Hello, and welcome to the Download. I'm your host, Dave Richardson. And I'm joined by another David, our good friend from the UK, David Riley, who is the chief strategist at Bluebay Asset Management. That seemed hard to say. I am up early because you're five hours ahead of me and that's a little rough on my ability to speak clearly. So, we'll let you do most of the talking since you're the expert, anyways. We've had some really interesting activity and news coming out of the UK. Of course, we were all saddened with the loss of our Queen, Queen Elizabeth. I know for all of us here in Canada, she's our Queen as well and it was sad to see her go. The only Queen I've known in my lifetime and I've been around a long time. And then, of course, a change in the UK government which has spurred on some unusual activity in British markets, which kind of had a spillover effect into global markets. So, David, what happened? I guess it was this mini budget that the new government put in place and then lots of crazy stuff happened.

In a nutshell, that is it exactly. It's good to speak to you. It’s unfortunate that it seems to be during periods of either economic, political or financial crisis in the UK. And you're right, the UK has a new Prime Minister, Liz Truss. She has a sort of radical tax cutting and deregulation agenda for growth. Our chancellor presented a mini budget which turned out to be anything but. So, they announced a huge energy subsidy package which will essentially cap the average or typical UK household energy bill at about £2500. That's still, I think, roughly about CAD 3800. It's a lot. And it underscores just how big this energy crisis and the rise of natural gas prices have been for Europe, including the UK. But that's the measure they've announced. It's very expensive, but it ultimately will prove temporary, a bit like some of the emergency fiscal support that was introduced during the Covid pandemic. But what really spooked investors is that the chancellor also announced much bigger than expected tax cuts, including top rate tax cuts that are benefiting the most wealthy in the UK, of £45 billion, with more to come. And this was completely unfunded; this is purely going to be paid for out of increased government borrowing. They presented a budget that wasn't independently costed or verified. There were no projections either for growth, for the overall level of public debt. And I think the market thought, wow, we've got a government that's come into place, is on a debt funded dash for growth, which is operating or moving against what the bank of England is trying to do, which is to try and slow the economy and to bring inflation down. It's got pretty much scanned, sort of disregard, if you like, for the implications for public debt sustainability and for the impact on inflation and interest rates. And this is a UK economy that has supply constraints, a huge 8% of GDP trade deficit and it's actually got the highest inflation in the G7. So, investors dumped UK government bonds, or Gilts, and they also dumped the British pound. But the moves were so brutal, so violent, that they started to morph into a broader financial crisis and threaten UK financial stability.

Yes. And for Canadians, we're somewhat insulated from an understanding of just how weak the pound has been, because Canadians— and we've talked about this on this podcast before— are focused almost completely on the exchange rate with the US. When we look at the Canadian dollar versus the US, we've actually held up pretty well. But the US dollar is on an absolute tear. So whereas the Canadian dollar is down— at the peak, it was down about 8% on the year, against the US dollar—, the pound is down over 20%. So for Canadians, it’s a good time to visit our friends over in the UK.

Yes. And bring some hard currency.

Absolutely. Bring some hard currency and maybe pack some natural gas, a couple of barrels of natural gas, as we go over as well. But these are not normal moves in currency, because this is a six-month period we're talking about. These are not normal moves in currencies. These are very big moves in currencies, which create all kinds of volatility. And then another thing that Canadians would be familiar with is being poked by the IMF. It happened to us about thirty years ago when our debt situation got a little bit out of control, but when the IMF is coming in and saying nasty things about a major economy like the UK, something's awry. So all of this happens, and then within the UK pension fund, that's where things really start to unwind. So why don't you talk about how that plays out and then ultimately, what has been the short-term solution for the issue?

