Governments and policy makers across the globe are racing to generate economic growth, which has led to a raft of quantitative easing (QE) measures. However, all wars have their victims and, while few would refute the importance of a strong domestic economy, the impact on institutional investors is a rise in deficits, a fall in yields and a self-reinforcing vicious cycle of gilt purchasing.
“As deficits increase, money flows out of corporates into pension funds rather than being invested in the real economy.”
Mark Gull
Can investors protect themselves from the onslaught of intervention or are they simply caught between a rock and a hard place?
Despite the aggressive intervention the UK has already seen in an effort to generate growth, the economy sank further into recession in the second quarter, shrinking by 0.7%. July saw the Bank of England (BoE) increase its asset purchase programme by £50bn in an effort to boost the flagging economy, taking the total to £375bn. That follows a £50bn increase implemented by the BoE only seven months ago.
Having cut its annual growth forecast to near zero for 2012 and forecasting inflation of below its 2% target, the BoE looks set to ease monetary policy further both through more QE, but also a potential cut in the base rate, something the International Monetary Fund has called for and the BoE has not ruled out.
Collateral damage
The impact of the growth war on institutional investors is severe given liabilities for corporate accounting and regulatory purposes are typically measured off long-term interest rates. Analysis from Hermes Fund Managers suggests the total £375bn of QE from March 2009 to November 2012 is equivalent to slicing a cumulative 280 basis points off the Bank rate to -2.25% or -5% after inflation.
While an increase in the price of gilts means a small increase in investors’ existing asset values, the drop in yields means a greater increase in liabilities as the discount rate goes down.
The National Association of Pension Funds (NAPF) calculates for every £1 increase in assets due to falling gilt yields, liabilities increase £5. Its research shows the impact of the first two phases of QE may have pushed liabilities up around £305bn. Despite some offsetting increases in the value of assets of around £30bn, gilt movements have increased the aggregate deficit by £90bn since the summer of 2011.
According to NAPF chief executive Joanne Segars (pictured above): “We need a strong economy and economic growth. QE is part of the medicine to deliver it, but in the short-term pension funds have to face very difficult issues. The impact of quantitative easing is to make what is already a gaping hole seem even bigger.”
Pension Corporation meanwhile estimates every basis point yield drop increases those deficits for defined benefit (DB) pension funds by about £2bn (assuming no other asset price drops).
More intervention on the way
In the short-term things appear to have stabilised. The MPC held rates and QE measures in August, but growth is a relative game that hinges on factors such as exchange rates. As a result, the economic health and subsequent interventions in international markets will have a marked impact on the longer-term outcome for UK institutions.
“The UK is stuck in a growth war with the US, eurozone and China,” says Peter O’Flanagan, head of FX dealing at Clear Currency. “From that respect, further QE is likely, which would initially be weak for sterling. Looking forward we have seen a change in rhetoric from the MPC, which was previously largely in favour of holding rates and QE, but is now majority in favour of QE to drive growth.”
Neil Williams, chief economist for global government and inflation bonds at Hermes, believes around £30bn in extra QE would be needed in 2013 to avoid tightening 2012’s policy position, but could mean as much as £450bn extra QE if the economy lapsed into a protracted recession. “In practice, the BoE will probably settle somewhere in the middle,” he says.
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