(The opinions expressed here are those of the author, a columnist for Reuters)
Not only are the chances of a UK recession rising, it may be the rare recession in which bond owners get badly beaten up.
Coming at a time of critical underfunding among UK pension funds, who have been among the biggest buyers of otherwise poor-value gilts, a bond-punishing recession would further undermine Britain’s retirement system.
With a fragile Conservative-led government engaged in fraught Brexit negotiations in which they are the weak hand, bad economic news continues to rain down on Britain.
A survey from credit-card company Visa released Monday showed consumer spending falling by 0.3 percent in the three months to June compared to a year ago. Another from accountants Deloitte showed 72 percent of CFOs gloomy about post-Brexit business prospects. Companies expect a fall in hiring, capital expenditure and discretionary spending, Deloitte said.
Not only are they not spending, British consumers are spending the smallest proportion of disposable income in more than 50 years, as below-inflation wage growth hits home. This is in an economy which was already at something close to a stall: first-quarter GDP growth, released in late June, showed the economy expanding at just 0.2 percent a year.
Complicating matters is hawkish sentiment among Bank of England policymakers, who must grapple with above-target inflation and a massive current account deficit which leaves sterling vulnerable. About half of BOE policymakers who have spoken recently either called for or said they may consider an interest rate increase soon, in what would be the first increase in base rates in 10 years.
Even Governor Mark Carney said in June he might consider a hike, reversing earlier comments, if wage growth and business investment picks up, neither likely.
“The UK relies on the kindness of strangers at a time when risks to trade, investment, and financial fragmentation have increased,” Carney said in June, in remarks which may tip his underlying concern.
It is not inconceivable that Britain could see both economic contraction, and, if the mood in financial markets turns ugly toward British assets, rate hikes to defend the pound.
So rather than bonds in investment portfolios serving their accustomed role as ballast, doing relatively well during downturns as equities suffer, bonds too could take a substantial beating during a recession, even before taking into account any hit to global investors from sterling weakness.
SADLY, WE MUST START FROM WHERE WE ARE
All of this is happening at a time when UK gilts represent particularly bad value in real, or inflation-adjusted, terms. Ten-year index-linked gilts have a real yield of -1.7 percent and even someone willing to lend the UK 30-year money in an inflation-adjusted bond faces a negative yield of -1.42 percent.
Those values are the result partly of a market view that growth will be subdued, both globally and in Britain. Those values are also, crucially, because many British pension funds want to hedge the monies they must, hopefully, someday pay out. As Legal and General Investment Management points out, UK defined-benefit pension funds have 1.765 trillion pounds of liabilities, generally linked to inflation, but the inflation-linked gilt market is only 400 billion pounds.
“But taking the UK’s structural weakness to its limit, particularly if policymakers misdiagnose problems or miscalculate their response, there is a risk that real yields reverse direction, potentially in a dramatic fashion,” Anton Eser and Daniela Russell of LGIM said in a note to clients.
Firstly, a downturn, or threat of one, could prompt whomever is leading Britain to loosen fiscal policy dramatically in an effort to stave off or diminish a recession.
Secondly, and perhaps in concert, foreign investors may lose confidence in UK assets, driving down sterling and forcing the BOE to hike, not just to fight inflation but also support the pound.
Having rushed to buy gilts to hedge their liabilities, in large part due to regulatory encouragement, a gilt sell-off during a recession, surely accompanied by a fall in equities, would be difficult for many UK pension funds to weather.
Consultants Punter Southall said it expects one in three UK defined benefit pension schemes to fail to pay out their promised benefits in full. Only 20 percent of schemes are rated by Punter Southall as “strong”. (www.riskofruin.co.uk/)
If rates must rise even as the UK economy falters, those figures may prove optimistic.