20 January 2017
Mark Twain said “The secret of getting ahead is getting started” and May has now played her hand saying long detailed negotiations are not on the cards: let the UK leave on our terms or the gloves are off.
Those gloves have weight: Sterling is cheap, we import more than we export and we have the most powerful financial centre in the EU even before we start to offer favourable tax regimes.
Theresa May’s logic is that “no deal for Britain is better than a bad deal”. In other words a Hard Exit is better than a Bad Exit so she swapped the Brexit dice for a coin: heads the UK wins, tails we lose. Alas, I doubt the odds are 50:50.
So May is not for turning and is forging ahead to extract the UK from EU’s single market with a mighty shopping list:
- A tariff-free deal;
- Co-operation in areas like crime and anti-terrorism;
- Full UK Border controls;
- Protect the rights of any UK citizen living in the EU and vice versa; and
- The two houses will get a vote but they will only be able to choose between the deal on the table or to leave the EU under WTO trade rules (Bad Exit). Hobson’s choice for sure.
Interestingly, I never hear or read the phrase “Regrexit” any more. In a relatively short space of time our leaving the EU has become the accepted reality. Ironically, the biggest danger to May’s strategy is that if she achieves her shopping list then other EU Members would probably want the same thing – Brexit envy.
The Brexiteers may all be cheering but Theresa May has probably not altered the outcome with her speech. John Harris in the Guardian summed it up well when he said:
“This was effectively May’s last big moment of political control before article 50 is triggered, negotiations begin, and all that stuff about the best deal in the best of all possible worlds collides with what the EU wants…”
Cynicism aside, at least there is a new phrase being bandied about: Clean Exit. Now we have a plan and this will help remove some degree of financial and economic uncertainty.
Commentators have focused on the immediate impact on Sterling (up) and the FTSE All share (down). What really matters, however, for most long term investors are expectations for interest rates and inflation.
The real yield on 20 year index-linked gilts (see chart on the left) have fallen from -0.95%pa in June 2016 to -1.65%pa at present. So, if you invest £100 today it will be worth £72 in real terms in 2037. Or, turning this upside down, a Trustee who has promised to pay a benefit of £100 in 2037 with RPI increases between now and then needs to invest £139 in Index-linked gilts today.
Most of this fall in the real yield on index-linked gilts has come from a 0.5% pa rise in twenty year inflation expectations. The right chart shows the implied RPI inflation derived from 20 year index-linked gilts and 20 year fixed interest gilts. This means that markets are expecting Brexit to result in extra inflation of just over 10% in aggregate over the next twenty years. Some of this is already heading our way as the fall in Sterling pushes up the cost of imported goods. Unfortunately, this extra dose of inflation is not expected to be enough to force the Bank of England to raise interest rates as expectations have fallen another notch since the Brexit vote.
So we continue to live in our topsy-turvy world of eternal negative yields and pension deficits. As the Brexit drama unfolds the financial tectonic plates of interest rates and inflation expectations remain stubbornly unmoveable.
So what does all this mean for Trustees and what can they do about it?
In a world of sustained negative yields two things become increasingly important and should be added to the agenda for the next Trustee meeting.
Firstly, covenant. If the assets we are holding will fall in value in real terms due to the head-wind of negative yields then the relative value of future contributions becomes increasingly more important. The more the real yields are negative, the more a deficit grows but what is really happening is your pension fund is becoming more like a “pay-as-you-go” scheme with long-term future contributions being increasingly required to pay pensions as they fall due. Of course covenant strength is always important but Trustees should be very clear on the potential impact of Brexit on their sponsor’s covenant and should be engaging with the Sponsor on these issues. If your head office or factory could be moving abroad then what will that mean for your Members and the recovery plan?
Secondly, boosting expected returns. It is increasingly looking like there will be no quick fix for Trustees. Unless the Bank of England suddenly starts raising interest rates much faster than expected then the only thing that will help pay the benefits beyond the company contributions is to generate better long-term investment returns. Equities have been doing well but traditional DGF managers seem to be struggling to generate decent returns. My clients are increasingly looking to trim the DGF allocation and rely on more direct diversification ideas such as illiquid credit opportunities. Other clients are considering nudging up their equity allocations as well. Ask your investment consultant if your assets are working hard enough and what ideas do they have for boosting investment returns?
For our latest investment thinking, take a look at our recent LCP Vista magazine - download it here