- When asset values move in surprising ways, they can cause painful unintended consequences.
- Pensions' use of margin to buy government bonds in liability-driven investing, or LDI, strategies, exposed them to margin calls as yields on U.K. bonds soared.
- In a 'too big to fail' moment, the Bank of England reversed course, buying long-term bonds to push bond values higher, giving insurers and pension funds room to maneuver.
When black swan events happen, something buckles or breaks. In 2008, an unwinding of an Oprah-Esque “mortgage for everyone” approach caused the collateralized debt obligation (CDO) market to implode, resulting in the collapse of Lehman Brothers - the fourth largest investment bank.
Until Lehman’s bankruptcy on September 15, 2008, there was considerable debate surrounding whether the government should intervene to prop up companies at risk of going under. The aftershocks caused by Lehman’s demise put the debate to rest, ushering in the “too big to fail” era. In short, governments’ decided it was better to intervene when things buckle rather than waiting for something to break.
London, we have a problem
This week, something was buckling badly in the U.K, given the Bank of England’s surprise decision to buy its long-term debt to drive down yields. Previously, it planned to sell bonds to lower rates (like the Fed here in the United States), not buy them.
The need to quickly reverse course was because of an investment strategy known as liability-driven investing, or LDI. This approach has won favor among insurers and pension managers because it’s designed to lower the risk that liabilities (ex: amounts being paid or expected to be paid out in pensions) too greatly exceed assets (investments tasked with being able to cover those liabilities). LDI strategies do this differently, but most rely on government debt and leverage. As long as markets behave somewhat normally, everything works as planned. However, when a black swan appears, things can go awry, which appears to have been the case this week.
U.K. bond yields, like in the U.S., have been rising because of inflation and rising rates designed to curb it. However, bond yields took off earlier this month after the government announced a new tax cut and spending program. Yields on 30-year bonds (in the U.K., bonds are called gilts) rose rapidly above 5%, a 20-year high and the fastest monthly increase since 1957.
This rapid run-up in rates caused a big problem. Yields move inverse to bond prices, so tumbling bond values, if left unchecked, could’ve triggered margin calls at pension funds and insurers who had bought gilts on margin as a part of an LDI strategy.
In short, the risk of a great unwind, triggering further unintended consequences, had risen considerably. The Bank of England’s two choices were to let “chips fall where they may” or halt the decline in bond prices. It chose the latter, announcing plans to buy $5.4 billion in gilts maturing in 20 years or longer every day until October 14.
The BoE’s decision caused gilt yields to tumble and a global asset rally on Wednesday. It also reminded investors that interconnected global financial markets pose systemic risks (bearish), and Central Bank policies, as much as they might argue otherwise, can change quickly (potentially bullish, given where we sit today).
Whether the BoE is forced by markets to extend its bond-buying program longer is anybody’s guess. Still, the fact it acted as quickly as it did suggests (1) there’s potentially more risk looming than many market participants were modeling, and (2) global central banks aren’t willing to give up on too big to fail yet.
In “The Bank of England, EPS and Market Instability: Is 'Risk-Free' Still Risk-Free?” Real Money Pro’s Doug Kass writes:
“I am not surprised the stock market reacted positively to the news of the Bank of England intervention of the gilts market (to buy gilt bonds with maturities over 20 years)...The policy move resulted in a seven standard deviation move in the gilts market…An even bigger picture issue is that it already has come to this again… It seems we have a system that can no longer tolerate what should be minor shocks…Bottom line is it did not take much to require central bank intervention in the UK…Should we be celebrating, as the markets did on Wednesday, the fact that the system has become this fragile? And what does it all mean going forward?”
Fragility can be overlooked during bull markets when asset appreciation provides insulation against unraveling. It’s hard to ignore when assets are already falling, leaving investors' willingness to absorb the risk of further losses razor thin. Investors are already walking on eggshells because operating margins are thinning due to inflation, and decelerating economic activity is cutting revenue.
Back to Kass:
“In normal times, EPS estimates are close to reality…During inflection points, they never seem to turn out right, to the positive or the negative. Not even close. That is because analysts are incremental, as are companies. In downside inflections especially, companies don't want to let all the hot air out of the balloon at once. Especially at companies full of equity comp where insiders sell like crazy. Analysts just follow company guidance. They never cut enough…Any valuation case for the market is predicated on two things -- earnings and the multiple those earnings will get…The problem is the earnings estimate is never right. It seems like you need a year or two of cutting or raising before you get estimates to the point where the ballpark they end up in is close to right…My guess is market EPS estimates will turn out being as close to reality as the FedEx earnings estimates were.”
Analysts are notoriously slow to change course when it comes to earnings outlooks, and as a result, the S&P 500’s forward P/E ratio may appear more appealing than it is. We’re already seeing analysts playing catch up, ratcheting back overly optimistic earnings outlooks.
According to FactSet, downward revisions have reduced the year-over-year EPS outlook for the S&P 500 to 3.2%, down from a laughably bullish 9.7% on June 30. Yet they’re still modeling 7.2% and 6% EPS growth in Q1 and Q2 2023, respectively. It’s hard to believe more companies won't follow FedEx's lead, resulting in additional downward revisions through year-end and early 2023.
The Smart Play
Despite Kass’ worrisome reminder of the risks we’re facing, he’s still opportunistically buying stocks because he believes many risks have become widely held, suggesting it's time to tilt the other way. However, Kass acknowledges he’s buying great companies at good, not great, prices, so he’s only tinkering with his exposure. Today, he wrote that he’s about 28% net long.
Historically, September is a poor performer, which is certainly true this year. In addition to raising cash to meet quarterly redemptions, stocks often struggle until the month’s end because of mutual fund repositioning and tax loss harvesting. Many mutual funds' fiscal quarter ends September 30, and according to J.P. Morgan, those funds control roughly 11% of U.S. stock-fund assets. It’s not a stretch to think funds are selling losers this week to reduce the tax hit associated with any winners they’ve had, such as energy stocks.
The headwinds improve in October when selling abates, and more people are back at their desks following Yom Kippur. That’s particularly true in mid-term election years.
Stocks tend to find their footing heading into November, providing solid returns through May. Of course, there’s no guarantee this year follows that playbook, especially if the Bank of England’s intervention was only the tip of the proverbial iceberg.
For this reason, wait for stocks to prove themselves and continue controlling risk. Like Kass, you can buy high-quality companies at good prices, but you still need to use risk-control strategies to protect yourself, such as limiting position size, using stop losses, and avoiding leverage.