A year in treasury

Originally published in The Public Sector Treasurers’ Handbook, May 2013

The global economic outlook stabilised over the 2012/13 financial year, mainly due to the major central banks maintaining expansionary monetary policies.  Equity markets performed well, despite disappointing economic growth in G7 nations, but bond yields and money market rates fell, telling a story of improving credit conditions but little real economic growth.

UK Economy

In the UK, the economy shrank in the first, second and fourth quarters of calendar 2012.  It was the impressive 0.9% growth in the third quarter, aided by the summer Olympic Games, which allowed annual growth to register a positive 0.2% for 2012. The expected boost to net trade from the fall in the value of sterling did not materialise, but raised import prices, especially for low margin goods such as food and energy, contributing to inflation.

Household financial conditions and purchasing power were constrained as wage growth remained subdued at 1.2% and was outstripped by inflation. Annual CPI dipped below 3%, falling to 2.4% in June before ticking up to 2.8% in February 2013. Higher food and energy prices and increased transport costs were some of the principal contributors to inflation remaining above the Bank of England’s 2% CPI target throughout the year.

The lack of growth and the fall in inflation were persuasive enough for the Bank of England to maintain the Bank Rate at 0.5% all year and also sanction an additional £50 billion of asset purchases in July, taking total quantitative easing (QE) to £375 billion. The possibility of a further rate cut was discussed at some of the Bank’s Monetary Policy Committee meetings, but was not implemented as the potential drawbacks were thought to outweigh the benefits.  In the March Budget, the Bank’s policy mandate was revised to include the flexibility to commit to intermediate targets alongside the 2% CPI inflation remit.

The resilience of the labour market, with the ILO unemployment rate falling to 7.8%, was the main surprise given the challenging economic backdrop. Many of the gains in employment were through an increase in self-employment and part time working.

The Chancellor largely stuck to his fiscal plans with the austerity drive extending into 2018. In March the Office for Budgetary Responsibility (OBR) halved its forecast growth in 2013 to 0.6% which then resulted in the lowering of the forecast for tax revenues and an increase in the budget deficit. The government is now expected to borrow an additional £146bn and sees gross debt rising above 100% of GDP by 2015-16. The fall in debt as a percentage of GDP, which the coalition had targeted for 2015-16, was pushed two years beyond this horizon. With the national debt metrics out of kilter with a triple-A rating, it was not surprising that the UK’s sovereign rating was downgraded by Moody’s to Aa1. The AAA status was maintained by Fitch and Standard & Poor’s, albeit with a Rating Watch Negative and with a Negative Outlook respectively.

UK Banks

The government’s Funding for Lending (FLS) initiative commenced in August, which gave banks access to cheaper funding on the basis that it would result in them passing this advantage to the wider economy. There was an improvement in the flow of credit to mortgagees, but it remained below expectations for SMEs.  George Osborne announced that he was placing heavier political pressure on RBS to concentrate its business on UK retail banking and scale back on investment banking.

Barclays and RBS, together with several other global institutions, came under investigation in the Libor rigging scandal which led to fines and settlements with UK and US regulators.  Other fines and compensation payments for mis-sold Payment Protection Insurance and interest rate swaps continued to affect banks’ profitability.  RBS reported a 2012 pre-tax loss of £5.5bn, while Lloyds lost £0.6bn. The underlying results of both banks improved, but significant loan impairments and regulatory issues weighed on pre-tax profit.  Barclays and HSBC fared better, although Barclays’ pre-tax profit of just £246m was down 96% on the previous year.  HSBC reported a 6% fall in pre-tax profit to $20.6bn, but as with other UK banks the underlying position was stronger.

Europe and America

The Euro region suffered a further period of stress when Italian and Spanish government borrowing costs rose sharply, with Spain forced to officially seek a bailout for its domestic banks. Markets were calmed by the ECB’s declaration that it would do “whatever it takes” to stabilise the Eurozone which led to the announcement in September of the Outright Monetary Transactions (OMT) facility, buying time for the necessary fiscal adjustments required.  This prompted a “risk-on” tone in European bond markets, so that neither the Italian elections which resulted in political gridlock nor the poorly-managed bailout of Cyprus which necessitated ‘bailing-in’ non-guaranteed depositors caused any serious market downturn.  Growth, however, was hindered by the rebalancing processes under way in Eurozone economies, most of which contracted in Q4 2012.

