UK Economic Outlook: Market Meltdown
I have been involved in financial markets for 20 years and have never seen anything quite like what occurred last month. The 2008/9 crisis had days that saw some wild market moves but the ferocity of last month’s price action was of another order of magnitude. Whilst the Covid19 crisis is not over, not even close, it seems the market tried to adjust to the New World Order in a matter of days rather than months. What was missing this month though was a sense of total panic. Maybe this is because people have other things to worry about, but maybe it’s because 2008/9 infected the central nervous system of the financial body, namely banks. If banks go bust it is cataclysmic, it takes down people’s savings, it inhibits lending, it freezes derivative markets, in short it poisons the plumbing of the financial system. The Covid Crisis is currently a truly terrible and upsetting humanitarian crisis, but it is not currently, and hopefully will not be a banking crisis; hence why the news remains concentrated on the health aspects rather than the financial aspects.
The economic fallout will be significant, with expectations that the decline in output will be greater than for the 2008/9 crisis and optimism around a rapid rebound quickly diminishing. The longer the trauma lasts, the longer the recovery will be. Equity markets are now starting to understand this with the falls seen over the last 2 months, the worst since 2008. Were it not for a 17% increase in the last 2 weeks of the month, including the best single day for US equities in history, then the 6 week decline between end of February and the middle of March would have been the largest fall since the great depression.
However whilst equities generate all the headlines they were not the most interesting asset class last month. Equities always fall in times of crisis, boring, let’s move on. There were also significant and dramatic moves in currencies and bond yields. Long dated gilt yields finished the month almost unchanged, but given the mind bending volatility this seems to be more by luck than judgement. As would be expected in a crisis, yields initially fell as investors sold equities and sought the safe haven of government bonds. In the first week of March UK 30-year Gilt yields fell by 0.44% reaching a new all-time low of 0.50%, from here however yields began to move up dramatically. Between 9th and 18th March 30 year bond yields moved up by nearly 0.9% to 1.36%. What caused this sudden reversal is not known for certain but there are a number of theories.
Firstly, investors could have become worried about the impact of Covid on government finances. The amount of money the government is spending and the impact it will have on the public finances is enormous. Early estimates suggest the interventions announced will result in a budget deficit of 10% this year and a debt to GDP ratio of well over 100%. It would be entirely appropriate for investors to demand higher yields in these circumstances. An alternative explanation is that investors needed liquidity quickly in order to cover losses elsewhere; they therefore sold the most liquid assets they had that were not trading at a mark-to-market loss. This will almost always be government bonds and, as such bond prices fell and yields rose. This was not a UK specific event with European and US government bond yields exhibiting similar behaviour. This type of movement did not occur in 2008 and is quite contrary to what would be expected.
Between 18th March and the end of the month gilt yields fell by 0.5% as the Bank of England cut interest rates to 0.1% and announced an extra £210bn of quantitative easing. This dampened volatility, given the market was confident there would be bidders for the large amounts of gilts that would need to be issued over the coming months - the DMO proposing to issue almost treble the amount of debt in April than it did in March and more than it did in in any month following the 2008/9 crisis.
Currency moves were also highly unusual last month with Sterling falling to 1.16 its lowest level against the US dollar since 1985 before recovering to finish the month at 1.24. The initial move was caused by excess demand for dollars as companies and banks hoarded dollars to pay their debts and keep business open during the shutdown. As is typical investors also increased demand for US Treasuries, widely regarded as the world’s safest and most liquid asset in times of stress. Again Central Banks intervened with the Federal Reserve making more dollars available that international companies could access through swap agreements with their domestic central banks.
What does this mean for investors, particularly pension funds? It has not been a comfortable month and there has never been a better reminder of the importance of diversification of the sources of risk. Whilst most risky assets fell, some fell more significantly than others. Even amongst global equities the performance differentials are striking with UK equities down 33% year to date and US equities down 22%. Credit related assets have performed significantly better with losses in the region of 10% - though no significant increase in defaults yet, and will likely return closer to par than the recent falls would imply. Its also an important time to reflect on low probability events. A scheme’s penultimate insurance policy is its holdings of gilts that protect against falls in interest rates. During the good times these holdings lower the funding ratio volatility of the scheme but during the bad times the provide an important other function. If the price of risky assets falls the schemes funding ratio declines, at the same time yields tend to fall and the schemes liabilities go up. This can be a painful double blow, the gilts however will cushion the blow by rising in line with the liabilities. A scheme gets a return for taking equity risk, it receives no such reward for not hedging its liabilities. The ultimate insurance policy for pension schemes is however its covenant – the sponsoring company. And it is here that we see the most acute pressure on funding plans at the moment, even more so than market volatility. There have already been some large casualties; there will likely be many more in the coming months before this crisis is over; a well-integrated and robust investment framework will be able to consider this holistically.