Were the UK pension funds just the canary in the gold mine?

by
Stephen Flood
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This week we ask if the wobble experienced by UK pension funds, last week, was just the canary in the gold mine for the global economy. If not for other central banks then this was certainly a reminder for individuals, who were prompted to ask about the levels of counterparty risk their savings and pensions were exposed to, and how they might better protect themselves in the coming months and years.

UK pension funds’ lack of liquidity is only the first fault line in a crumbling financial framework. UK pension funds came under major distress after the plummeting price of gilts triggered margin calls totaling more than £100 million (US$107 million) last week. Also, the Bank of England was there to save the day. See our post- Ross Geller inspires Bank of England policy.

The BoE’s bond-market rescue, to the tune of £65 billion (US$69 billion), came after gilt prices plummeted, along with the pound, after the new government’s announcement of unfunded tax cuts.

At the center of the pension, a meltdown is a derivative-based strategy, that like most plans, started with good intentions. The ‘good intentions’ were from UK regulators that pushed private pensions into investments called liability-driven investments, aka LDIs. These are linked to the returns of UK government bonds.

These investment strategies worked great until the surge in UK government yields sent everyone to the exit at the same time.

“The regulator thought that LDI was a virtually zero risk strategy and encouraged schemes to adopt it.

The Pensions Regulator challenged funds that refused to use derivatives or used them sparingly, according to the pension trustees and consultants. In conversations with trustees, the regulator would tell funds they needed to lower their risk to big swings in the markets. This is by increasing exposure to U.K. government bonds, known as gilts.

Gilts are considered safe, like Treasurys. But because yields on them were low in the slow-growth years after the financial crisis. Holding more of them exacerbated the shortfalls pension plans forecasted to pay retirees far in the future.

A solution was to own LDIs instead. They invest in interest-rate swaps and other derivatives that are tied to gilts. But because they typically use leverage, they free up the pension fund’s balance sheet to invest in other higher-yielding investments such as stocks, private equity or real estate…

… The Pensions Regulator saw the strategy as a way of helping pensions manage their assets better. Reducing the risk that pension plans would have to be bailed out by a public fund meant to be a backstop for failed employer schemes, the pension trustees and consultants said”, (WSJ, 10/4).

The push towards LDIs has increased the investment class to a total of nearly £1.6 trillion (US$1.79 trillion). This is more than two-thirds the size of the British economy—no small feat to bail out if the market continues to implode.

This is reminiscent of the no-fail, no-loss, no-risk strategy of the US housing market mortgage-backed derivatives that led to the 2008 financial crisis. It works only until the price falls and the counterparty risk is exposed!

Are the problems in the UK pension funds only the canary in the mine?

The United Nations (UN) warns that there are more widespread financial meltdowns on the horizon if the Fed and other Central Banks continue to raise interest rates.

The UN warns that the result will be a global recession following prolonged stagnation – high inflation, high unemployment, and low growth.

The UN report estimates the rapid increase in interest rates has reduced economic output in emerging countries. This is by over US$360 billion over the next three years. Additionally, tightening will do even more harm.

The report suggests that instead of central banks hiking rates, which aim to stifle demand, policymakers should target high prices directly through price caps. This should be on large profits by energy companies.

India’s central bank (The Reserve Bank of India, RBI) also warned that the aggressive monetary policy tightening will cause the third major global shock to the economy in three years. Following the shocks of covid and the Russia invasion of Ukraine.

RBI has raised rates four times since May to try to bring inflationary pressures down. The RBI has also drained close to US$100 billion in foreign-exchange reserves. This effort to defend the rupee from slumping further against the US dollar.

Both the UN and RBI governor Shaktikanta warned that the spill-over effect of aggressive tightening. This is not only slowing growth but increasing financial instability.

A storm Brewing for Emerging Markets

A storm is brewing for emerging markets which are now facing slowing economic growth on top of a higher commodity (especially energy and food prices) along with declining currency values. This is culminating in distressed debt, often priced in US dollars.

The financial problems of raising interest rates in today’s climate of high leverage and debt are starting to crack open. As central banks stumble through what comes next we refer readers back to our post in March Even Volcker Couldn’t Volcker in Today’s Economic Conditions.

As always, we remind readers the reason to own physical metals is that counterparty risk is zero. Counterparty risk at zero means you don’t rely upon some regulator or bank to confirm what you own.

Certainly, there is no regulator pushing you to own derivatives when interest rates are artificially low. There is also no chance of someone deciding to create millions of tonnes of gold or silver at the push of a button, at the whim of a central banker or inexperienced Chancellor.

If events in the UK and elsewhere have you wondering how to reduce the level of counterparty risk your portfolio or pension is currently exposed to, why not contact a member of the GoldCore team to discuss how to buy gold or how to hold gold in your pension?

Events in the UK economy and its wider implications is something we also explore in the latest episode of The M3 Report, with Rick Rule and Ed Steer. Conversations with both guests offer up some new insights as well as discussions around the importance of owning gold. Watch now: Rick Rule Interview on The M3 Report.