I discussed with Jonathan his last post on the value of looking to the long term and he suggested I could set out how I see the macro and micro economic issues that might impact our work. So here goes.
The global impact of the coronavirus will trigger significant changes economically, socially and culturally. Whilst it has been relatively easy to lockdown economic activity it will take much longer to reverse, substantially reducing future economic activity.
Even when some government restrictions are removed (and it is not certain all will be), our own behaviours will change and we may never return to how things were.
The initial response by most governments has been to introduce massive spending programs and these will continue for some time; financed by debt issuance on a scale not seen since the global wars.
We have seen limited co-ordinated action in this area, each country is acting on its own, which will make currency and inflation levels the determinants of global wealth (re)distribution. For a fairly long period, the lack of economic activity may keep inflation under apparent control.
Low demand and large excess labour supply will drive this. However the vast amount of paper issuance cannot but help increase prices of scarce goods and weaker currencies will suffer at the expense of stronger ones.
There will always be a currency pecking order and the dollar will surely remain at the top - effectively the reserve currency of the world.
Some may argue that gold (or possibly bitcoin) will become stores of value. It seems to me they will be only marginal actors in the global trade realignment. China may seek to take opportunities to exploit any perceived weakness in the dollar but the continuing lack of trust and the realisation of its critical role in the supply chain will lead to less, rather than more, trade with the east.
Many politicians will seek to exploit a populist nationalism exacerbated by the crisis and this can only serve to restrict economic activity further.
One interesting area will be the euro. As ever, the question will be whether or not the German economy is willing to underwrite the debt issuance of other countries. For now, this seems to be the case as all countries are on a roughly parallel path but the already weaker Mediterranean economies look likely to need further support.
If the stringent economic demands of the EU are politically too great then the temptation to revert to the lira or the peso may become considerable. This will drastically slow the EU “project” and much reduce its power to drive national policies.
Britain, Brexit and beyond
Of course, the UK and Europe still have to deal with Brexit. Despite strong words from the UK, the reality is that Brexit will, like the Olympics, Wimbledon, and the Premier League, eventually be postponed.
The government will be seen to reluctantly agree to an EU request to delay but what another year or two years of stasis will do for the re-election prospects for the Conservatives is another question.
It seems a reasonable assumption that the UK economy could stagnate for a couple of years whilst the marginal but enjoyable activities like dining out, pubs, cinema and football are restricted by choice or regulation.
If the pound weakens against other currencies (particularly the euro as the EU will still provide much of our staple requirements) then inflation could take a firm hold as there will be great reluctance to raise interest rates – whatever the independence of the Bank of England may say.
So, I speculate that the year-on-year GDP reduction for 2020 compared with 2019 will be around 30 per cent (i.e. little or no recovery until year-end) and then a gradual return over two years to around 90 per cent of the 2019 levels.
This is a massive decline. However, it was from a strong starting point and we do not have the same levels of wealth destruction or labour destruction that followed the global wars. So an acceptable new normal is possible within a few years.
Pensions amid the pandemic
What might this mean for UK defined benefit pension schemes and their sponsors?
Companies that make things or do things (often the sponsors of defined benefit pension schemes) will find profits hard to come by. Sales will be substantially less, and costs will be harder to reduce. But lack of profits doesn’t kill companies, lack of cash does.
How banks and other lenders operate will be key to how businesses fare. The financial crisis showed that (under government and public pressure) banks can hold off calling time on businesses that normally would not survive true commercial scrutiny.
Will we see lots of pre-pack administration with equity write-offs and creditors all taking a hit – landlords particularly ? Or will there be another chapter in the low interest rate business “zombie” category that has become increasingly familiar with businesses suffering death by a thousand cuts?
These options create interesting scenarios for trustees and sponsors.
It is almost always in the interest of members to have a scheme continue as long as possible, especially one that is underfunded on Pension Protection Fund level of benefits.
Given these are minimum benefits underwritten by the PPF (and potentially by government), the longer the scheme runs (when benefits are always greater than those paid through the PPF), the better the overall payment to all members.
The PPF and The Pensions Regulator recognise this of course and so work hard to resist obvious exploitation (such as 100 per cent investment in risky assets – which would be an optimal action for trustees in many cases).
Unfortunately, this then puts pressure on any sponsor who would want to pay as little cash as possible in the current circumstances. The regulator appears to be in support of this by encouraging “flexibility” in the approach to current valuations. This usually means adoption of a risk-heavy investment strategy to justify higher expected returns and discount rates.
As with the banks, this “kick down the road” approach may misallocate capital in the longer term but certainly offers the opportunity to exploit off-market arbitrage, which gives many members greater benefits than the pure economics would suggest, at the ultimate cost to the taxpayer, who will eventually support the PPF.
Post-pandemic, there’s also a question mark over buy-ins. Typically, a buy-in swaps the flexibility of gilt ownership and the carrying of mortality risk for implicitly holding inflexible corporate bonds until maturity plus longevity insurance.
Since neither option looks great at the moment and corporate strength has generally weakened values, this might now come under review. Longevity swaps, in particular, might not prove good value as it currently stands, particularly if demands to post collateral arrive at times when the remaining risky assets are at low values.
It is often said that actuaries are a bit too cold and analytical about death and mortality, and maybe these thoughts confirm that. These are simply meant to be musings on a situation from a keyboard in isolation from our friends and families. And maybe the realisation that these are the important things in life is the important lesson from this experience.