I honestly don’t want to keep returning to the UK’s fiscal and political kerfuffle, week after week.
But like a newspaper’s travel correspondent who finds herself the only reporter in town during an air raid, the battle keeps thundering in.
This week was one of truth and reconciliation – in as much as the truth hit home and it had to be reconciled with a hostile political reality.
Most notably, with senior Conservative MPs openly stating that they wouldn’t support it, PM Liz Truss caved on scrapping the 45% tax band.
Instead it was her proposed tax cut that was scrapped. A twitch of fiscal sanity, sure, but from her party not her chancellor. And as it only saves a couple of billion pounds, the bond vigilantes’ Excel spreadsheets won’t have budged much anyway.
Indeed the Office for Budget Responsibility would likely confirm a black hole in the nation’s finances, were it to release its independent forecast today.
Bean counters
The Guardian quotes Sir Charlie Bean, an ex-member of the independent watchdog and a former Bank of England deputy governor:
“It will be in the order of £60bn to £70bn relative to its previous forecasts,” he said, adding that Kwarteng would face three options: further U-turns on his tax-cutting plans, deep cuts to public spending, or risking the ire of already rattled financial markets by substantially adding to the national debt.
“What he’ll be confronted with, and I don’t think to be honest most observers and MPs have really woken up to this yet, is the extent to which the public finances has deteriorated since the spring,” Bean said.
“It will be interesting to see what the chancellor comes up with, what rabbits he can pull out of the hat. They could U-turn on the tax cuts they announced a fortnight ago, but that of course I’d say would be politically terminal for the Truss government.”
I’m starting to suspect it was no accident that big concrete spending cuts – as well as the promised supply side reforms – were put off until November, even though this is what roiled the markets.
The tax cuts were perhaps meant to prepare the ground for future pain by obviously straining the country’s finances – in the same way that a patient is less inclined to complain about an imminent amputation if gangrene has already set in.
Create a frightening shortfall, then you’re swinging the axe not as a mad man but as a surgeon.
But if that was the idea, it looks a long shot now.
With her party in open revolt and many Tory MPs fearing for their jobs, the politically difficult decisions that Truss said she sought – some of which in isolation may be well-judged – seem as hard a sell to Parliament as to the country.
Bad medicine
Many Monevator readers might be sympathetic to those who suffered a real terms benefits freeze, but fewer would be directly affected. (State services such as a flailing NHS are another matter).
No, we’ll mostly feel the ongoing pinch at the tax rather than spend end of the equation.
And on that score it’s still widely under-appreciated just how static tax allowances – combined with raging inflation – amplify the tax take.
According to the Institute for Fiscal Studies, taxpayers are set lose twice as much from frozen allowances next year as they will gain under the promised tax cuts, writing:
Freezes to personal tax parameters alone will reduce households’ income by £1,250 on average by 2025–26.
Adding in freezes to benefits and gradual policy roll-outs brings that figure to £1,450, or 3.3% of income, and means a £41 billion boost to the exchequer.
That is double the £20 billion gain in household income (and loss to the exchequer) from the high-profile personal tax giveaways – the reduction in National Insurance contributions and 1p cut to the basic rate of income tax.
In other words, on average for every £1 households gain from high-profile cuts to rates of income tax and National Insurance, they lose £2 from the freezes and policy roll-outs.
My co-blogger The Accumulator has been banging this drum for months. He even made a rare foray off the fence in our comment thread on the Mini Budget to say:
It’s a joke. The tax thresholds are still frozen until April 2026 with inflation rampant. Most will pay more tax not less.
This is a conjuring trick.
T.A. has had a draft article knocking about since early summer that tried to unpick very precisely how much not raising the various allowances would cost a person, versus a counterfactual world where allowances rose with inflation.
However I felt it was too confusing for readers. It also teetered on a vast and fairly unfathomable spreadsheet that underlined how difficult it is to do these sums for yourself.
My bad for not publishing it anyway, in retrospect, though like my warnings about imminent contact with sequence of returns risk and my urging readers to stress test their mortgages, it might have been a little early to truly hit home.