Yeah. UK pension funds, they have about one and a half trillion pounds of assets that are based on liability-driven investments. So, overall, UK pension funds are in total especially even bigger. But these one and a half trillion pounds are still a huge number that are managed using this so-called liability driven investment (LDI). The thinking behind that is actually very familiar, I'm sure, with people on this call, and it makes a lot of sense: I have a pension fund, I've got long term pension liabilities— obviously, what I've got to pay out to current and future pensioners— and so I seek to match that on the asset side by holding safe, long maturity, long-dated, ideally inflation-linked assets. And so, the obvious thing to hold is government bonds, and particularly inflation-linked government bonds, but government bonds more generally. And so, okay, fine, if interest rates go up, obviously I lose on my bond portfolio as a pension fund, but so does the present value of my pension liabilities as well. So, both sides of my balance sheet match and I'm pretty much indifferent to where interest rates go. That's all great, it's all fantastic. However, as unfortunately there is a tendency to do, amongst some of us in the financial markets, dare I say, is we take a good idea and then we just stretch it a little bit too far. And one of the ways it's been stretched in terms of UK pension funds is that firstly these pension funds aren't fully funded, so they don't actually have current assets that fully offset all their liabilities. So, they can't really completely match their asset and liabilities. They still need to generate returns to build up those assets to pay off those liabilities. So what they've done is enter into derivative contracts, mostly interest rate swaps, where they've essentially leveraged their long bond portfolio. By using leverage, by using the interest rate swaps, they can match their liabilities with this sort of synthetic government bond Gilt exposure. That frees up capital, that frees up funds, which they can then invest in more risky, less liquid assets, like UK real estate or US equities or leverage loans, private credit, private equity, etc., in order to generate the higher returns. However, we had such a brutal sell-off as a result of this mini budget that pension funds and the LDI asset managers were facing huge margin calls on these interest rate derivative positions which they had, and they were much bigger, those margin calls, than the cash which they had available. These positions were out of money, so you have to start posting cash or collateral. So, what did they do? Well, they are holding a lot of government bonds, so they start selling the government bonds. So, you're selling into a falling market where there's no bid on the other side, that pushes up the yield, pushes down those bond prices, leading to more margin calls, leading you to sell even more. This is a kind of doom spiral of forced selling; this is 101 on investing which is you never want to be in a position where you're a forced seller and that's exactly what UK pension funds were involved in. And given the scale, there's one and a half trillion, given the pension funds, you've got LDI asset managers, you've got other counterparties which could be including UK banks, that forced the bank of England to intervene. It basically announced that it was going to buy up to £65 billion worth of UK government bonds of Gilts up until the 14^th of October. And that announcement had a huge impact. They've bought some bonds, but actually not that many, because just knowing that the bank of England is standing ready to buy those bonds puts a floor on the price. I mean, it is a massive reversal, of course, by the bank of England, because only a week before, it said it was going to sell or start selling its UK government bonds, because it was supposed to be in a world of quantitative tightening, not back in a world of quantitative easing. So, it's another illustration as well, if you like, whereby the mini budget was acting against precisely what the bank of England was trying to achieve. So, it's calmed the market, at least for now. But UK government bond yields are still much higher. UK expectations around the bank of England base rate, or the policy rate, before the budget, was expected to peak at about 4%. Now it's expected to peak around about 5.5%. So, there's still a big overhang facing UK mortgage holders. Most mortgages in the UK are two to five years. A lot of those, obviously, were written when interest rates were incredibly low. They're going to be running off and people are going to be facing not only this big increase in their energy bills, but also potentially, depending where bank of England interest rates go, but they're going to go higher than they otherwise would have done, a much increase in their mortgage rates as well.

Yeah. Just to put it in very simple terms for Canadians, and just relating it to an individual situation where, say, you've got a million-dollar house with a $900,000 mortgage, and all of a sudden, interest rates go up, and if you're on a variable rate mortgage, you've got to make a higher payment and you've got to find that cash. And the cash isn't there and you're leveraged and you need to find somebody to come and bail you out. I know when that happened to me, many years ago, fortunately, my parents were around. In the case of the UK pension, we had the bank of England as the parents to come in and solve the issue. I think that's a very simplistic analysis, but you're leveraged out, so you got a mortgage and you got a house, and most of the house is mortgage, so you're leveraged in terms of your down payment and then rates go up and you get a cash call and it forces you into making some very challenging decisions. And in this case, of course, the bank of England has to come and bail. It's a clumsy comparison I'm drawing here, and again, very simplistic, but there are other spots around the world where obviously leverage is being used. We learned from the global, the great financial crisis, that leverage, when monetary conditions tighten, creates issues, the value of liquidity, particularly in challenging times. What do you think the takeaway is for the rest of the world from what's happened in the UK? Because if it can happen there, you'd almost think it can happen anywhere. What should we be watching for here?

