried about whether the pension schemes have had enough time to adjust.
Speaker: And so there's currently real uncertainty about what will happen next.
Speaker: And as I say, there's this cliff edge tomorrow when the purchases are due to end.
Speaker: And over the last couple of days, we've seen the Bank of England increasing the amount of guilt it has been buying, which is perhaps an effort to try and stabilise the market before their buying ends.
Speaker: But there's still very much questions over what happens next week.
Speaker: What we really need from here is for the market to stabilise and for there to be less volatility.
Speaker: And that will ease the pressure on pension funds to continue to address these liquidity challenges
Speaker: And also, more stable conditions might begin to restore confidence and attract investors back into the gilt market and attract them to buy.
Speaker: But, and if there's anything that recent weeks have reminded us, anything can happen.
Speaker: We could still hear something further from the Bank of England this week.
Speaker: And even if that's not the case, it's safe to say that they will be closely watching the gilt market over the next few weeks.
Speaker: And there are plenty of challenges yet to be crossed.
Speaker: So what are the next milestones to look out for, Dani?
Speaker: Well, the real big one is the fiscal event on the 31st of October, when markets are looking for the Chancellor to announce a credible plan to get debt lower over the medium term.
Speaker: were also due to get the start of active guilt sales from the Bank of England that day.
Speaker: But we could possibly see that delayed again or perhaps changed in some way in terms of the structure.
Speaker: But even before then, we'll also hear from two rating agencies on the 21st of October, when they'll give their verdicts on the credit worthiness of the UK.
Speaker: What we really don't want to see is another big rise in yields in the short term.
Speaker: That would risk a repeat of what we've just had.
Speaker: It's possible that the most volatile days are behind us, but investors are certainly nervous.
Speaker: And so for now, our wait for quieter times continues and the Bank of England will no doubt be watching closely.
Speaker: So a very fast moving environment.
Speaker: And I know it's going to keep you very busy.
Speaker: Before we let you go, Danny, what does that mean for the future of LDI?
Speaker: Well, there have been a lot of concerns and criticism of LDI as a strategy.
Speaker: But I think that actually, you know, this has been very much a liquidity issue and not a solvency one.
Speaker: And, you know, in the past decades, as interest rates have been falling, actually LDI has proven to be a very successful strategy in helping to protect
Speaker: the security of future member incomes.
Speaker: So I think that, yes, lessons can be learned and perhaps less leverage can be used and should be used in the future and they should have bigger buffers so that if these calls for cash return, that they're able to better service them.
Speaker: But I think we shouldn't forget the success that LDI has had as an investment strategy.
Speaker: Dani, thank you very much indeed.
Speaker: Thank you.
Speaker: I'm Harold van der Linden.
Speaker: And I'm Fred Newman.
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Speaker: We finish this week with a look at the prospects for emerging markets, which have endured five consecutive quarters of negative returns.
Speaker: With a challenging growth environment, high inflation and a strong dollar, there doesn't appear to be any let up on the horizon.
Speaker: Let's hear from Ali Chakaroglu, emerging markets strategist.
Speaker: Hi Ali, thanks for joining us.
Speaker: Thank you very much, Ali.
Speaker: So what are the prospects for emerging markets following this poor performance?
Speaker: The macro outlook still remains quite challenging.
Speaker: Obviously, global economic activity, which is one of the main drivers of emerging market returns, is losing momentum.
Speaker: Inflation remains a major source of concern, especially in the developed world.
Speaker: And we are also seeing more signs that the price pressures are broadening towards stickier core components.
Speaker: And this should mean that more rate hikes from core central banks and particularly from the Fed
Speaker: And on top of that, we are seeing a sharp tightening in global liquidity conditions, which is also leading to a tightening in emerging market financial conditions.
Speaker: So net-net, the macro backdrop is very, very challenging.
Speaker: Now, against this backdrop, there have been outflows.
Speaker: Indeed, so far this year, especially from fixed income assets, we have seen quite sizable outflows of around $70 billion.
Speaker: And a large part of that owes to the fact that there has been a huge rise in bond market volatility, as well as the rate hiking cycle by core central banks.
Speaker: On the equity market space, there have been inflows of roughly $50 billion, but these inflows were led by the entries into ETF funds, and active or non-ETF funds have actually seen sizable redemptions as well.
Speaker: And what is the strategy for EM?
Speaker: Well, given this challenging backdrop, I think it's fair to say that we are cautious and selective on emerging markets.
Speaker: As a matter of fact, this has been our view throughout most of this year, and we don't see a reason to change it for the time being.
Speaker: And obviously, technical picture remains supportive.
Speaker: Valuations are attractive, positioning is low, and investors are holding high cash levels, as well as the sentiment is quite depressed.
Speaker: This should mean that some tactical bounces, but for us to be structurally positive on emerging markets, we would need to see the macro picture turning much more supportive.
Speaker: Are there any countries that stand out in terms of potential opportunities?
Speaker: Well, we like the markets that offer attractive risk premium and those who are well advanced in combating inflation.
Speaker: But in our view, the next dividing line for emerging markets will be the outlook for fiscal policy because the last couple of years, we have seen a huge increase in public debt to GDP ratios.
Speaker: So the public accounts will matter more going forward.
Speaker: And based on this criteria, we like markets like Brazil, Mexico and the Gulf economies.
Speaker: Ali, thanks very much for your time.
Speaker: Thank you very much, Aline.
Speaker: So that's it from all of us this week.
Speaker: Thanks to our guests, Danny Russell and Ali Kachiroğlu.
Speaker: We hope you found the discussion useful.
Speaker: From all of us here on the team, thanks for listening.
Speaker: We'll be back again next week.
Speaker: Thank you for joining us at HSBC Global Viewpoint.
Speaker: We hope you enjoyed the discussion.
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