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Investment Strategy De-risking in the New Market Regime

Interest Rates and Inflation – Update on Market Conditions

There has been a rapid and significant shift in the broad market environment this year to date with a particularly material impact on fixed income markets.

These changes have come about as a result of global inflationary pressures in the UK and wider global economies and a spike in short term realised inflation. The pressures have been driven by the economic recovery after the COVID pandemic, global supply chain issues, and rising energy prices magnified by the Russia/Ukraine conflict, increasing “cost-push” inflation.

In an effort to curb inflation, the Bank of England have made multiple interest rate hikes over 2022. While, the recently announced mini-budget, its implications for future debt issuance, and a subsequent sharp fixed income sell-off have driven significant volatility in UK Gilt markets, and led to significant rises in nominal and real long term UK Gilt yields.

Asset valuations have been underpinned by the low interest rate environment since the Global Financial Crisis, and as such a broad array of growth asset classes have also seen increased volatility and negative returns.

We expect elevated interest rates and inflation to extend beyond this short-term period, and as such we believe LGPS Funds should consider whether any immediate and/or longer-term investment strategy action is appropriate.

Market Commentary and Outlook

2022 so far has proved to be a challenging period for the financial markets. Emerging from of the pandemic, supply-chain bottlenecks have fuelled inflation, and the already fragile economic outlook has deteriorated further due to the ongoing fallout from the Ukraine-Russia conflict. The UK Gilt market has been directly impacted by increasingly tight monetary policy expectations, with material negative returns over the year to-date.

Further to this, the government’s recent announcement of the mini budget has added further inflationary pressure and volatility to the markets. The unfunded budget has been received poorly by the financial markets due its implications for long term government borrowing. This has led to investors viewing the UK’s sovereign debt as higher risk, and an ensuing fall in the value of Sterling, and a rise in UK sovereign gilt yields.

The Bank of England stepped in to support the bond market on 28 September by agreeing to purchase the long-dated UK Gilts. This support ended on 14 October, with significant ongoing uncertainty around the market.

Real Gilt yields – Year to 21 October 2022

Gilt-implied inflation – Year to 21 October 2022​

Nominal Gilt yields – Year to 21 October 2022

Isio's comments

2022 has seen increased volatility in inflation expectations (middle chart), volatile and upward trending long-dated nominal interest rates (chart to the left), and volatile and upward trending long-term real yields (chart to the left).

The impact of the recent market volatility has been exacerbated in recent weeks by the announcement of the government’s mini budget. The market reaction to the spending plans (without clear plans for how to fund them) was to sell government bonds. This was followed by forced selling by pension schemes which employ liability driven investment strategies, leading to a further spike in both nominal and index-linked gilt yields.

A short-term intervention by the Bank of England served to reduce volatility temporarily, however this has since come back up.
​

Current market levels

 

 

Long term interest rates have risen significantly over 2022 and long-term inflation expectations have fallen. We believe that the fall in long term inflation expectations is likely to have been driven by specific market dynamic differences between Gilts and Index-linked Gilts. The Bank of England’s initial lack of intervention in the Index-linked Gilt market (i.e. choosing to only purchase fixed interest bonds) has meant that there is significantly less demand for inflation linked bonds than their fixed interest counterparts. As such, prices have fallen further, yields have risen more (and the yield differential between fixed interest and index-linked gilts has narrowed).

This also represents a materiality different market environment for yields since the date of the both the March 2022 and March 2019 Actuarial Valuations.

A new regime

We believe we have now entered a new regime in which Nominal Gilts are yielding significantly higher than recent previous years and Index-linked Gilts currently providing an attractive positive yield.
In comparison to historic levels, the current market levels are now significantly more attractive for LGPS Funds to consider.

Actuarial assumptions (discount rate)​

The LGPS funds in England and Wales are is currently in the process of finalising their March 2022 Actuarial Valuations with may having recently agreed the assumption basis used for the valuations, including the discount rate used to value the liabilities. This is a key assumption in the process.

In the new market regime, Nominal and Index-linked Gilt yields are now significantly closer to the expected 2022 Actuarial Valuation discount rates for many LGPS Funds.

This means there is greater scope to invest a larger amount in fixed income, and specifically UK Government Bonds (Nominal and Index-linked), and so de-risk portfolios compared to the current position whilst still achieving the current Actuarial basis.