Yeah, it's a good question. I think, as you alluded to, Dave, as well in the introduction, this has come against a backdrop where we've seen, in many respects, an historic appreciation of the US dollar. It's not so much the level of where interest rates have got to, it's just how quickly we've got there. Obviously led by the Fed, but all the other major central banks, bank of Canada, bank of England, even the European Central Bank— only the bank of Japan is kind of standing out against this rise, but that's probably for another discussion. So, we've had this really dramatic, as you've said, sort of tightening global financial conditions, most broadly defined. And I think in that situation, what happens is that weak links get exposed. And what we've seen is actually that the UK and some of its pension fund arrangements and regulations proved to be a weak link. And sure, UK has got its particular sort of idiosyncratic issues and weaknesses, and so was kind of vulnerable. But I think this is the point that is worrying investors more generally: okay, so we've got this tightening global financial conditions, what's going to break, what's going to crack? We've had the UK face potentially quite a serious financial stability crisis. Hopefully that's been addressed now by the bank of England. But where else could we see this happen? Things like LDI isn't unique to the UK. You have not dissimilar arrangements in other jurisdictions, but I think, again— and it speaks exactly to your point, Dave—, the takeaway for investors is, in a low volatility world, leverage can work very effectively and it can be using these as tools to manage your risk and return profile. It can be very efficient. I'm not suggesting that this is bad in all circumstances, but when you've broken into a new regime where not only interest rates are higher, but you're getting these big swings in currencies and actually overall levels of volatility in asset prices are much higher, then if you have leveraged exposure to some of those asset prices, you can be very dangerously exposed from a financial point of view. And it does speak to the value of liquidity. Because not only do you not want to be a forced seller of assets, ideally you want to be in a position where maybe you could be a buyer of assets when everyone else is fearful, when everyone else is being forced to sell. I do think that we are going to see some more episodes not dissimilar to that of UK. And I think it's also something which I've been talking, for example, with Eric Lascelles and Dan Chornous and others, which is we've gone from a world where governments could spend and change taxes and borrow without really having to worry about the availability of finance and the cost of finance because interest rates were zero; central banks were buying lots of bonds, there was a great investor search for yield. But now we're in a world where actually there is a lot more risk premium in yield. You don't have to necessarily go out and invest in government bonds or other assets to get yield. And I think it's therefore a world where economic fundamentals and policy credibility, and I think essentially what happens in the UK is a crisis of credibility. It's not really a financial crisis, it's a crisis of credibility of UK policy institutions. So, yeah, I think the lesson, hopefully that other governments take, is you've got to have sustainable fiscal policy, public finances. The lesson for investors, including institutional investors, is be wary about the amount of leverage you have. And if you do have leverage, make sure you've got plenty of buffers to be able to absorb that. And clearly some UK pension funds and LDI managers didn't have that. And don't underestimate the value of liquidity in a world where markets are so volatile.

Yeah, just to come back to my simple analogy of a Canadian homeowner, we've had in Canada, for the last 20 years, generally rising housing prices, and over time housing prices go up. Over the last 40 years, up until the last two years, we generally had a long-term downtrend in interest rates. So again, you could use leverage to your advantage. You buy a house at a high price; you get a mortgage for most of it. So say your leverage 3, 4, 5 or 10 times— in the example I use, with a million dollar house, $900,000 mortgage, nine times—, and all is good as things are stable and calm, but all of a sudden, rates jump and housing prices are challenged. If you don't have that liquidity, that's when it becomes more risky. And we've moved into a period very rapidly this year where that volatility or interest rates spike up, currencies are moving all over the place. And that's where having that liquidity and having credibility too, being a reliable mortgager, for example, in my analogy, helps you as well. And then, as always, we love to have that liquidity from an investment perspective— I think that was a great point you made—, so that instead of being the forced buyer or the forced seller, we're sitting there on the other end when someone's forced to sell, that we can buy.

That's where the value is created. And I mean, there was such a big sell-off in UK Gilts that there was some value— which I didn't think there was any value, to be frank—, there was some value that had been created even in that particular asset class. So, yeah, I think all those points are exactly right. It's a situation where you just need to be aware and understand the portfolio, understand the contingencies, if you like, around your investments, just as you have some good financial planning around when you borrow to buy a home as well, and revisit those. It's always worth revisiting those, having a review. And yes, actually, as you say, because there is going to be value being created and obviously volatility can be pretty painful from an investment point of view, but there's no doubt that some opportunities are arising and you do want to be in the right place to make the most of that when you're investing, particularly over the longer term.

