Photo by Etienne Martin on Unsplash
Hello,
Welcome to Known Unknowns, a newsletter that has been waiting its whole life for LDI to be a major news story.
Did LDI nearly take down the British economy?
Pension geeks everywhere got a rush of excitement last week when everyone was talking about liability-driven investment (LDI). For a minute, it was the new mortgage-backed security. And it was unfairly given a bad reputation. LDI is the main risk strategy for pensions. Pensions are simply obligations to pay people money in the future, just like a bond. So, if you invest in bonds that have the same duration as your pension liabilities, you hedge your risk that markets or rates will change. Now LDI, at least if you do duration matching, has some weaknesses. It does not work so well with non-parallel shifts in the yield curve, for instance. And many funds are short duration because there are not long enough bonds out there.
But the biggest weakness with LDI is you need to buy a lot of bonds. Over the years, bonds have become very expensive, and many pensions were underfunded to begin with, so they could not afford to hedge—they needed to take on more risk. Consultants convinced pension funds in the UK that they could have the best of both worlds if they levered up their bond portfolios. (We really need to talk sometime about pension consultants—some are great and do great work, but others act as a way to remove accountability, enabling sponsors to make some bad investments.) High returns and complete risk hedging—what could go wrong?
The same thing that goes wrong anytime anyone tells you they can get you low-risk and high returns: There was a tail risk lurking. Pension funds were only prepared to post collateral if rates went up 100 basis points, but then rates went up 400 basis points in less than a year. Because, yeah—that’s what rates do when people get freaked out. Unfortunately, the whole world has memory-holed its US bond market data from the years preceding 1995. So, the pensions lost their hedge, the underlying bonds were sold, and the Bank of England had to step in.
What should we learn from this?
1. LDI is still a good risk strategy. Unless you lever it up multiple times. I see many stories blaming LDI for the whole mess, and suggesting stock or private equity investments would have been safer. No. This is the same old problem of taking on more risk and calling it a safe asset. LDI, when done properly, is an important risk tool and is still the gold standard.
2. Any time a consultant says you can get low-risk and high returns, you need to fire them.
Also worth noting: UK pensions have never been better funded because of the high rates. They are not in danger of not paying benefits. But some just lost their hedge.
The Fed needs to stay the course
The UK pension problem has demonstrated the challenge of monetary policy these days. Tamping down on inflation is never easy. It requires slowing down the economy, people lose jobs and the stock market falls. Rates rise, and bad risks come out of the woodwork. Nobody likes these things, and no one ever has. In the 1970s, people also said central banks shouldn’t raise rates because “It’s a supply problem,” “The unemployment isn’t worth it,” or, “We just need price controls!” (Seriously, UN?! What are you good for?) The result was inflation in fits and starts for nearly a decade and slow growth.
Yes, there is a risk of the Fed going too hard, but also a very serious risk of pulling back too soon. Jason Furman points out that the very same people who argued monetary policy should be extremely loose until we see “the whites of inflation’s eyes” are now saying monetary policy has done enough—let’s pull back, there’s a lag. Even though core inflation is still very high.
Another thing. These same people expect the Fed to pump up inflation when there’s a recession (actually, in good times, too). I agree that this is an important and valuable policy tool that saves people lots of misery. But the ability to do so comes at a cost. The Fed can only boost the economy when it needs to if it also slows the economy when it is overheating. It needs credibility to be effective in all markets.
Just like leveraged LDI, there is no free lunch. The Fed needs to stay the course.
The supply-side revolution is already here
I’ve always been a supply sider. No, I don’t think tax cuts pay for themselves. But I’ve been concerned that there are serious structural issues holding back growth and productivity. People don’t have the right skills, it is too hard to move to good jobs, and it is too hard to start a business, etc. There is something wrong with the labor force when so many prime-aged men aren’t working, even when the economy has lots of jobs.
But after the financial crisis, it was all about demand. In large part because, when households lost lots of wealth in the housing bubble, they stopped spending. But the narrative became that we could solve all our problems if people and the government just spent more to boost demand. “Consumption is the economy, so just grow that,” the thinking went. That was also the playbook going into the pandemic. But mix together demand stimulus and supply constraints, and you get inflation. So now the policy du jour is all about supply. It’s long overdue.
But, so far, this just seems to mean industrial policies like the Build Back Better plan, the CHIPS Act, and Europe’s €2 trillion-plus Green New deal. The UK is trying something different—rather than directing resources, it is trying to get out of the way with tax cuts and deregulation.
Which one will work? Markets seem to hate the UK plan, and the execution has not been great so far. But it is odd that markets have found deficit religion in Britain and don’t seem concerned about European countries spending gobs of deficit-financed money on industrial policy—and many of these countries are in worse fiscal shape than Britain to begin with.
It may be that the current vibe is spending on industrial policy is a wise investment in the future and that tax cuts are reckless. But they are two sides of the same coin. Industrial policy is great if you pick the right projects and the best people to execute them. But the government tends to be pretty bad at picking these things. I think the market does a better job. But we’ll see what happens.
Until next time, Pension Geeks!
Allison
The past three decades have shown that the CEOs and CFOs of America's companies will structure the supply chain to maximize short-term profits by picking countries with reduced wages and environmental regulations. The past two years have exposed the fragility of what they have wrought. It has been proven many times over that most companies are not particularly good at risk management, especially regarding fat tail risk.
I generally don't like subsidizing companies, but if that is what it takes to convince them to bring critical manufacturing back to North America, then it is an unfortunate but necessary step. Since the US already has relatively low taxes and also relatively low regulation in many areas when compared to places like Europe, it is not really possible to bring these types of industries homes with tax cuts and deregulation because the competitors are places like China, Taiwan, and South Korea which are structured to shove through industrial policies to encourage companies to be there and bulldoze through barriers to development. So unfortunately, things like the CHIPS Act are necessary evils and it appears to be working.
Related to green energy, there is a huge difference between the new energy systems and the old style infrastructure. Old energy infrastructure was very centralized with big projects and either government agencies or regulated public utilities. The key to the future renewable energy is that muc of it is going to be very decentralized, down to household rooftop solar. Increased efficiency is also very decentralized down to individual appliances in homes and businesses. So the big old style infrastructure spending on large projects won't work.
The key is going to be the rebates and tax credits to convince individual actors to install these technologies to achieve critical tipping points where they have enough momentum to overcome much of the cost advantage that old depreciated industries have, especially when those old industries are scrimping on O&M and accepting lower reliability to keep those costs low (e.g. Texas natural gas systems did not heat trace due to the cost and their systems literally froze in the deep freeze 18 months ago shutting down natural gas electrical production). Two decades from now, it is likely that a lot of the existing transmission infrastructure will be shunting local energy production among users and generators on a neighborhood level instead of the current model of bringing it in from hundreds of miles away.
Initial large government expenditures on new technologies goes back 200 years to the Erie Canal and when the US gave away much of the country to railroad companies to create the immense railroad network the country grew on. Other major investments were the large western dams for irrigation and power, rural electrification programs, the Interstate Highway network, etc. These were all heavily or entirely subsidized by government and so have current cost advantages over competing technologies today. Commuters driving on interstate highways funded through US General Fund instead of increased Highway Gas Tax moan about the cost of subsidizing a public transit system and state that it should pay its own way, not realizing the road they are driving on did not pay its own way.
"High returns and complete risk hedging—what could go wrong?"
Did you mean *incomplete* risk hedging? The paragraph before was about funds not being able to buy enough bonds to hedge. Or is it about duration risk was hedged but tail risk (gamma?) wasn't? (The following paragraph wasn't clear.)