Here’s how the IFS sees the upfront damage in terms of where the various bands would be if they’d risen with inflation:
Reading this table doesn’t really reveal how it all adds up for you, however. And you can try to do the sums like The Accumulator did, but it’s mind-bending stuff.
Which is why of course politicians prefer this conjuring trick to hiking tax rates directly.
First, do no harm
Sympathizers might ask who can blame them?
We have a perma-sluggish economy afflicted with poor productivity growth that – borrowing aside – must fund ever-growing commitments and a relentless string of one-off spending splurges, most recently the energy support measures.
Tax as a share of national income income is already getting on to its highest level since the aftermath of World War II.
The tax cuts may well been chosen for their political bite. But at least they take the edge off.
Look, Liz Truss and Kwasi Kwarteng have clearly bungled the delivery of their chosen hardcore medicine. And it certainly appears to be more from the chemotherapy end of the spectrum than a holistic retreat to the Alps to take in the air.
It’s not the treatment course I’d prescribe. The ordering has been back to front. You’d hope for more competent doctors.
But as I said in my ambivalent response to the Mini Budget, I don’t quibble as much as some do with the diagnosis.
Post-mortem
As has been the way of Tory politicians for half-a-dozen years though, they soon exhaust my short store of sympathy with their lofty disregard for the facts.
This time saw Truss and her followers claim the drama of the Bank of England having to intervene to shore up reeling pension funds was all down to global matters.
Ukraine was even mentioned a few times.
Luckily the Bank of England remains independent enough to shoot that down.
The Bank’s Deputy Governor Jon Cunliffe told MPs that some pooled investments in the now-notorious liability-driven pension investment funds would have been worth zero if it hadn’t acted by stepping in to buy gilts.
His letter to Parliament also directly linked the crisis to the Mini Budget (or fiscal event, as it was formally called), not Russia’s war or even the US Federal Reserve.
See if you can spot the correlation that Truss and Kwarteng strain to notice:
As I say, I’d love to talk about something else next week. But we can’t duck how this all impacts our finances in the here and now, let alone the never-never of future government borrowing costs.
There are links below to the ongoing stress in mortgages, for example, and to reports of a sudden nosedive in the housing market.
The big danger now is this administration doesn’t have any political capital left to push through the controversial cuts and reforms that are required even by its own lights.
That could leave our economy in an 18-month limbo, until the next General Election.
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I watched the new three-part Netflix documentary Eat The Rich this week. And I got nostalgic for an experience I took almost no part in.
The documentary centers on GameStop’s brief life as a meme stock, culminating in the short squeeze in January 2021 that sent its price parabolic.
Fortunes were made and lost in a day. At least on a mobile screen.
Eat The Rich presents a comprehensive Big Short-flavoured overview of the whole saga. The run-up, the peak, and the party-pooping aftermath.
We see the perspective of all the key players, too, although only a couple of Wall Street pros took part.
“I like the stock”
I knew the pandemic lockdown trading boom was big at the time. But only really because I saw its impact on several listed companies I follow, like Hargreaves Lansdown.
I’d also laughed along with the memes and the lingo. Stonks, diamond hands, HODL, and all the rest. But again, only when it bled on to Twitter or the blogs.
I imagine 20 years ago I would have been in the thick of it. Time flies, and investing bulletin board posters become old bloggers.
Maybe that’s why even though my sole, tiny contribution to the drama was to urge GameStop traders to dump their shares if they still owned them – just before the peak as it happens – I was a bit sad to have missed the craziness.
Perhaps not what you’d expect from a website about sensible investing?
Yet by its end the meme stock frenzy had almost nothing to do with the ‘proper’ investing principles that relics like me employ. Not for 99% of the participants, anyway.
It probably had more in common with a riot.
There was a similar energy and even a (fickle) camaraderie that was intoxicating.
Chasing meme stocks and bragging about your blowups on Wall Street Bets is about as far from passive investing via index funds as you could imagine.
It’s very bad for your wealth. It also appears to have been a hoot.
Down and out in London and Wall Street
I don’t want to imply that my tracker-philic co-blogger The Accumulator doesn’t know how to have a good time.
