As relative calm returns to the financial markets it is tempting to think that all in the world is rosy. But the fundamental issues with the global economy remain, higher inflation, rising interest rates and low growth and the forthcoming earnings season is unlikely to be full of joy.
Downgrades to earnings expectations are likely to stress markets further and so the crisis in Britain’s pensions market last week may not be the last with banks and insurance companies likely to see their balance sheets tested further.
In echoes of the 2008 banking crisis it may be that a little-known – but not insignificant at £1.5trn – corner of the financial markets, LDIs, or liability-driven investment strategies become all the talk of the urban dinner parties set.
At first glance, LDIs have little in common with the CDOs (collateralized debt obligations) that triggered the financial crisis in 2008.
However, there are clear similarities – LDIs are underpinned by AA-rated credit bonds and have been treated as risk-free, just like the AAA-rated CDOs, which quickly became near-worthless junk.
Further similarities to 2008 are also there to be seen, a low interest rate environment encouraging investors to look at riskier assets, regulators and banks arguing the markets were suffering from liquidity issues rather than any deeper weaknesses and weak corporate governance.
Saying that, the Bank of England highlighted the LDI market as an area of concern in 2018.
On page 54 of its November 2018 Financial Stability Report it argued that it is "not clear" whether pension funds and insurers pay sufficient attention to the liquidity risks involved in using LDI programmes intended to improve the returns from gilts.
So what happened? Four years after this warning, the taxpayer was required to rescue a market involving the life savings and pensions of 10mln people with a £65bn intervention from the Bank of England.
What are LDIs? In essence, the liability-driven investment strategy is an investment strategy of a company or individual based on the cash flows needed to fund future liabilities, a derivative meant to help insulate pension funds from the impact of inflation.
They became popular with City firms such as BlackRock, Schroders and Legal & General, which used borrowed money, derivatives and other techniques, to improve the performance of gilt portfolios.
The objective was to strengthen the funding of private sector pensions, many of which were in deficit, and it was so successful that the LDI market tripled in a decade to £1.5trn.
But last week, LDIs were at the centre of the crisis in financial markets, which prompted fears that many British retirement funds could implode and which forced the Bank of England to intervene.
Soaring bond yields in the wake of chancellor Kwasi Kwarteng’s mini-budget led to large cash calls on pension funds in relation to the LDIs and the falling value of bonds led to funds being asked to put up more capital to support their investment positions.
In the UK, Legal & General Group PLC (LSE:LGEN) is one of the biggest providers of LDIs, alongside BlackRock and Columbia Threadneedle, and analysts at Jefferies estimate that L&G has £387bn of its assets under management relating to LDI funds.
Will the concerns on LDIs be heeded? Lord Wolfson, the chief executive of Next, said last week that his treasurer wrote to the Bank of England in 2017 to warn officials about risks associated with LDIs.
The retail boss said that his business rejected advice to invest in LDIs, and cautioned the Bank that they were a looming “time bomb”.
While analysts are not suggesting L&G is at risk and indeed, it reassured the market only today with regard to its liquidity position, there may be some longer-term reputational damage.
But it is the speed at which the market moved last week that will concern market participants and regulators alike.
Experts said that if bond yields – which move inversely to prices – had risen more gradually, the problem would have been manageable, but how pension funds would raise enough money at increasingly short notice is unclear, meaning a sell-off could quickly spread to other assets including stocks and corporate bonds, triggering a so-called doom loop.
We may never know quite close firms were to insolvency last week, if at all, but the echoes of 2008 are there and all those companies that failed then we were told could never fail.