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Two of London’s showcase markets are living through the best of times and the worst of times. One is the Frieze art fair, a haven of eccentricity and extravagance, that is partying with abandon. The other is in the City, where that most sober of sectors, pension funds, is on life support.
Until last week, few of Britain’s 18 million pensioners had ever heard the acronym LDI and known that it stands for a mainstay of their pension fund income, namely Liability Driven Investment. Even fewer would have surmised that mismanaged LDI might cause savings accumulated over decades to drain away in a day.
Disaster was averted by the Bank of England. Markets were becalmed by the Bank buying up gilts. Another crisis, another bailout. May pensioners now rest assured that all is well in the world of LDI?
Information provided about the nature of LDI by a major provider of LDI advice, Insight Investment, is meant to offer reassurance. LDI, one learns, is “about adjusting the investment profile of a pension scheme so that it is more likely to meet its liabilities. Applying an LDI approach will improve the pension scheme’s risk management.” One would like to understand better how a pension fund could be put in jeopardy by a line of business that had its express purpose in making it “more likely to meet its liabilities.”
The sector is vast. Insight Investment “has €630bn of LDI assets under management, managed by a team of 58 LDI investment professionals working alongside a 116-strong Fixed Income Group.” Insight Investment is by no means the only LDI provider. Others are household names in the City, such as Blackrock or Legal & General Investment Management. With so much expertise and resources deployed, it strains credulity that nobody seems to have noticed the risks inherent in LDI, long before they became acute in October.
How LDI practitioners could get things so wrong is a matter internal to them. But the dysfunction of the LDI sector has affected financial markets more widely, and taxpayers have a right to ask about the causes and consequences of this crisis and what they imply for market stability. After all, it is they who fund the Bank of England.
It has become increasingly common for Central Banks ever since 2008 to repair market dysfunction through purchases of government bonds, a practice known as Quantitative Easing (QE). Reservations against this policy were voiced from the start, on moral and on practical grounds. For one, by keeping interest rates lower than the market would allow, Central Banks subsidise underperformers that markets would have flushed out. And market distortions ensue further down the line. Interest rates cannot stay low for ever, and the longer the delay in raising them, the greater the ensuing stress.
These Cassandras were ignored but the 2013 US ‘temper tantrum’ proved their point. The Federal Reserve that year announced it would phase out buying Treasuries, but when soon after bond markets seized up, the policy had to be reversed. From then on interest rates remained ultra low.
Ultra low interest rates were tolerable as long as inflation was ultra low. But now inflation is rampant. The Bank of England, forced to abandon QE and limber up for letting rates rise, let it be known over the course of summer months that it would resume selling gilts in September.
Markets were not slow to intuit that raising rates might derail some sectors of the market. The expected scenario was for something like a game of musical chairs – with every uptick in rates some player might have to drop out from the merry go round. Speculation was rife who that first casualty might be.
The obvious suspects were sectors that rely on levering borrowing to boost earnings. Private Equity came to mind. But pension funds? They were on nobody’s list.
By announcing the phase out of QE sale of gilts well ahead of time, it was hoped that markets would be primed and have put their house in order. In the event, September’s carefully crafted game plan was obsolete by the end of the first week of October. It seems that Central Banks have the tools to make interest rates drop, but they cannot let them go up without risking market mayhem. If resumption of gilt sales fell at the first hurdle, what prospect is there for this strategy to work next time?
An apt metaphor for the precarious brittleness of financial markets is under way at one of the highlight events of the Frieze Arts Fair. Damien Hirst is burning art works in exchange for issuing unique digital replicas. These replicas are called NFTs, which stands for Non-Fungible Token. A NFT in the world of art serves an analogous function to that of LDI in the world of investment. It denotes a virtual asset that is tied to a material asset. By all accounts Damien Hirst’s arbitrage between notional and material manifestations of his oeuvre seems to be going well.
What a shame that art may imitate life, but life cannot imitate art.
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