William Bourne Article in Room 151: Tariffs and Bond Vigilantes

Room 151 has published an article by William Bourne on investing in the new world of tariffs and bond vigilantes.  The Federal Reserve will struggle to keep all the plates spinning, and investors should therefore expect greater volatility.  Flexibility and nimbleness will be at an increasing premium, and William makes the case more generally for products based round objectives (for example, mitigating inflation) over those based on traditional asset classes.  In particular this could help LGPS funds as implementation moves to the pools under the Government's Fit For the Future proposals. 

Please find the article here.

Tariffs and bond vigilantes: LGPS investors in a new world will need to be nimble

Donald Trump’s “Liberation Day” of tariff announcements almost certainly marked the turning

of a page in the world’s economic history. The last 45 years, since Reagan and Thatcher’s

reforms removed capital controls and unleashed market capitalism, are receding rapidly into

the rear-view mirror. But what will take its place and how should LGPS funds react?

The two most important determinants in the short term are the response of the Federal

Reserve and how the authorities in China react. The Fed. has at least four plates to keep

spinning if it can. It has two formal objectives of 2% inflation and maximising employment,

and two equally important but implicit ones: keeping the cost of debt service under control,

and heading off a crisis in the U.S. financial system. Pressure from Trump and his cronies to

cut rates adds to the difficulty of good decision-making.

The realistic question for investors today is probably which plate they choose to drop. At the

moment they are keeping monetary policy tight, but the result of that is likely to be a deeper

economic downturn. The squeeze on liquidity also heightens the risk of secondary banks

becoming unable to meet capital requirements and causing a financial crisis later in the year.

But long bond yields are already rising in anticipation of declining U.S. creditworthiness, and

the Fed. faces an increasing challenge in financing the ballooning U.S. debt pile. I suspect

they will eventually be forced to change tack and revert to Quantitative Easing, much as in

March 2023 when Silicon Valley Bank went under. However, this would likely result in higher

inflation, catnip to the bond vigilantes.

What about China? In recent weeks they have used both monetary and massive (over

US$1 trillion) fiscal stimulus to try and generate growth and inflation. But the over-valued

exchange rate and the level of private real estate debt hang heavy over their economy, and

Trump’s tariffs are bound to reduce Chinese exports regardless of what trade deal is finally

struck. Corporates are shaken by what has happened and will try and shorten supply

chains.

Low economic growth seems almost inevitable globally for all these reasons. The

combination of that and higher bond yields with the added possibility of a financial crisis

presents obvious challenges for both governments and investors. The underlying problem

for the latter is that the outcomes depend on political decisions, and the range of possible

ones is wide.

In the shorter term, this means that flexibility is important. But many LGPS funds now have

substantial weightings in illiquid investments and indeed are being encouraged by the

Government to go even further. If they want to build up bond holdings now that yields are so

much more attractive, there are few alternatives to selling down listed equities.

Pooling structures may help provide flexibility, but a change in mindset will be needed. Most

pools run unitised sub-funds, which makes it easier operationally to be more nimble. But

there is an even better way, as Railpen have shown. They offer only four sub-funds to their

captive clients, based on outcomes such as Growth, Liability Matching, or Inflation

Mitigation. This is in contrast to the much more numerous sub-funds created by the LGPS

pools round asset classes.

The advantage of the Railpen model is two-fold: the sub-fund objectives align much better

with the limited role that the Government envisages for the LGPS funds setting high-level

risk and returns; and the pools can react more quickly within the sub-funds to rapidly

changing market conditions.

LGPS funds today also need to think hard about the long-term implications. Change is

certain, but will market capitalism continue to be the main method of allocating capital? How

far will globalisation retreat? Will U.S. Treasury yields remain the bedrock of finance? How

will the U.S. government afford to service the debt it is piling up? Could currency controls

return?

I do not have the answers to what will happen, but the range of outcomes is wider than it has

been throughout the near 45 years of my investing lifetime. Things we take for granted,

such as the creditworthiness of western nations or the freedom to move money round the

world, may come into question.

The half dozen pools with larger and more professional investment teams may in aggregate

turn out to be better equipped to deal with these new challenges, though history says it is

unlikely that they will all be successful. In order to give LGPS funds the best available toolkit

for the future, I would argue for i) a smaller number of broader sub-funds, preferably based

round outcomes as objectives rather than asset classes ii) structures allowing them to use

other pool products if they are superior iii) more transparency on performance, so that funds

can make fair comparisons. I appreciate it is not Christmas, but I can still ask.