Roundup: Keeping Track of Britain

While US financial headlines remain preoccupied with regional banks after Tuesday’s Congressional hearings on the failures of Silicon Valley Bank and Signature Bank, the UK is having a rather eventful week. A new trade agreement is reportedly on the home stretch, the Bank of England (BoE) has weighed in on pension fund regulation, and new lending data raise some questions for the economic outlook. What does it all mean for markets? Read on!

If the UK Joins, Is It Still the Trans-Pacific Partnership?

For a long while now, the UK has been pursuing membership in the regional trade agreement known as the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP)—which, as the name implies, frees trade among 11 nations surrounding the Pacific Ocean. (This is the deal that arose from the ashes of the Trans-Pacific Partnership after America exited talks in 2017.) Those negotiations are now reportedly complete, and a source slipped to The Telegraph that ministers will sign off on the agreement Thursday and announce it Friday. As far as we know, a change in name is not on the agenda—it will not suddenly be the Comprehensive and Progressive Trans-Pacific and British Partnership. We will just have the amusement of a Pacific trade deal that includes an island nation in the upper Atlantic. How fun.

Inevitably, we are already seeing a lot of wild claims about what this development means. Some say it makes Brexit irreversible by pulling the UK away from EU customs rules. To us, that seems like a stretch: We suspect a nation that figured out how to leave the EU could probably leave a trade bloc if society decided to head that way in the future. Others tout its economic benefits, giving the UK access to a big trade bloc that rivals the EU in economic size and is faster-growing to boot—essentially arguing CPTPP membership will offset any trade losses from Brexit. Philosophically we get it, although for a lot of small businesses it isn’t that simple. Not when you must also factor in higher shipping costs and the like. Proximity still counts.

We do see some potential long-term benefits here. The UK’s trade with non-EU parts of the world was growing faster than trade with the EU for years before Brexit happened. Reducing friction in trade with Asia therefore could have some pretty big potential. But over time is the key phrase here. Trade deals are usually too slow-moving to be big near-term economic drivers. That is likely the case with CPTPP, considering its scheduled tariff reductions happen gradually over the 30 years after it came into force. That means it will be about 25 years before the treaty is fully implemented. So while it probably helps the structural backdrop for the UK’s economy to a degree, it is probably well outside the scope of economic drivers markets will look to in the next 3 – 30 months.

The Bank of England Thinks Pensions Need More Capital and Stress Tests

As recent events have reminded America, whenever there is a dust-up in financial markets, regulators will always mull rule changes in hopes of preventing a repeat. While the US is going through this now with Silicon Valley Bank, Britain has been mulling over what to do about pension funds since last September. Back then, when long-term UK Gilt yields jumped as the market (in our view) overreacted to the government’s fiscal policy plans, pension funds using a tactic called Liability Driven Investments (LDI) got hit with margin calls as bond prices fell. To meet the sudden need for cash, they sold the easiest thing available—UK Gilts—causing a vicious cycle of forced sales and rising rates. The crisis ended after the BoE backstopped the sector with emergency liquidity programs, putting pensions on the bank’s docket. The question: How should regulations change to make such forced sales less likely in the future?

The BoE’s Financial Policy Committee, which handles regulatory matters, weighed in today with recommendations on how LDI funds can “increase their resilience to interest rate shocks substantially.” In its report, it recommended that the creatively named The Pensions Regulator (TPR) adopt higher cash buffer requirements and subject LDI funds to regular stress tests measuring their ability to withstand a 250 basis point (2.5 percentage point) jump in long rates without fire-selling assets.

These are just general recommendations, so time will tell how TPR writes the actual rules and whether the details reveal some unintended consequences. At a high level, this seems like a change that won’t kill off LDI, as some have feared, but also won’t crisis-proof it. Higher cash buffers are probably beneficial, and preserving the funds’ ability to use leverage—whatever you may think of that—reduces the regulatory disruptions that could have emerged from deeper changes. But stress tests have a rather mixed record of identifying troubled institutions since their criteria may not match real-life developments. As several commentators noted after Silicon Valley Bank failed, the Fed’s most recent stress test exercises didn’t include the conditions that led to the bank’s demise, likely rendering it moot even if SIVB had been subject to it.^[i] Perhaps stress tests designed to measure one specific thing—an interest rate jump—will be better tailored, but it will depend on the model and its inputs.

The good news is that LDIs’ hiccup last year was a very idiosyncratic, short-lived problem. Long rates fell almost as quickly as they spiked, and the BoE’s involvement didn’t last long. Reducing the likelihood of this happening again may shore up sentiment, but it was already a low-probability event, and it wasn’t a systemic risk.

Keep an Eye on Weak Lending

When the UK avoided a GDP contraction in Q4 (pending revised data out Friday) and notched 0.3% m/m GDP growth in January, economic sentiment improved quite markedly. Outlets forecasting doom and gloom last year began saying the UK could avoid recession this year. Some even implied it was a fait accompli. We don’t like raining on anyone’s parade, but we thought at the time this was perhaps premature. January is just one month, and one-off factors have skewed GDP data lately, making a mild British recession entirely possible (though not guaranteed).

Since then, purchasing managers’ indexes suggest growth continued through March. But recent lending data aren’t exactly growthy. Total lending turned negative year-over-year in February, per data out Wednesday, falling -0.3%.^[ii] That is the first year-on-year decline since early 2014.^[iii] On a month-over-month basis, the -0.9% drop was the fourth decline in five months.^[iv] Lending to households grew both month-over-month and year-over-year, as the disruptions from the aforementioned autumn yield spike faded into the rearview, but business lending’s decline accelerated from -0.5% m/m in January to -1.0%.^[v]

Why is always harder to know than what, but the BoE’s Q4 Credit Conditions Survey hinted at both weaker demand and tighter supply. It also pointed to commercial real estate lending as the main weak patch, so it is entirely possible that credit is still flowing to businesses for capital investment and other non-property purposes. Weakness was also concentrated in small and medium businesses, which have well-documented and long-running headwinds. So we aren’t calling this some massively negative sea change. Yet it is also true that credit is a big source of capital, and as it falls, there is less new investment to multiply throughout the economy, which is a headwind.

This doesn’t make recession automatic. The UK has grown through weak lending patches before. But it does speak to the need for realistic expectations. Markets aren’t too far out over their skis, in our view. There is a lot to suggest they pre-priced economic weakness last year. But if a recession does arrive after this spate of sunnier forecasts, it could catch investors off guard and prompt some knee-jerk reactions. By keeping the possibility of a mild recession in mind today, you will likely be better able to make sense of any headline handwringing that might ensue later.