You’d better hope you’re not nearby when he discovers an ETF with a 0.04% lower ongoing charge figure. Something is liable to get broken in the celebrations.
But let’s face it, passive investing is mostly boring and it even feels wrong. We do it because it’s the best way to secure long-term wealth. It will never inspire a movie.
In contrast even when they’re losing money, the Reddit traders make a show of it.
Piloting a $280,000 portfolio to an 80% loss in less than 18 months takes some doing. You might even be tempted to snicker.
Yet – albeit in their scabrous and hilarious way – the comments that followed on Reddit are overwhelmingly supportive.
The community understands the desire to gamble all on escaping from corporate life. Not the slow and steady way we do it, but ultra-speedily.
And for a few brief months in the midst of the lockdowns and at the height of a speculative bubble, it was possible. For a lucky few, anyway. All from making highly-levered bets on a free share trading app.
Many people did achieve life-changing wealth – at least for a while. A minority may even have got out before the implosion.
But as a counterpoint, the best comment for Monevator purposes is buried deep in that thread above:
Source: Wall Street Bets
‘Impressive’ in a Wall Street Bets context hails the seeming immolation of yet more of this trader’s money.
However in this case, his retirement funds were tucked safely away in trackers.
And there the bear market that we boring sensible investors have bewailed has been – relatively-speaking – a life-saver for the down-and-out Redditday trader.
There’s a lesson in that. But the Monevator audience is not really the one that needs to hear it.
So long and thanks for all the memes
While Wall Street Bets lives on, meme stock mania for now is in the 2021 history books. (Along with a lot of other weird stuff from that year.)
Nearly all the runners and riders long ago saw their share prices crash back to reality.
And you’d at least that hope the extremely over-sized yet complacently held professional short positions that made GameStop’s price gains so explosive – and blew up at least one hedge fund – are in the dustbin of posterity, too.
But even so, it won’t be the last time a collective trading mania takes over the markets.
We’re all still getting more connected, not less. And the greed, desperation, or economic injustices that motivated so many into recklessness have hardly gone away.
The same forces of social media and virality have also driven changes at the business end of investing.
For example, a plethora of baby venture capital start-ups were founded during the boom on the back of podcasts and newsletters. It’s yet another way of using the distribution superpower of the Internet to pool capital.
You even see viral mobs at work with reviews for Eat The Rich on Rotten Tomatoes.
Critics love the series. However the audience says it’s diabolical. Presumably the Reddit faithful disapprove of the filmmaker’s even-handed approach and so they have voted it down en masse.
Similar ‘review bombing’ was seen a few weeks ago with Amazon’s Rings of Power spin-off. It undermines the legitimacy of what we once called user-generated content – which was meant to be a special forte of the Internet era.
One by one our vanities are blowing up.
The people in this country have had enough of discounted cash flows
The very low audience rating for Eat The Rich seems unfair to me.
But perhaps trying to tell the whole story fairly only guaranteed it would equally piss off everyone.
We live in an age where you must be either for or against something. Even-handedness is a weakness. There are no shades of grey.
Indeed the same wicked social media dynamics that made meme stock trading so potent we also see in everything from domestic politics to the culture wars to calls for a nuclear confrontation with Russia.
Experts are, famously, out. Reducing complicated positions to a mouse click – a like or a cancellation – is the order of the day.
That’s how the Conservative Party ends up voting against the guy who tried to admit to the fragile economic situation we’re in – and instead for the woman who just said she’ll fix it, the way you used to bang on a TV to get the picture working again.
Fewer people seem prepared to take the difficult path. Whether it be analyzing a company’s accounts or a politician’s pitch.
One week a deeply troubled computer game retailer’s valuation rockets from $2bn to $24bn then straight back down again.
It’s almost like the experts were on to something.
Divided by dividends
Being old-fashioned though, I thought the documentary did a good job of covering the GameStop story from different perspectives.
In Eat The Rich we see hedge fund managers as over-paid and self-regarding economic vandals. But we’re also reminded that they’re stewards of the capital of pension funds and university endowments.
The Reddit day traders are portrayed as self-reliant iconoclasts but also, at points, as clueless dummies.
