DBFX Daily: UK pension funds and the pound’s correlation to risk: FXWW

From the FXWW Chatroom: We’ve previously argued the pound’s positive correlation with global risk was
linked to the UK’s current account. Stronger global demand improves the UK flow
picture via higher income receipts from FDI in financial services and commodities.
But there is also a link with the liability side of the balance sheet.
Our starting point is portfolio investment flows. Since Brexit, there has been a
sharp slowdown in foreign purchases of UK assets but portfolio inflows have not
collapsed. One reason is that UK investors have been heavily repatriating capital.
In the last two years, the UK has liquidated GBP 511bn worth of foreign portfolio
holdings – the largest liquidation since the financial crisis (figure 1).
What’s behind this? The answer is UK pension funds. As statistics from the ONS
show, recent repatriation correlates to behaviour from the UK fund management
industry (figure 2). Insurance companies, investment trusts and pension funds
have been reducing their exposure to foreign equities. Simultaneously, pension
funds have been ramping up purchases of gilts (figure 3).
UK fund managers have accumulated substantial holdings of foreign assets in
the last twenty years (figure 4). The weak exchange rate since Brexit and rise in
global stocks has seen significant gains on their equity portfolios, helping funding
ratios. As our colleagues have noted, funds then hedge gains by buying gilts due
to the negative correlation between gilt prices and global equities. This dynamic
is different from currencies such as JPY or CHF where risk-off dynamics typically
see repatriation, and is one reason why GBP/JPY remains one of our favourite FX
trades to express a weakening of global growth (figure 5).
Can strong repatriation flows continue? Weaker global equities would leave the
UK more reliant on the kindness of strangers as domestic repatriation reverses.
As repatriation would also slow down if the pound rallies, gains in GBP will be
naturally capped unless higher rates attract foreign investment.
Big picture, we don’t expect structural allocations from UK funds to foreign assets
to start changing soon. Indeed, even as pension funds have been selling foreign
equities, the share of foreign equities in holdings has risen, signaling aversion
to domestics stocks. One risk is that gilts cease acting as an effective hedge for
global equities. This might materialise if, for example, the UK curve steepened as
a result of a significant inflation shock, as after ERM exit or the GFC. Weak global
growth and a much steeper UK curve usually proves toxic for sterling (figure 6).
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