The US Federal Reserve extended its QE through ‘Operation Twist’, in which it buys longer-dated bonds with the proceeds of shorter-dated US Treasuries. The Federal Reserve shifted policy to focus on the jobless rate with a pledge to keep interest rates low until unemployment falls below 6.5%.  Political deadlock over the extended budget negotiations took the world’s largest economy over the fiscal cliff, but US growth remains remarkably resilient in comparison with its Western peers.

Interest Rates

One direct consequence of the UK FLS was the sharp drop in rates at which banks accepted deposits from local authorities.  3-month LIBOR halved from 1.03% to 0.51% over the year, while the 12-month benchmark fell even further from 1.86% in April to 0.91% in March.  Inter-authority rates also fell, with even 12 month loans being agreed at rates as low as 0.26%.

Gilt yields and PWLB rates also ended the year lower than the start in April.  By September the 2-year gilt yield had fallen to 0.06% and PWLB repayment rates hit 0.02%, raising the prospect that short-dated yields could turn negative. 10-year yields fell by nearly 0.5% ending the year at 1.72%. The reduction was less pronounced at the longer end; 30-year yields ended the year at 3.11%, around 0.25% lower than in April. Despite the likelihood that the DMO would revise up its gilt issuance for 2012/13, there were several gilt-supportive factors: the Bank of England’s continued purchases of gilts under an extended QE programme; purchases by banks, insurance companies and pension funds driven by regulatory requirements and the continued preference of foreign investors for safe harbour government bonds.

The PWLB introduced its Certainty Rate in November 2012, allowing local authorities that complete an annual forecast of loan requirements to borrow at 0.80% above gilt yields, a reduction of 0.20% on the Standard Rate.  December’s Autumn Statement revealed details of the Project Rate, which will allow Local Enterprise Partnerships in England to nominate a single infrastructure project to be eligible for funding at a further 0.20% discount.

Local Authorities’ Response

2012/13 saw a change in many local authorities’ approach to treasury management.  For several years, entire investment portfolios have been kept at short durations, partly to maximise flexibility in case deposit taking banks are downgraded and partly in the hope that an economic recovery will lead interest rates to rise at some point.  However, action by regulators, governments and central banks, especially the introduction of the FLS in the UK, blunted both of those drivers – banks are generally considered to be more creditworthy, especially in the short-term, while interest rates have continued to move lower, not higher.

The traditional response of many authorities in the past would have been to make longer-term bank deposits and take advantage of the higher rates available at longer dates.  However, a flattened yield curve and latent credit risk fears have driven treasury managers to seek alternative homes for at least some of their surplus cash.

Lingering doubts over the security of long-term bank deposits are well founded.  While it still seems very unlikely that the authorities would allow a major financial institution to collapse overnight in the style of Lehman Brothers or Landsbanki, there are other ways to lose money in a bank.  Investors in failing Dutch, Danish and Cypriot banks have all suffered haircuts or bail-ins in recent years, with a sizable fraction of their deposits seized to cover the bank’s losses on its lending.

Lending direct to the corporate sector, cutting the dysfunctional banks out of the middle, became a feature of several authorities’ strategies last year.  The risk of default may be higher, but with gross lending rates of 5% to 8% per annum, even an above-average loss rate can still lead a widely diversified portfolio to yield more than equivalent bank deposits.  Corporate bond funds, with a wide variety of risk profiles, and loans to SMEs made via peer-to-peer portals were the most common methods of investing, with a small number of authorities also buying individual high quality corporate bonds.  Property was another popular asset class in 2012/13, with the market probably close to its low point in terms of entry price and net rental income consistently around the 6% mark.  Again, we saw a mixture of both funds and direct property purchases, depending on authorities’ investment sizes and risk appetites.

Sometimes the lowest risk investment of all is repaying your own debt, but just £100m of PWLB loans were repaid prematurely last year, as the high premiums payable deterred authorities from seeking to make savings in this area.

There was however an increased focus on local authorities using their strong balance sheets to support the Council’s priorities in a crossover between traditional treasury management and front-line services.   Loans to local businesses and housing associations, supply chain finance solutions, mortgage guarantees and partnership funding all form part of the new local government finance agenda.

David Green is Client Director at Arlingclose Limited.  This is the writer’s personal opinion and does not constitute investment advice.

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