Lawmakers and regulators are simultaneously asleep at the wheel, in cahoots with Big Finance, and sympathetic to claims the capital markets have been ‘rigged’ against the little guy.
Oh and they’re also clueless dummies. (Everyone gets that treatment.)
Sensible observers know all these things can be true at different times.
Yet it’s also indicative of yet another facet of modern life. Our implicit trust in the structures surrounding us really does seem to be breaking down.
Very few celebrate bankers as The Masters of the Universe these days. Not many more would raise a glass even for captains of industry.
Like everyone involved in investing – apparently – they’re all said to be out only for themselves, one way or another.
Even you sensible investors who find a spiritual home at Monevator should get used to being called names.
Sometimes we’re the strivers, responsibly taking control of our financial futures. Giving up hedonistic pleasure today to ensure we’re not a burden in our old age.
Other times though, we’re layabout rentiers making money off the labour of others. Which makes us fair game for windfall taxes on our firms and higher rates on our dividends and other profits.
Which is it? Are investors part of the solution, or does society believe we’re actually a problem?
Eat the rich, the poor can have cake
If a pundit or politician wants to make the case for nationalizing the utilities or the railroads, then the dividends legitimately paid out to shareholders or pension funds are a green light to confiscate their gains.
On another day, when it’s time to encourage people to invest in start-ups or to make more capital available to growing companies, then the government courts investors with warm words and even special vehicles like ISAs or VCTs.
It used to be that different parties might hold these different views.
Now it’s as likely to be the same politician on a different day.
It’s hard not to get cynical. But there’s an even bigger problem.
As I suggested last weekend, it all reveals a society that is deeply uncomfortable with the capitalism that has facilitated much of the societal richness we see around us. From infrastructure to state pensions.
Perhaps we feel we can afford to be cavalier about capitalism, snug in the bounty it has provided. There’s surely some truth in that.
But I believe people are also distrustful because they believe that capitalism betrayed them. Most clearly with the financial crisis of 2007 and 2008 that animated the meme stock traders. But also with the steady rise of inequality at the high-end, and the winner-takes-most dynamics of the Internet era.
It is a dangerous direction of travel. As I wrote back in 2012:
I believe it’s a responsibility of all of us who support free markets – let alone those of us who hope to profit from them via investing – to stand up and be counted, and to be sure we can justify any aspect of the system that we defend, rather than indulging in fantasy politics of any persuasion.
I hope we do not come to regret not doing more to defend capitalism – including from itself.
I guess even fewer people were reading Monevator ten years ago than I’d realized…
Because while the tools of investing – from cheap tracker funds to free share trading to abundant information – have only gotten better, the image of investing in most people’s eyes has not.
That’s how you end up with a public that can call for windfall taxes without wondering how and where their pensions are invested.
And it’s how smart young people who two decades ago might have been reading Warren Buffett and preaching capitalism as a force for good end up believing that by rallying together via a trading app they were going to smash the system.
Aaargh! [Breathes deeply. Thinks about dolphins.] That’s better. [Peeks through fingers and looks at portfolio again.] Aaaaaaargh!
If you enjoyed the disaster movie Don’t Look Up, you’ll love the sequel: Don’t Look Up Your Portfolio.
Bad things are happening in there.
The Slow & Steady passive portfolio is taking its biggest run of beatings ever. For the first time in a dozen years we’re down for three calendar quarters in a row.
Our UK government bond losses are especially grim. Government bonds are on course for their worst year in history.
But let’s not get too despondent. For all the drama, the portfolio is still only down 15% in 2022.
And less – 11% – over one full year.
Step back and we’re up 6.26% for every one of the 12 years we’ve been tracking the portfolio. Call it a 4% real annualised return.1
Admittedly, if you add inflation to this year’s nominal losses then for sure we’re deep in bear market territory this year.
But previous generations of investors have come back from worse.
First we have to get through the present. And it’s natural to second-guess your decisions in the midst of market declines like we’ve seen in 2022.
In particular, you may be questioning why you bought bonds in the first place.
