Andrew Bailey: The exposure to liquidity risk is focused on the companies, like us, that are known as bulk purchase annuities (BPA) writers as well as our pension scheme customers. We have long-term liabilities and long-term assets, but there are always mismatches, due to the depth of the UK market we invest overseas, which leads us to have both interest rate risk and foreign exchange risk. We don’t want to take those risks if we can avoid it.
So firms such as ours potentially have a lot of market risk, which we hedge with derivatives and transform the risk to liquidity risk. Pension schemes suffered more than insurers, who were possibly the most pain free in the 2022 crisis, which is interesting because insurers are similar in liabilities and assets to those pension schemes.
The pension schemes did very badly, whereas most insurers have done relatively well. So why the difference? The insurers that have done well, looked carefully and were aware of the risks they took, and importantly they didn't just focus on regulatory compliance.
They focused on risk and did risk management properly. Some firms have focused on regulatory compliance, thinking that was sufficient, but insurance and pension scheme regulation for liquidity risk is still in development. Those who suffered quite extensively in September last year are most likely those who just followed the regulations. They had the same business model, but a different awareness of risk.
Then you've got the non-Life insurance companies at the other end of the risk spectrum. Their problem is caused by non-market factors – such as a sudden stress event – but not market stresses. For example, if there's a major hailstorm and they have to pay out whilst they're waiting for reinsurance claims and settlements. Generally, that's less risky as the cash drains out much more slowly than a collateral call from derivatives counterparties.
After last year, it is clear some have managed well, seeing the crisis as an opportunity to buy and use their liquidity to invest at wide spreads caused by the liquidity event. I think we will see more people waiting to take advantage of market volatility.
Andrew: The big thing for us is that holding cash is very expensive in an inflationary environment, and cash is always your go-to source to cover liquidity risks. So, you want to minimise the amount of cash you’re holding to avoid the effective loss from negative real interest rates.
Liquidity buffers, as I mentioned previously, aren’t necessarily the best solution either. We’ve found that enabling or paying fees – for example to be able to post corporate bonds against our cross-currency swaps – pays off in the current market. We still have our investment returns from fixed income, but we can use those assets to support our liquidity.
"We have to post credit assets with haircuts, but those credit assets are becoming more volatile in value as perceptions of recession risk ebb and flow."
The ‘perpetually impending recession’ is worrisome if you’re a credit investor. We have to post credit assets with haircuts, but those credit assets are becoming more volatile in value as perceptions of recession risk ebb and flow. This means we just have to be much more aware of the impact on our Treasury functions – and we have to be more aware of these assets’ valuation on an ongoing basis.
We have a diversified portfolio, and we have good quality credit securities, so we should have less volatility. But if you’re a marginal investor – you’re investing in lower-quality credit to make a higher return – you need to be more aware because you’re probably in a more difficult situation. Those credits are more prone to volatility and recession threats, with higher valuation swings.
However, we are providing good quality credits that have liquidity – and that credit quality will shine through. That means they are still good assets for our posting as bond collateral.
Andrew: Any forecast I make is bound to be wrong - but I don't think the recession will happen within the next six months given a recession is defined as two quarters of negative GDP growth, and the UK has posted positive GDP growth, so the earliest we would have a technical ‘recession’ would be in six months.
I’m more in the ‘it’s a year away’ camp. There are countervailing factors. For one, the on-shoring of manufacturing capability from China is expansionary in the West. If you look at the recent Chinese actions on useful materials for semiconductors like geranium or selenium, let’s say, they are expansionary as they encourage investment in the West. It’s not that you can’t produce geranium elsewhere, but you do have to invest to do so, and markets incentivise capital going into productive assets. There are lots of opportunities, which is why I feel the recession will be mild. It’ll take longer to develop, but I do think we will have one and it’ll be painful for people involved in the real economy.
Andrew: Yes, I’m not a doomsayer.
"I do worry about state credit; now you look at the state of sovereigns
and wonder if you want any exposure to them."
