Roundup: Updates from Around Britain

Whilst many financial commentators we follow remain preoccupied with Financials sector news, the UK is having a rather eventful week, in our view. A new trade agreement is reportedly on the home stretch, the Bank of England (BoE) has weighed in on pension fund regulation, and new lending data raise some questions for the economic outlook. What do we think it all means for markets? Read on!

If the UK Joins, Is It Still the Trans-Pacific Partnership?

For the past couple years, the UK has been pursuing membership in the regional trade agreement known as the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP)—which, as the name implies, frees trade amongst 11 nations surrounding the Pacific Ocean. (This is the deal that arose from the ashes of the Trans-Pacific Partnership after the US exited talks in 2017.)^[i] Those negotiations are now reportedly complete, and a source slipped to The Telegraph that ministers will officially announce the news Friday.^[ii] As far as we know, a change in name probably isn’t on the agenda—we don’t think it will suddenly be the Comprehensive and Progressive Trans-Pacific and British Partnership. We will just have the amusement of a Pacific trade deal that includes an island nation in the upper Atlantic. How fun.

Commentators we follow are making many claims about what this development means for the UK economy. We have seen some arguments that the agreement makes Brexit irreversible by pulling the UK away from EU customs rules. To us, that seems like a stretch: We suspect a nation that figured out how to leave the EU could probably leave a trade bloc if society decided to head that way in the future. Other financial commentators we follow tout the membership’s economic benefits, giving the UK access to a big trade bloc that rivals the EU in economic size and is faster-growing to boot—essentially arguing CPTPP membership will offset any trade losses from Brexit.^[iii] We understand this view from a philosophical standpoint, although for many businesses, our research suggests it likely isn’t that simple. For example, consider the likelihood of higher shipping costs. Geographic proximity still counts, in our view.

We do see some potential long-term benefits here. The UK’s trade with non-EU parts of the world was growing faster than trade with the EU for years before Brexit.^[iv] Reducing friction in trade with Asia therefore could have some pretty big potential over time, in our view. But we think over time is the key phrase here. Our research suggests trade deals are usually too slow-moving to be big near-term economic drivers. That is likely the case with CPTPP, considering its scheduled tariff reductions happen gradually over the 30 years after it came into force.^[v] That means it will be about 25 years before the treaty is fully implemented. So whilst it probably helps the structural backdrop for the UK economy to a degree, we think it likely falls well outside the scope of economic drivers markets will look to in the next 3 – 30 months.

The Bank of England Thinks Pensions Need More Capital and Stress Tests

Recent events in the US provide a reminder: Whenever there is a dust-up in financial markets, we find regulators typically mull rule changes in hopes of preventing a repeat. Whilst the US is going through this now with regional financial institution Silicon Valley Bank (SIVB), Parliament has been mulling over what to do about pension funds since last September.^[vi] Back then, when long-term Gilt yields jumped as the market (in our view) overreacted to the short-lived Truss government’s fiscal policy plans, pension funds using a tactic called Liability Driven Investments (LDI) got hit with margin calls as bond prices fell.^[vii] To meet the sudden need for cash, they sold the easiest thing available—Gilts—causing a vicious cycle of forced sales and rising rates. The crisis ended after the BoE backstopped the sector with emergency liquidity programmes, putting pensions on the bank’s docket.^[viii] For many observers we follow, this raised the question: How should regulations change to make such forced sales less likely in the future?

The BoE’s Financial Policy Committee, which handles regulatory matters, weighed in on Wednesday with recommendations on how LDI funds can “increase their resilience to interest rate shocks substantially.”^[ix] In its report, it recommended that the creatively named The Pensions Regulator (TPR) adopt higher cash buffer requirements and subject LDI funds to regular stress tests measuring their ability to withstand a 250 basis point (2.5 percentage point) jump in long-term Gilt yields without a rush to sell assets.

These are just general recommendations, so time will tell how TPR writes the actual rules and whether the details reveal some unintended consequences. At a high level, this seems like a change that probably won’t completely eliminate LDI—which we have seen some concerns over. But it also likely won’t crisis-proof it. In our view, higher cash buffers are probably beneficial, and preserving the funds’ ability to use leverage—whatever you may think of that—reduces the regulatory disruptions that could have emerged from deeper changes. But in our experience, stress tests have a rather mixed record of identifying troubled institutions since their criteria may not match real-life developments. As several commentators we follow noted after Silicon Valley Bank failed, the US Federal Reserve’s most recent stress test exercises didn’t include the conditions that led to the bank’s demise, likely rendering it moot even if SIVB had been subject to it.^[x] Perhaps stress tests designed to measure one specific thing—an interest rate jump—will be more telling, but we think it will depend on the model and its inputs.

In our view, the good news is that LDIs’ hiccup last year was a one-off, short-lived problem. Long rates fell almost as quickly as they spiked, and the BoE’s involvement didn’t last long.^[xi] Reducing the likelihood of this happening again may shore up sentiment, but in our view, it was already a low-probability event, and it wasn’t a systemic risk.

Keep an Eye on Weak Lending

When the UK avoided a GDP contraction in Q4 (pending revised data out Friday) and notched 0.3% m/m GDP growth in January, it seemed to improve economic sentiment quite markedly.^[xii] Outlets forecasting doom and gloom last year began saying the UK could avoid recession this year.^[xiii] Some even implied it had already dodged a downturn.^[xiv] We don’t like raining on anyone’s parade, but we thought at the time this was perhaps premature. January is just one month, and we have seen one-off factors skewing GDP data lately, making a mild British recession entirely possible, in our view (though not inevitable).

Since then, purchasing managers’ indexes suggest growth continued through March.^[xv] But recent lending data suggest a more muddled picture. Total lending turned negative year-over-year in February, per data out Wednesday, falling -0.3%.^[xvi] That is the first year-on-year decline since early 2014.^[xvii] On a month-over-month basis, the -0.9% drop was the fourth in five months.^[xviii] Lending to households grew both month-over-month and year-over-year, as the disruptions from the aforementioned autumn yield spike faded into the rearview, but business lending’s decline accelerated from -0.5% m/m in January to -1.0%.^[xix]

We think why is harder to know than what, but the BoE’s Q4 Credit Conditions Survey hinted at both weaker demand and tighter supply.^[xx] It also pointed to commercial real estate lending as the main weak patch, so we think it is entirely possible that credit is still flowing to businesses for capital investment and other non-property purposes.^[xxi] The report showed weakness was also concentrated in small and medium businesses, which have well-documented and long-running headwinds.^[xxii] So we aren’t calling this some massively negative economic development. Yet it is also true that credit is a big source of capital, and as it falls, our research has found there is less new investment to drive growth, a headwind.

This doesn’t make recession automatic, in our view. The UK has grown through weak lending patches before.^[xxiii] But we think it does highlight the need for realistic expectations. Markets aren’t missing anything on this front, in our view. There is a lot to suggest they pre-priced economic weakness last year.^[xxiv] But if a recession does arrive after this spate of sunnier forecasts, it could catch investors off guard and prompt some knee-jerk reactions. By keeping the possibility of a mild recession in mind today, we think investors can be better prepared for any financial headline handwringing that might ensue later.