We do need to talk, but first let’s face up to the results. They’re not pretty:
The Slow & Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000. An extra £1,055 is invested every quarter into a diversified set of index funds, tilted towards equities. You can read the origin story and find all the previous passive portfolio posts tucked away in the Monevator vaults.
Bond-o-geddon
Nothing is working right now. Rapidly rising inflation and interest rates are scalping everything in sight.
But it’s most unsettling that bonds – supposedly our refuge in difficult times – are plunging like equities.
Our gilts tracker is down -28% year to date.
Previously the worst annual return for gilts was -33% in 1916 – recorded in the year the British army was scythed down at the Somme.
That was a real return though and they were extremely long bonds.2
This year UK long gilts are cratering even harder than their World War One counterparts. They’re down -45% year-to-date3. With inflation raining hammer blows on top.
This matters because if you’re cursing your choices it’s important to know you’re caught in the cross-hairs of history.
On one front we’re suffering the withdrawal symptoms that accompany the world giving up its negative interest rate meds.
On another we’re dealing with a needless act of economic quackery by our own prime minister, Liz Truss. Like an ill-qualified psychiatrist she’s determined to unleash her experimental electro-shock therapy while the patient lies strapped and terrified on the table.
As Truss fiddles with the voltage, gilts’ vital signs have deteriorated faster than their global peers. Culminating in a cardiac arrest that only the Bank of England could step in to relieve:
Source: justETF: intermediate gilt ETF vs intermediate global gov bonds (GBP-hedged)
This is a self-inflicted wound. It’s also a political choice.
Which means much of the harm can be undone by another political act. Polls point to a Tory rout. The party will force Truss to recant, or it will decapitate yet another leader if she won’t. They’ve got form.
Hence the UK-only damage suffered by government bonds may yet be reversed – at least in part.
But even then the wider global sell-off would make any holder plenty miserable.
Buy high, sell low?
We all know that buy high, sell low is a classic blunder. So why is your hand still magnetically attracted to the sell button next to your bond ETF?
Offloading bonds during their darkest hour is probably a mistake. Swearing off them for life is probably a mistake.
Falling prices have certainly inflicted a short-term defeat on most bond funds. But lower prices equate to higher yields. That’s bond maths 101.
Moreover as yields are up across the board, investors will demand higher coupons4 in exchange for buying the future debt issued by the government.
It takes time but these improved cashflows will actually set our bond funds on a higher growth path than they were previously taking.
As your fund sells off its old bonds, the proceeds are ploughed into the new higher-yielding variants that are coming on to the market.
And as those new bonds pay more interest, it gets reinvested (if you own an accumulation fund or do it yourself), ratcheting up the transition from low income assets to higher income ones.
Pound-cost averaging accelerates the process. New money buys more of the higher-yielding debt.
The upshot is your bond fund will eventually deliver a higher annualised return – after interest rates stabilise – than if we’d never gone through this.
How long that will take depends on the average duration of your fund. The longer duration your bonds, the longer it takes – but the greater the potential reward.
Carry on regardless?
It’s the same principle as when equities are on sale. High-quality government bonds are now a better deal than they were.
Plus, if the wind changes direction again and the economy goes into recessionary convulsions, then nominal government bonds are still the best diversifier you can buy.
In the passive portfolio, our short index-linked bond fund is down 6% year-to-date. Not down -30% like a long-dated UK index-linked gilt tracker. (We took evasive action back in 2019).
Cash is currently yielding 2% and gold is up nearly 13% so far this year.
I’d still urge that level of diversification for a baseline portfolio, although we’ll continue to track the Slow & Steady as it stands, sans gold and cash.
Note your optimal allocation to equities may be higher if you can handle the risk.
Relegation form
I’d like to advocate one more change for us to think about.
I used to be ambivalent about whether to pick intermediate gilts or intermediate global government bonds (currency-hedged back to the pound) for recession protection.
Gilts were the obvious choice for a UK investor, and as a proud Brit I was happy to hold them. I bought into the idea that we belonged in the premier league of nations.
Well, the last six years and one month have smashed that delusion.
We could argue about Brexit and probably will forever. But you can’t argue with the decline of the pound and the gilt market’s verdict on Trussonomics.