I do worry about state credit though. If you hold gilts, you can consider it will be liquid. What they will be worth is another question! Gilts – along with other sovereign debt – used to be the go-to asset for liquidity. But now you look at the state of sovereigns and wonder if you want any exposure to them.
The question is: is it better to have exposure to corporates with some real-world activity or to a state that has a towering pile of debt?
Andrew: If you’re an equity market player, your time horizon is much shorter – which means your worry is shorter and you should have the ability to sell.
If you’re a private market equity investor, your liquidity concerns are going to be enormous by comparison. You essentially have an illiquid credit – or an illiquid equity investment. Often, in a leveraged organisation, if you’ve invested in private equity, which will be harmed by increased interest rates, then you have no way of exiting the position. That’s not great.
There are recent examples of this: for one, the Ontario Municipal Employees Retirement System and the UK’s University Superannuation Scheme (USS) have been involved in the debt issues of Thames Water, one of the UK’s largest utility companies. Thames Water shareholders are being asked to put money in to shore up the company. So I don’t see prospects being great. An investor in the operating company debt however is going to be secure, we need water infrastructure in the South East of England after all.
Andrew: It’s worrying. Central banks have lost so much credibility, and they need to regain it quickly, which means these 50 basis point rises are likely to continue as they desperately try and claw back inflation-fighting credibility.
I think it’s more likely central banks will cause a recession. My personal views are that rates will continue to go up – perhaps by another entire percentage point. But it remains to be seen how the economy responds.
Andrew: There’s a high-level answer: to not rely on model calibrations. Financial markets have a habit of looking at what’s happened previously and focus on what’s happened recently – and then taking those data points as the entire universe of possible outcomes; many of the industries models are calibrated that way.
"To have two events not in data tells you the biggest lesson is that the world doesn’t operate according to the perceived rules of the last few years."
However, using more recent crises as an example – March 2020 with Covid and September 2022 with the mini budget – these events were “not in data”. To have two events not in data within two years tells you that the biggest lesson is that the world doesn’t operate according to the perceived rules of the last few years.
We’ve had low interest rates since 2008, and now we are back to the interest rates we had in 2007. So the lesson is: don’t be so myopic and only look backwards over such a short period. Otherwise, you shouldn’t be in the risk industry.
The other lesson is to take advantage of opportunities when they arise. There are many good companies in the world, and there are a lot of good investments people can make. Being leveraged to the hilt to generate a bit of extra return probably says you’re not being discerning enough about what you’re investing in, and your actual risks are much greater than you thought. But, because you didn’t do the analysis, your risk-adjusted return was much lower than it actually was – and you needed to leverage.
Andrew: Absolutely. I’ve been writing about increased macro volatility since 2021 and have been explicit internally about seeing a more uncertain macroeconomic environment. We need to prepare for more market volatility because now we can see that inflation isn’t transitory and self-correcting.
The question is: how long will this carry on? It will likely carry on longer than people think because the more stress there is in the world the more things will break – and we’re ramping up on that stress.
Conflict and territorial challenges in the South China Sea and the war in Ukraine are examples. There is also immigration concerns, state indebtedness, public and private indebtedness, and ageing populations in most countries. There’s a lot to worry about right now, which implies that the non-inflationary continuous expansion ‘nice’ period is over and we should expect volatility.
Andrew: The short answer is, yes.
"The real question is how selective you were and how careful you were
about the risks you were running."
When you’re an investor you can’t not invest, so the real question is how selective you were and how careful you were about the risks you were running. The people that were achieving returns with leverage – which exposes them to an enormous amount of liquidity risk in the long run – are now under significant distress. I think we’ll see them drop out of the market.
There is a strong investment realignment, but what does it change? Does it encourage people to credit, for example? I think so. The returns are becoming more reasonable for the risk; it’s a more balanced situation.
Some investors can remain discerning for long periods – and they have exposure protection. We’ll find out soon who was investing with a risk-return balance and who was just investing for a return. But we won’t know for a while how that translates to fund managers’ reputations; however, the strain will start to show.