So we happen to be checking in with you today on an issue in the UK, but your expertise goes way beyond your own borders. You're not just Mr UK, you're Mr Worldwide. You have that look too right now, David, by the way. It's a podcast, so they can't see you, but I can. When you look around at what's happening with interest rates in general, inflation around the world, what's your view on how this is going to play out? We've had some other folks on that are very clearly on the side that inflation has rolled over that as we move out, and it's hard to pinpoint exactly when inflation normalizes and rates start to turn down. But what's your view on inflation and where interest rates go in major economies around the world?

Yeah, this is such a good question and hence, it’s such a difficult one. I tend to think of inflation as a process that has a huge amount of inertia. When inflation was very low and below the central bank's targets, it stayed there for a long time, and then when it breaks higher, for a whole host of reasons you get much higher inflation, then it also has its own inertia. And I think the concern, which I have, particularly at this point in time, where I think investors are starting to think, well, okay, inflation has peaked, it will start coming down. That means that the Fed and the bank of Canada and other central banks are going to pause and might even pivot to lower interest rates during the course of next year, during the course of 2023. My concern around that— and why I think actually that is too premature—, is that I think inflation falling from 8, 9% down to 5 or 6%, even 4%, is going to be happening and it's going to happen over the next six, seven months or so, in part just because things like higher energy prices are going to roll off in the calculations just through base effects. But I think getting inflation from 4% down to near 2%, that's going to be tough and I think it's going to take quite a long time. And I think the central banks— obviously the Fed, but not only the Fed—, the takeaway from the 1970s that they've drawn is that when inflation started to come down at one point after the initial shock in the 70s, they started cutting rates and then inflation started moving back up again. And ultimately, they had to engineer a really deep and painful recession to break the back— the whole focus of the Fed, etc.—, to break the back of inflation with a huge cost in terms of mass unemployment. So, I think we are in a world where inflation is going to be coming down, but it's going to say stickier and higher than many people expect. I think we're in a world where we're going to have higher and longer interest rates. And against that backdrop, I think it's going to be quite tough for quite a lot of so-called risk assets and growth sensitive assets like equities to really sustain a big rally until we really are confident inflation is going to be getting down to 2% and central banks can stop because they believe that they've done their job. But it's a difficult time for bank of England, because if it doesn't raise interest rates maybe more aggressively than it wanted to do so, then it potentially could see a big sell-off in the pound, which in itself is inflationary. In Europe, with the European Central Bank, it's been behind not just the inflation curve, it's been behind nearly every other central bank, and most notably the Fed. And so, it's trying to catch up. But at the same time, Germany and Europe as a whole is going into recession because of the Ukraine war and because of the impact on gas supplies and gas prices. And then obviously in North America, United States and Canada, you're in, I think, a much better position both in the economics and because you've got less of this other kind of moving parts, if you like. But inflation is still well above target. You still got very tight labor markets and so it's still going to be a big challenge, I think, to engineer a soft landing. So, I'd still be reasonably cautious. That doesn't mean not being invested, but I think you still don't get carried away by the narrative that inflation is over as a story and central banks are done. I don't think they are.

Yeah. And we're really seeing that the last month or so in equity markets has been a perfect example of this tug of war in terms of that view that you get a couple of days like we've had right here to start October, where, oh, wow, maybe inflation is not going to be so sticky. Even if we have a little mild recession, that means rates come down, so that's going to be good for stocks, whereas all the way through September, it was more your view that inflation is sticky and it's going to be around for a long time. Even, as you say, if we get it from 8% down to 4%; from 4% to 2%, it’s going to be really hard. So that's going to mean a bumpy ride for stocks. And it's this back and forth that creates all that volatility. And again, if you go back and look at equity markets through the 1970s, as we went through that experience that you were walking us through, it was not a fantastic time for equity investors. So now is the time to pick your spots and to make sure that you know what you're doing as you're picking assets. And of course, you and your friends at Bluebay Asset Management in the fixed income space, there are maybe nobody better on the planet at doing that. You're the key behind that. You're the strategist. So, I know how much impact you have on that. Although, you know, and this is the second time that you've gotten this fine on this podcast, $5 fine for saying «idiosyncratic». All the portfolio managers come on and they know that. And that's an expensive fine for you because it used to be nothing and now it's pretty much £5. So, we'll put that in the coffer for charity. And thank you for making that mistake.

It's a pleasure as always. And I'll be more careful in the future because I just can't afford to rack up too many dollar fines.

Exactly. So, David, thanks again and we'll check in with you shortly. I'd like to get you back a little bit more often because you've always got incredible insights. So thanks a lot.

Thank you, Dave. Good to speak to you.