Fog warning

 

Until the mini-budget mayhem of last September many of us will have been blissfully unaware of Liability-Driven Investment (LDI). This is a basically a strategy to enhance returns within some UK defined benefit pension funds from government bonds. Unfortunately, the mini-budget created a seismic shock within the LDI sector that, in turn, almost led to a collapse in the UK gilt market forcing the Bank of England to step in with emergency support.

The LDI episode is just one of example of an investment product where all seems well until there is a bout of unforeseen volatility. None of us is likely to forget the financial crisis of 2007-08 in a hurry. This was triggered by the US mortgage-backed securities bubble and led to the spectacular collapse of Lehman Brothers.

We therefore sat up and took notice of the recent warning from the Bank of International Settlements (BIS) based in Basle, Switzerland.  This is known as the ‘central banker’s banker’, an umbrella body for the likes of the Bank of England, European Central Bank and the US Federal Reserve. The BIS has highlighted the risk within the foreign exchange debt swap market (FX debt swaps). Global companies, pension funds or insurers, as well as speculators can use FX debt swaps to hedge against currency fluctuations. They offer a company access to a loan in a foreign currency that can be less expensive than when obtained through a local bank.

Reuters recently estimated that pension funds and other ‘non-bank’ financial firms could have more than $80trillion of hidden, off-Balance Sheet dollar debt in FX swaps. The problem appears to be that non-US banks and pension funds could have twice as much FX swap Dollar obligations as the amount of Dollar debt that is shown on their Balance Sheets. The BIS described the FX swap debt market as a ‘blind spot’ that risks leaving policy makers in a total ‘fog’.

We all know the danger of travelling in fog. With the spotlight on the issue and central bankers now aware of the problem, then hopefully they can prevent any seismic shock arising from any speculative excesses in the FX swap debt market.

What have we been watching?     

A positive start to the year for investors …long may it continue!

Markets continue to look through rising Covid-19 cases in China and the emergence of new variations and instead have focused upon some early signs of inflation starting to fall. Eurozone markets in particular, took encouragement from economic data suggesting lower inflation and only a moderate growth slowdown. In the US, investors focused on a slowdown in wage growth adding to hopes that inflation has peaked. China also lifted quarantine restrictions for inbound travellers over the weekend and this also helped lighten the mood.

It looks as if the world will have to live with Covid-19 and new variants for some time to come. A ‘highly-infective’ Omicron sub-variant XBB.1.5 ‘Kraken’ has already been identified in over 25 countries including the US where, it is believed to be responsible for 40% of cases. Cases of the new variant have also been identified in the UK, which together with flu, is placing additional pressure on the NHS. The ‘twin-demic’ of flu and Covid-19 appears to be placing pressure on healthcare systems across Europe. Meanwhile, Chinese officials have admitted that its Covid-19 deaths are ‘huge’ while one doctor believes that as many as 70% of Shanghai’s 25million residents may have been infected already.    

The US announced a further $3bn military aid package for Ukraine, while in Russia there were reports that Putin is planning to call-up a further 500,000 soldiers.

 

In the UK, the mild weather has seen a further pullback in wholesale gas prices. While there will be a lag before households feel the benefit, nonetheless it will be helpful and should also remove some of the inflationary pressure.  The government is due to announce a new scheme to support businesses with their energy bills later today. The cost of the previous six-month support scheme is estimated to be over £18bn. Chancellor Jeremy Hunt has already said that this is ‘unsustainably expensive.’ The new package will offer a discount on wholesale prices rather than a fixed price. Meanwhile, the December manufacturing PMI activity reading hit a 31-month low of 45.3.

 

In Europe, hopes that inflation has peaked were bolstered by data from Germany which showed that inflation had dipped by 0.8% in December to 8.6%. French inflation also slowed unexpectedly in December dipping from 7.1% to 6.7%. Sentiment was also helped by a modest upward revision from the ‘flash’ December Eurozone PMI business activity indicator which, although the sixth month of contraction, did recover to a five -month high.      

 

In the US, the ISM manufacturing activity index dipped slightly in December and was the weakest reading since mid-2020 – a level historically consistent with recession. New orders contracted for the fourth month in a row. The Federal Reserve (Fed) issued the minutes of its most recent meeting. The Fed still appears to be trying to dampen market hopes of a possible pivot in interest rate policy in 2023. The minutes confirmed that no members of the Fed Committee envisage a cut in policy rates this year.  ‘A slowing in the pace of rate increases at this meeting would better allow the Committee to assess the economy’s progress as monetary policy approached a stance that was sufficiently restrictive.’ Not surprisingly, markets latched onto the latest jobs data that showed a slowdown in wage growth to an annualised rate of 4.6%, adding to hopes that inflation has peaked.  Republican favourite Kevin McCarthy was eventually elected speaker of the US House of Representatives after an historic fifteen rounds of voting.

Read our latest Chinese investment insights from Alpha PM

 

China’s manufacturing sector’s five-month contraction intensified in December with a reading of 49.0. The Covid crisis has evolved from the impact of lockdown restrictions to climbing infections. Meanwhile, the People’s Bank of China (PBoC) announced it is looking to introduce policies to improve liquidity for the country’s ‘too big to fail’ property developers.

Read our latest investment insights from Alpha PM

 

Brent oil dropped to $78 on concerns about the impact of rising Covid-19 cases in China for short-term oil demand. China is the world’s biggest importer of oil. However, the Brent oil price recovered to $80 on news over the weekend that China has lifted quarantine requirements for inbound travellers, ending almost three years of self-imposed isolation.   

Finally, the winter flu season has placed even greater burden on the NHS. The surge in illness has however also been reflected in the high street with pharmacies and supermarkets reported to have run out of cold remedies such as paracetamol, Strepsils, Lemsip and Night Nurse. ‘Coughs and sneezes spread diseases’ but are great for the profit margins of Consumer healthcare brand owners.

Read Last Week’s Alpha Bites – The Global Investment outlook – What do we see for 2023?

 

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