Monthly Commentary June 2018
Rates, Bills and Tariffs
It was a full month of news by all accounts, not least the thawing of US/North Korea relations on the back of a successful (?) Trump-Kim summit, but we’re going to focus on another three major themes in this note: unwinding of QE (and other central bank news); a fractious Brexit Bill in the UK Parliament; and the next escalation of Trump’s trade war with the rest of the world.
Firstly, the ECB announced that it would begin tapering its QE purchase activity, with monthly purchases reducing from €30bn to €15bn from the start of the fourth quarter, reducing to €zero from 1 January. Expectations for rate rises were pushed back from June 2019 to September 2019. Whilst the Bank of England didn’t announce any actual change to base rates or its own QE activity, the minutes of the MPC meetings contained a hawkish surprise; voting for a rate rise was defeated 6-3, rather than the expected 7-2, as Andy Haldane (Chief Economist at the BoE) dissented from the majority for the first time. Notable too was the update to guidance around tapering its QE purchases – the target interest rate at which they would taper was lowered from 2% to 1.5%. The US FOMC didn’t disappoint either, by increasing rates by a further 25bps (now targeting between 1.75% and 2%). This marks the 7th rise since the crisis low and the market expects two more hikes by the end of the year. The two speed central bank action couldn’t be more apparent at this point. Rob Scammell’s note looks at these points in further detail.
This month in Brexit – yet more of something happening, but not quite anything you can put your finger on to reveal what on earth the relationship between the UK and Europe will actually look like in April 2019. Following a series of votes, amendments, and amendments of amendments, concessions that were and concessions that weren’t, and in the end concessions that look like wisps of promises without actual commitments, an EU Withdrawal Bill passed through Parliament. As the Bill actually revealed nothing of particular note on the post-Brexit relationship with the EU (other than a hard Brexit was arguably slightly more likely), there was little market reaction. The latest news is that UK Cabinet is working on a third option for a future customs arrangement that might have more cross-party support (or frankly even inter-Tory-party support). Another chapter in the political equivalent of Love Island – endless hours of cringeworthy TV with no meaningful progress but which everyone seems to be talking about.
“ And finally, we come to trade wars.”Nikesh Patel, Head of Investment strategy
And finally, we come to trade wars. The US imposed $50bn of tariffs on Chinese imports, reciprocated and matched immediately by China, and escalated by Trump in plans for tariffs on a further $200bn of Chinese goods and prohibit or restrict Chinese investment in certain US firms and sectors (which China has promised to mirror). Trump further threatened a 20% tariff on European cars (on top of the steel and aluminum tariffs against which the EU has already responded with highly targeted tariffs in response – Harley’s and bourbon being the most high profile examples). We are watching closely; whilst the threats to global trade are so far largely immaterial from the perspective of a typical UK pension scheme’s diversified approach to global equities, the risk of further deterioration and escalation is visible in heightened market volatility. Of course, whilst the risk to portfolios is currently low, it is well worth remembering that these tariffs (and the threats of tariffs) are already having meaningful impact on thousands of jobs and several major companies – the ebbs and falls in these markets are not in the abstract for them.
On the whole, June was negative for most UK pension schemes. As I’ve commented before, it’s no longer good enough to consider the relative performance of equities and gilts to determine how funding might have fared; hedging levels are at all-time highs (and getting nearer their theoretical peak) meaning the exposure to gilt yields (and inflation) are lower than ever. Similarly, currency hedging is typically high for most pension schemes at this point. Equities were broadly down in local currency terms (particularly emerging markets given the strengthening dollar) meaning funding overall would likely have been modestly negative. Notably though, not nearly as negative as it could have been (we have only to remember the Taper Tantrum). It seems central bankers are getting pretty talented (or at least well practiced) in managing their impact on market volatility, and investors more accustomed to a world of rising market volatility. In these environments, where pension schemes can be extremely sensitive to model risk (i.e. with such low expected returns, even a small change in assumptions can be materially negative), it is more important than ever to manage investment risk through the lens of realistic scenarios (even implausible scenarios – as these appear to be more plausible under Trump!) rather than just esoteric probability distributions. Look back to the future for managing today’s downside risks.
A tale of three banks
Central banks, which over the past few years, have taken second place behind politics in market moving events mounted a concerted bid to move front and centre last month. The Federal Reserve, European Central Bank and Bank of England were all in action in June and all three offered something different in their outlook or statements.
The Bank of England were going to raise policy rates in May until Mark Carney decided, not for the first time, and at the last minute, that this was no longer a good idea. Since then there has been an expectation that policy rates will instead rise in August, with market participants currently assigning a 66% probability to this. The minutes of the June meeting revealed that three members voted for an immediate increase in rates, with The Bank Chief Economist, Andy Haldane, flipping his vote from no change to rise to join Ian McCafferty and Michael Saunders who have voted for a rise in the policy rate at 7 out of the last 9 meetings. With Q1 GDP growth having been revised up to 0.2% from 0.1% and the more recent data stronger than the soft patch seen in Q1 and start of Q2 an increase in rates does seem more likely now, but we have been here in the past only to be proved wrong.
Of more interest to pension funds was the fact that the MPC also discussed the outlook for QE, specifically at what point would it be appropriate for the current level of QE to be reduced. Previously The Committee had expected to start reducing the outstanding stock of QE when the policy rate rose to 2%, following the review this has now been reduced to 1.5%. For pension funds whose liabilities are measured relative to gilt yields this represents a modicum of good news. The sooner QE is unwound, the sooner £435bn of gilts are released into the market pushing up yields, reducing liabilities and increasing funding ratios. This would also represent good news for employers who could use reduce the level of their contributions and use the cash for other things such as investment or wage rises.
“However it also shows that the MPC have a diminished level of confidence that Bank Rate will reach 2% in the near future, reflecting the lower growth outlook. ”Robert Scammell, Senior Portfolio Manager
However it also shows that the MPC have a diminished level of confidence that Bank Rate will reach 2% in the near future, reflecting the lower growth outlook. Realistically neither 1.5% nor 2% Bank Rate are expected to happen within the next few years so I suspect that for most investors this will be filed away in the “I’ll believe it when I see it” box.
There were also changes afoot at the ECB following their meeting on 14th June. The ECB pledged to reduce and then end their Quantitative easing programme by the end of the year. However they also pledged to continue to reinvest the existing stock of purchased bonds such that the amount outstanding remains stable. However this was offset by some dovish forward guidance stating that policy rates will stay on hold until at least summer 2019 meaning rates are expected to stay lower for longer. Markets regarded the statement as somewhat mixed with the end of QE coming sooner than expected being offset by the pledge to keep rates lower.
Finally the Federal Reserve delivered another 0.25% increase in its policy rate in June. In addition they indicated that there would be an additional two 0.25% increases this year and a further three 0.25% increases in 2019. This implies a policy rate of 2.75% by the end of 2018 and 3.5% by the end of 2019.
This represents a change from previous guidance issued in March that showed one fewer rate rises this year. The Fed also remains confident about the outlook for the US economy with expectations for growth and inflation accelerating and expectations for unemployment declining.
What does this mean for UK pension schemes? The outlook in the US and EU is of more than marginal relevance to the prospects of UK investors. A strong European and US economy helps cushion the impact of a slowing UK economy. Rising yields and the end of central bank balance sheet reduction abroad can help to increase yields at home. However it is also interesting to note the difference in prospects for rate rises across the three different currencies.