Cover story – The markets in 2023
“There are decades where nothing happens; and there are weeks where decades happen,” is an expression often attributed to Russian revolutionary Vladimir Ilyich Lenin. While it is dis- puted whether he actually said it, the UK bond markets are a case in point. Between late September and early October, dec- ades of investment consensus unravelled. Seemingly rock-solid interest and inflation hedges crumbled within hours under the weight of collateral calls, turning some of the country’s largest defined benefit (DB) schemes into forced sellers of anything investors would buy. As DB schemes threw the metaphorical kitchen sink at preventing a liquidity crunch, stock markets plunged, the pound fell and property funds were forced to stop institutional investors from with- drawing their capital.
While a modern day storming of the Winter Palace was ulti- mately averted with the Bank of England stepping in and the government swiftly changing course under new leadership, the consequences of those weeks of turbulence in the autumn are likely to shape the British economy for years to come as the country braces itself for higher borrowing costs and austerity. Just like the revolution of October 1917, turmoil in the bond markets did not occur in isolation. The backdrop is a sea change in macro-economic factors, from rising inflation to monetary tightening, volatile stock markets and risks of reces- sion, investors are facing a new normal.
As the dust settles on the bond market meltdown, investors are taking stock. Will changes in the economic environment prompt adjustments to institutional investment strategies for 2023?
The cost of living
A key question going forward is how persistent will inflation be. At the time of writing, the UK consumer price index (CPI) hit 11.1%, while across other developed markets, price rises remain in double-digit territory. But despite the sharp spike, central bankers are confident that inflation will eventually set- tle down. The Bank of England expects prices to fall back to 4.2% by the end of 2023 and reach their 2% target in 2024. But many investors are cautious. More than 70% expect UK inflation to remain above 3% for the next five years, according to the IMF. For Mike Eakins, chief investment officer at Phoenix, an insurer, inflation and monetary tightening will continue to dominate in 2023. “Inflation is not suddenly going to decline; we will see it begin to taper off but the pace of that is uncer- tain,” he says.
Eakins predicts that geopolitics and the weather could be the decisive factors influencing price levels in 2023. An escalation of the Russia-Ukraine war and a colder winter could trigger higher energy prices, while an end to the hostilities and a warmer winter could help lower them. Inflation is also high on the agenda at Border to Coast, a £38bn local government pension pool. “Our portfolio managers, internal and external, consider inflation as one of the many inputs into the investment process,” says deputy chief invest- ment officer Mark Lyons. While Lyons sees a risk that inflation could become entrenched, he also predicts that economic recession and a slump in consumer spending could act as counteracting, deflationary forces.
If 2022 has taught us anything, it’s that ‘business as usual’ no longer holds.
Maria Nazarova-Doyle, Scottish Widows
While all investors face the macro-economic trends of infla- tion, rising interest rates and recession, the conclusions they draw from them differ significantly depending on the position- ing of their portfolios and income requirements.
DB: Assessing the benefit
The need to take stock and assess the damage caused in the autumn is perhaps most urgent among DB schemes, particu- larly those using a liability-driven investing (LDI) strategy. On the face of it, there is good news. Funding levels have improved dramatically. Schemes in the Pension Protection Fund’s (PPF) universe booked a combined surplus of £374.7bn at the end of October, compared to £103.2bn a year earlier. Yet it is still early days in assessing the damage of the LDI cri- sis in terms of asset values. At first glance, the value of assets in the PPF universe grew marginally to £1.49trn from £1.45trn during October. But this seemingly benign trend masks signif- icant differences between schemes. For example, the BT Pension Scheme’s asset shrank by a reported £11bn during October, accounting for more than a fifth of its assets under management. Others, such as the Royal
20 | portfolio institutional | December-January 2023 | Issue 119
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