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“Gilty” as charged

The Markets

This week: ASX v Wall Street

FYTD: ASX v Wall Street

The Australian market fell by a whopping 8% over the past two weeks.

However, had you checked your investment portfolio a month ago, and again today, you would be wondering: what was all the fuss about?  

Why? The market looks set to end the week 1.4% higher than it was two weeks ago, in spite of it all.

The last few weeks harken back to the 2010 Flash Crash, or the early days of the COVID crash that were marked by US Treasury instability. The share market fell quickly and recovered even quicker.

The culprit? A “profligate” UK budget proposal, which rippled through markets.

We take a look at some of the action over the past two weeks as we ponder what lessons can be drawn from a wild, but ultimately uneventful few weeks in markets.

Trickle down: opening the floodgates

It all can be traced back to when newly appointed UK finance minister Kwasi Kwarteng handed down a new “mini-budget”.

The general theme of the budget was one of “growing” the country out of trouble (with the UK economy staring into a recession). How?  through a series of tax cuts, heavily favouring higher tax brackets.

We will avoid commenting on the merits of “trickle-down” economics. Or the prudence of turning on the fiscal taps at a time when inflation is raging.

The market’s reaction was enough of a retort.

The pound plummeted by 2.6% (relative to the Aussie dollar).

This was mirrored by a sharp rise in the yield on UK Government Debt (known as “Gilts”) as seen below:

Source: Trading Economics

Above: Yield on UK 3-Year Government bonds

As our readers are well aware by now, in general for bond yields to rise, bond prices must fall.

And this is where the trouble began…

Defined benefit, defined liability

To understand how this rippled through markets, we cast our eye over to UK Pension Funds. Specifically, those with defined benefit schemes.

These funds have to pay out a fixed amount to retirees, escalating by inflation.

Defined benefit funds generally like higher rates (well, at least real rates – or interest rates after taking into account inflation).

Why? Higher interest rates generally mean higher returns on “safe” assets like bonds, meaning they need fewer dollars of assets today to meet their future liabilities.

However, this is the opposite in an environment of falling interest rates. It gets harder for these funds to meet their future liabilities.

Was there a way for these funds to have their cake and eat it too?

Perhaps. Funds could “hedge” out some of their interest rate exposure by buying complex financial products – derivatives – using them to match their liabilities.

Why derivatives? Derivatives allowed them to reduce their interest rate exposure while putting little or no cash upfront.

Having done this, the cash “saved” could be invested in risky assets to boost the fund’s returns. In effect, the funds used derivatives to achieve a degree of financial leverage, while still being able to claim that they had neutralised their interest rate risk.

This works well when bond prices are relatively stable or declining. But when they are volatile and prices are swinging around, the counterparties to these derivatives (those on the other side of the trade) start to get nervous. As a result, these funds have to put more cash behind their positions, or “margin”.

Over the past few weeks, with UK bonds rapidly rising, these positions took a big, big, hit.

This led to counterparties asking UK Pension Funds for more margin. And so the scramble to find cash began.

What does a UK Superannuation Fund do to raise cash? It begins to sell its assets.

The impact of a group of large sellers desperately trying to raise cash was apparent in the market.

How the dots connected, how this selling fed through to expectations, and how these expectations fed through to prices is almost impossible to know.

What was clear, however, was the impact: prices of financial assets fell globally.

Central banks to the rescue again

This all came to a crest as the UK Central Bank (Bank of England) stepped in.

It announced it would begin buying Gilts to stabilise prices and help slow UK Pension Fund’s mad scramble for cash.

And so we saw a very sharp and rapid recovery in global markets.

Subsequently, we saw the Truss government back down from its proposals. Crisis averted.

But were there any lessons learned?  Perhaps, and perhaps not. As economist and market historian Russel Napier puts it “progress is cumulative in science and engineering, but cyclical in finance.”

In short, this has all happened before, and will likely happen again.

And so rather than providing a lesson, the last few weeks provided some pertinent reminders and perhaps a few insights.

Lessons? Or reminders?

These wild few weeks serve to provide a few reminders.

Firstly, we live in a highly interconnected global financial system (where one person’s asset can be another person’s collateral).

As a result, things can occasionally go “bang”, especially when there are rapid shifts in markets. And we are seeing a lot more rapid shifts in the current environment, where the trajectory of inflation and interest rates are up in the air.

However, what should bring some comfort is that authorities are now far quicker to reach into their toolkit when things get rocky.

There were clearly some lessons learned (or re-learned) through the events of the global financial crisis and COVID. Governments and central bankers have a lot of tools to stem a crisis (that is not to say there are no longer-term consequences of this).

Secondly, the last few weeks may have been another toe in the water for “bigger government”. Governments around the world learned that they have an enormous capacity to support incomes and economies during COVID.

A key question is whether, given this knowledge, governments will begin to prioritise social outcomes over financial ones and take a bigger role.

As the saying goes “no society is more than three meals away from a revolution”. We have already seen several European countries rolling out substantial energy subsidies to avoid leaving their citizens in the cold.

How this will impact inflation and interest rates in the longer term is up in the air.

However, the potential for this is not lost on us. We are conscious of leaning client portfolios towards companies that are integral to the real economy, which may be supported explicitly or implicitly by governments under such a scenario.

Lastly, these few weeks provide a reminder that volatility means different things for different investors.

For sure, it is likely a number of currency traders were walloped over the head over the past few weeks.

But a retiree or long-term investor who hadn’t checked their portfolio over the past few weeks would have barely batted an eyelid.

We expect more volatility in the near term.

The market is weighing up the outlook for the fundamental foundations of asset prices: inflation and interest rates. We expect it will be a bumpy ride over the next few months (at least).

However, volatility should be framed by an investors time horizon and an investor’s individual circumstances. For long-term investors, much of this volatility becomes a blip, in hindsight. And we are investing our clients’ funds for the long term. As such, we see this short-term volatility as throwing up long-term opportunities.

Company News

De Grey Mining (neutral impact) announced a $150m capital raise.

Proceeds from the raise will be used to continue exploration initiatives, fund the definitive feasibility study at Hemi (the next stage on the company’s journey towards development), pre-development activities and general working capital.

The placement was conducted at 8.3% discount to the company’s previously traded share price.

We elected to participate on clients’ behalf.


The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.

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