News & analysis


LDI activity surges as investors prepare for the UK’s exit from EU


Interest rate and inflation hedging activity increased sharply in the third quarter, largely driven by investors’ fears of a potential no deal Brexit.


Interest rate hedging rose by 75% while inflation hedging nearly doubled to 95% in the third quarter, according to BMO. The sharp spike suggests that ongoing Brexit negotiations are leading to a deferred effect as many schemes attempted to secure their portfolios in between the initial March deadline and second exit date in October. Investors took a risk by conducting such big transactions in a volatile market envi- ronment. Throughout the summer, the entire euro swap curve briefly dipped below zero. “These mid-August sub-zero rates were driven by unusual and unanticipatedly strong and aggressive fixed rate receiving from local European names. Given the magnitude of this demand, it spilled over across asset classes: swaps, bonds, options and others but always with a focus on dura- tion,” said Rosa Fenwick, director and LDI portfolio manager at BMO.


Over the medium term, the outlook for real yields remains low, ironically partially due to LDI hedging activity, as demand for UK inflation-linked bonds remains higher than supply, driving prices up. “If and when yields turn higher, we do not anticipate a broad-based sell-off, so long as inflation remains low and monetary policy retains its current trajectory,” said Sonja Laud, chief investment officer at LGIM. In its most recent inflation outlook pub-


lished in August, the Bank of England pre- dicted that annual inflation would be 2%, but much has happened since, most impor- tantly the delay of Britain’s official exit from the European Union. In September, headline annual inflation hit 1.7%, according to ONS data, the lowest level in three years.


One crucial driver to drag inflation down could be the recent rise of the sterling, which has made imports more affordable.


Index of UK pension liability hedging activity (based on £ per 0.01% change in interest rates or RPI inflation expectations i. e. in risk terms)


100.00 200.00 300.00 400.00 500.00 600.00


0.00


Q1 09


Q1 10


Interest Rates


Q1 11


Inflation


Q1 12


Q1 13


Q1 14


Q1 15


Q1 16


Q1 17


Q1 18


Q1 19


Source: BMO Global Asset Management.


Special payouts mask third quarter dividend dip as profits fall


UK dividends hit a three-year low in the third quarter of 2019, but the effects of the downturn were masked by huge spe- cial dividend payouts and favorable cur- rency effects.


At first sight, the news looked good for investors in UK equities with dividends ris- ing by 6.9% to the tune of £3.5bn. Excep- tionally large special dividends and the weaker pound proved to be a key driver of dividend growth.


Investors in mining stocks and financials were the main beneficiaries of these pay- outs, as dividends for banking stocks increased by 40%. The leap was driven by Royal Bank of Scotland, which returned £3bn to shareholders in the third quarter. Investors in oil firms were also on the win-


ning side. The average dividend in the sec- tor increased by around 30% due to larger payments by Rio Tinto and BHP. But the picture was a lot less rosy for inves- tors in utility stocks. Shareholders in tele- coms saw their payouts drop by 40%, largely due to Vodafone cutting its dividend by 60%. Marks & Spencer, Superdry and Dixons Carphone also cut their payouts. The effects of the decline were to some degree masked by the weaker pound. On a constant currency basis, underlying divi- dends dropped by 3%, to the weakest level in three years. Michael Kempe, chief operating officer of Link Market Services, warns that investors should brace themselves for further adver- sities. “As the world economy falters and the UK remains mired in its political crisis,


8 | portfolio institutional | November 2019 | issue 88


we are witnessing a significant slowdown in UK plc’s dividend growth rate. This is inevitable given companies’ increasingly lacklustre earnings performance. Unlike 2016, it is not due to problems in just one sector; it is a more generalised slowdown. “2019 will almost certainly prove a tempo- rary high-water mark for UK dividends. Volatile specials are likely to revert towards the mean, and sterling is already partially pricing in a disorderly exit from the EU, so these more superficial factors will provide less cover for a more sluggish underlying performance in the year ahead,” he added. The gloomy outlook for dividends chimes with a generally weaker picture for UK plc as profits fell for the first time in three years in Q3. Compared to the previous quarter, profits fell by 1.6%.


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