If you want to know what hard-headed, independent operators think of the UK’s recent performance then just consult the charts. Money talks and it’s telling us this country is in a relegation battle.
And so I wish I’d chosen to diversify my fixed income risks with a global government bond fund.
Other countries may put maniacs and shysters in charge, but I thought it couldn’t happen here.
Come to Jesus.
New transactions
Every quarter we throw £1,055 into the market wishing well. Our hopes and dreams are split between seven funds, as per our predetermined asset allocation.
We rebalance using Larry Swedroe’s 5/25 rule. That hasn’t been activated this quarter. Thank heavens.
These are our trades:
UK equity
Vanguard FTSE UK All-Share Index Trust – OCF 0.06%
Fund identifier: GB00B3X7QG63
New purchase: £52.75
Buy 0.245 units @ £215.18
Target allocation: 5%
Developed world ex-UK equities
Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF 0.14%
Fund identifier: GB00B59G4Q73
New purchase: £390.35
Buy 0.791 units @ £493.64
Target allocation: 37%
Global small cap equities
Vanguard Global Small-Cap Index Fund – OCF 0.29%
Fund identifier: IE00B3X1NT05
New purchase: £52.75
Buy 0.145 units @ £362.80
Target allocation: 5%
Emerging market equities
iShares Emerging Markets Equity Index Fund D – OCF 0.2%
Fund identifier: GB00B84DY642
New purchase: £84.40
Buy 47.209 units @ £1.79
Target allocation: 8%
Global property
iShares Global Property Securities Equity Index Fund D – OCF 0.17%
Royal London Short Duration Global Index-Linked Fund – OCF 0.27%
Fund identifier: GB00BD050F05
New purchase: £116.05
Buy 110.84 units @ £1.05
Target allocation: 11%
New investment = £1,055
Trading cost = £0
Take a look at our broker comparison table for your best investment account options. InvestEngine is currently cheapest if you’re happy to invest only in ETFs. Or learn more about choosing the cheapest stocks and shares ISA for your circumstances.
Last week we debated the Mini Budget on Monevator in a couple of excellent threads of reader comments.
By Wednesday morning all that was out the window.
Any potential benefits to the new administration signalling a growth agenda or to its seemingly ill-timed tax cuts were moot. The gamble had already backfired.
The UK government bond (gilt) market was in meltdown.
Most of the headlines had focused on the weakness of the pound following Kwasi Kwarteng’s bolt from very blue.
But the impact on the gilt market was soon apparent.
Indeed as the week began I was tinkering with my ‘low volatility’ sub-portfolio I’d set up specifically to feel safer in what looked like being a choppy 2022.
Longer duration bonds – and a few proxies such as REITs – were sliding.
Time to nip and tuck?
But by Wednesday morning, my now ironically-named low-volatility basket was shedding value like sheets of snow slewing off a roof in the warming sun.
This was not supposed to happen – at this pace – with government bonds:
It looked to me like forced selling and I doubted it could stand for long.
Was it, then, a chance to load up?
I was on the scent – pension funds were in difficulties. But my learning curve – and the slope the descent – was too steep for me to get confident about a wholesale switch into these supposedly super-safe assets. How bad would it get?
Then – even as I was giving myself a crash course in the ‘liability driven investment’ (LDI) hedging strategies behind the plunge – I saw the same index-linked gilt ETF was climbing.
Was I missing the boat? Had big investors stepped in?
Now it was motoring! The sheer pace made it clear I’d missed a ‘red headline’ on a Bloomberg.
So there I was just before lunchtime on Wednesday, when the Bank of England stepped in to save the pensions sector from imploding.
Where were you?
The doom loop
Like always with these events – from the Global Financial Crisis to September 11 to Pearl Harbour – there’s a paper trail you can follow with hindsight, after the worst has happened.
It turns out insiders had warned about the potential risk of a spiraling LDI crisis months ago.
LDI is big business, having more than tripled in size over the past decade, and the reason is simple — it helps funds manage the risks in meeting their pension promises for members, partly through derivatives.
But now funds are facing calls from counterparties to put up collateral to fund those trades. The sums are potentially huge and asset sales to meet the calls could have a knock-on effect to markets such as equities.
