Market reaction to UK fiscal event: our thoughts

What are the market reactions to the ‘mini-budget’?

The large increase in government borrowing required to finance the measures announced on Friday has caused major gyrations in financial markets. Gilt yields have moved significantly higher and Sterling lower against both the USD and EUR. UK credit spreads have widened. In summary the market now perceives the UK to be a more risky place to invest and demands greater risk premia to do so.

The steps announced by the Chancellor are inflationary and create an inherent tension with the Bank of England, which has been increasing rates to try and bring inflation under control. There is some speculation that the BoE will be forced into an emergency rate hike to stabilise the value of Sterling.

Implications for schemes

These moves have accelerated a shift higher in bond yields which was already occurring, due to the tightening of global central banks in order to combat inflation.

Pension schemes are generally hedged up to the value of TP assets (rather than full liabilities) and therefore have seen rapid progress towards long term objectives. Higher bond yields since Friday will have accelerated this trend though some of the progress could potentially be undermined if growth assets react badly over coming days. Illiquids will see a lagged effect in performance.

Schemes have already been required to recapitalise LDI portfolios, which entails selling out of growth assets into LDI, due to the higher yields. Liquidity is therefore the key concern going forward – schemes with high allocations to illiquids could potentially be required to take a haircut on these assets or, in extremis, reduce the target level of hedging.

What steps should trustees be taking?

Trustees should consider the following:

1. Asset allocations will likely have moved away from strategic targets and trustees should consider whether some rebalancing is warranted to bring growth/matching splits back towards target. This will involve selling growth assets and increasing matching assets.

2. Re-assess progress towards long term objectives and consider whether any de-risking is warranted.

3. Assess liquidity position and plan for adverse outcomes in which bond yields continue to move significantly higher and LDI portfolios need to be recapitalised to a much greater extent.

4. Any schemes which have a large proportion of illiquid assets could run into liquidity problems – so please flag if you have concerns.

5. A lesser priority is to consider FX hedging or transferring accumulated foreign currency into Sterling.

6. Consider putting any transition of assets e.g. appointment of new managers/fiduciary managers on hold.

7. Keep scheme sponsors updated on current actions.

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