Of course nobody paid much attention.
UK politics has been quietly mullering the economy for years, but it hadn’t yet crystalized in a drama that stood apart from the fug of lockdown. The damage was real, but diffuse enough to dismiss pre-Brexit concerns as scaremongering. Yields were rising, but that was a global thing.
But this time was different. What Rishi Sunak had warned would happen in his debates with Liz Truss had started before Kwasi Kwarteng had barely stopped talking.
Confidence was shot, and investors started to mark down British assets.
And through the hedging strategies of pension funds, there was a mechanism for shit to get real, quickly.
You’ve probably had your fill of explainers over the past few days. This was one of those weeks where our little corner of the Internet becomes front page news. (Honestly, it never happens if Egyptology is your hobby.)
But in short: in less febrile times pension funds hedged away the risk of prices moving against them – and impacting their ability to fund their liabilities – with derivatives. These hedges were backed with collateral, including but not limited to gilts. As gilt prices fell they triggered margin calls, which to some currently unknown extent prompted more gilt selling. That drove gilt prices lower. Causing more margin calls. You get the picture.
I haven’t seen anyone else make the comparison yet, but what this most reminds me of is the 1987 stock market crash.
That year’s short, sharp plunge was blamed on portfolio insurance strategies. Again they were meant to protect against declines that they were afterwards blamed for accelerating.
Of course the 1987 crash was in equities – where we’re all ready to shrug our shoulders and say it happens.
Not in the ‘safe’ gilt market, which is meant to be the bedrock of the financial system.
We’re all in it together
Yet for all the drama of a highly-rated government bond market in meltdown, even a crash of this magnitude is not truly surprising to me.
As long-term readers know – and have suffered – like others I’ve been warning about the political direction of travel in the UK for years. That it’s finally culminated in something like this is arguably a feature not a bug of the narrative’s fairy tale thinking, to borrow Sunak’s phrase.
Even for markets generally, it’s almost surprising it took so long for something to really break given the regime change of 2020.
As I wrote in April when high inflation had started to cause ructions in student loans:
I’m surprised we haven’t heard about massive financial blow-ups yet, given the pace of developments.
Another one ticked off the To Do list.
I also warned about quantitative tightening back in February, of the likely hit to retirement plans, and urged readers to stress test their mortgages even as others celebrated a return to double-digit house price inflation.
I’d argue Monevator was ahead of the curve on all that. Yet a fat lot of good it’s done me personally, so fast have things gone off the rails.
Hitherto you could kind of wave away the cost-of-living crisis if you had sufficient funds to put the heating on without a care and to do your weekly shop at Waitrose.
It was awful, of course, to imagine families on the breadline without the money to heat their homes.
But you wouldn’t be personally much at risk.
Now though the realities of 2022 are becoming manifest for all of us.
Keep calm and carry on cutting
How will this all resolve itself in the weeks and months ahead?
Your guess is as good as mine.
But for starters, I suspect the pound ended the week strengthening not because the markets are suddenly smitten with Trussonomics – as the reliably-ludicrous John Redwood claimed on Twitter.
Rather, traders surely sense that – with Labour more than 30 points ahead in the polls and Tory backbenchers up in arms – we’ll see a personnel change and/or a row-back of policy.
Or, more frighteningly, an enormous axe taken to already-straitened State provisions.
As I said last week, I’ve nothing against lower taxes or even an aspiration to shrink the State, in principle. A long time ago I even voted Conservative once or twice.
I also agree Britain has a long-term productivity problem – plus now the self-inflicted wounds of leaving the EU. (Trade frictions, staff issues, higher inflation, and so on).
But even with a sympathetic read, the Mini Budget seemed to have its priorities mostly wrong. Especially with the relatively cheap but politically toxic scrapping of the 45% rate of tax.
One day, sure. But why now?
Meanwhile talk of supposedly game-changing supply-side reforms are just talk until November.
Add to the Budget surprises the government’s high-handed treatment of everyone from the civil service to the OBR to the Bank of England to the media, it’s not surprising investors took flight.
Something must be done to calm things a longer-term basis. Otherwise borrowing costs will go haywire, provoking a truly deep recession and making the UK’s debt burden a noose.
Just keep in mind that to reassure the gilt market, Truss and crew only need to show they understand Britain’s particular economic problems – especially its big trade deficits – and that Britain will pay its bills in a vaguely inflation-sensitive fashion.
The market doesn’t really need to care whether Truss and Kwarteng have a palatable project in mind.
Gilts trade in a financial market. They are not tallied up on a morality-weighing machine.
Which means a calming resolution here might be as ugly as the cause, for many people.
There’s talk, for instance, Truss could cut benefits in real terms to help balance the nation’s books.
More pain, more gain
Perhaps hard-right Tories would see bringing fire and brimstone to the welfare state as making the best of a crisis.
Time will tell.
However in the same vein of looking for a bright side in a car crash, I want to conclude by stressing there’s a silver lining to this bond market roiling.
I’ve been surprised recently how often people here and elsewhere are asking whether they should now dump their bonds.
I’d say that boat has sailed. On the contrary, from here on bonds may regain their place as a useful portfolio diversifier.
Because while bond prices have fallen further and faster than almost anyone anticipated – at least until the Bank of England stepped in – that has in turn driven up yields for new purchasers.
Clearly it’s easier for me to say this as a naughty active investor who came into 2022 with zero in gilts or Treasuries. (I have had swingeing losses on what I bought this year though, so do share some pain!)
But in the long-term, higher returns than they otherwise could have expected – at least compared to what were at worst nailed-on negative yields – will hold be for passive investors, too.
Lower bond prices are – eventually – beneficial to bond fund returns. Bonds will rollover and the money is reinvested into higher-yielding issues. These deliver more income bang for your buck in future years.
Again, this sea-change has been fast and dramatic.
The 30-year index linked gilt yield-to-maturity (YTM), for example, was negative 2% in December 2020. You were paying the government to inflation-protect your capital.
But the sell-off sent its yield above 2%. You could lock in a 2% real return if you wanted.
That seems attractive right now. Will it amount to much in the years ahead? As ever we cannot know. But it’s certain that positively growing wealth is a lot better for your portfolio than an asset priced to eat it.
It’s a similarly remarkable story with the 10-year vanilla gilt yield:
We are back to pre-2010 levels here.
Again, 4.1% doesn’t seem amazingly attractive with inflation running near-10%, but that shouldn’t last. Moreover there’s now some yield firepower to buffer a portfolio again, should equities fall.
And the 10-year gilt yield was as high as 4.5% before the Bank of England intervention.
It ain’t over until it’s over
Incidentally, some people say the Bank is back to QE in trying to manage down longer-term yields.
I believe that’s wide of the mark.
The Bank of England has said its gilt buying is a temporary measure designed to restore market functioning. It’s even put a date on stopping the purchases.
To me the Bank clearly aspires to get pension funds enough time to fix their positions and then to let gilt yields go where they may.
And when that happens, prices could resume their fall, and yields climb again. Which would price fixed rate mortgages even higher, among other things.
Of course the Bank may be overtaken by events again. But the point is the same push-me pull-you dynamic that I cited last week (and that The Sunday Times paid, um, homage to) is still in place.
The Bank of England wants to raise rates to curb inflation. Meanwhile the government (so far) has only announced extra borrowing and tax cuts.
The first tightens money. The second is loose. Something has already given. There’ll surely be more drama to come.
Oh and while this week’s acute crisis was of the government’s own making, it’s true that the sell-off in bonds in 2022 has been historic globally:
That’s a lot of pain to go around.
It’s all go
Lastly, a housekeeping note.
Readers who peruse Monevator via mobile may have found they couldn’t read our new passive investing guide on their phones this week.
The special mobile theme that we were using didn’t render the page properly.
That theme delivered a lovely browsing experience on mobile and I know some of you loved it. But it has been causing problems for years now.
So we’ve decided to turn it off. Instead, the standard responsive Monevator theme will now load across all devices.
Sorry if you regret the change. But please do check out the passive investing guide – and forward it to your family and friends! It’s really comprehensive.
