MM084: Carnage in UK Bond/FX Markets – What happened, what’s next?

Welcome to the Market Maker podcast hosted by me, Anthony Cheung, where every Friday I talk to a member of the team about what happened in markets this week. From macro themes and single stock news to cryptocurrencies and careers in finance, our aim is simple: to make finance interesting and easy to understand for everyone. So let's get to it.

Hello and welcome to episode 84 of The Market Maker. And as you can probably tell, uh, Ant is on holiday. Uh, and Piers, it's happened again.

Yeah, I mean, well, look, I, I told everyone last week, I said, heads up, Ant's going on holiday. And you know what that means? And what that means is every single time he steps off the desk, the whole world implodes. And in this, in this particular instance, this time round, it's more, it's more, it's more domestic implosion rather than global. So yet again, I mean, further evidence, not that we needed it, but further evidence nevertheless that Anthony Cheung is the glue that holds together society and financial markets.

And I think, well, we've never really explored where he goes when he's on holiday as well.

This is it. I think he goes off to his— he must have some kind of secret kind of trading cave somewhere where he just sits there and just kind of goes maximum long the VIX. And just sits back, feet up, and, uh, just watches the chaos ensue. That's what I imagine in my head.

Yeah, yeah, definitely, definitely a cave, a lair maybe. But no, so I've been getting— so I put out a video yesterday, uh, trying to explain a little bit about what's going on, uh, and I got a lot of stick for it because everyone kept telling me, no, no, no, you're missing it. It's the other way. I got it wrong. I could have saved 6 minutes and just kept it to 30 seconds. But anyway, we are going to talk about what's been going on. It's going to be very much a UK-focused episode today with a little bit of Germany tucked at the back end. But what better place to start, Piers, than talking us through the last week. And, and, and maybe I can start with hitting you with a few stats if you don't mind.

Yes.

All right, so here we go. Uh, on Monday, sterling dropped to its lowest level in 37 years against the dollar, uh, before recovering at the back end of this week. Uh, 30-year government bonds rose by 120 basis points between last Friday and this Wednesday. The level of government debt is expected to increase by £160 billion following the budget. The Bank of England has committed to spending £65 billion buying gilts to raise bond prices. And this is the kicker for me, by the way. According to YouGov, Labour has opened up a 33-point lead over the Tories, effectively meaning that if the election was held tomorrow, the Tories would be the third biggest party. So my question to you, Piers, having listened to the podcast last week, do you stand by the fact that it was actually quite a bold and good thing that, uh, that, that, that Kwasi did in their mini-budget last week?

Um, well, I mean, I would say I, I gotta be careful how I answer this. I think I, I would say that in, in principle, some of their actions, um, I, I, I support. I, I think I don't support all of them. And I think the big thing though is the execution has been— it has to go— it probably does go down as one of the spectacularly most poorly executed kind of big political move, possibly in the history of politics. I mean, the execution of this has been an absolute disaster. I love that stat. What did you say? 33 points is the gap between Labour and—

Yeah, it was 11 points this time last week.

I mean, God, even that's got to be a record in terms of pointage move in such a short space of time. So yeah, I mean, obviously that just measures and quantifies what what I've just said in terms of it being so poorly executed. But yeah, if we just talk about the market moves just briefly and put them into context, and especially on the bond yield side, because, you know, look, it was the long-dated, the long kind of duration, uh, UK government bond markets that moved the most. And we'll get into the kind of detail of why it was the long-dated bonds mainly where the action was. But to kind of put this into context, like these bonds as an asset class, and especially government bonds, and especially safe haven, in inverted commas, government bonds, this is a really dull market. Relatively speaking, in terms of price action and volatility, basically they don't move. Okay? If you compare it to equity prices, and this is one of the attractive things of bonds from an investor's point of view, or that type of bond, it's safe, right? It's a safe haven. There isn't massive volatility. There isn't huge price action. It's where you go when you're worried about everything else. And so It's a dull place from a price action point of view. And actually the 30-year bond averages, I think the average daily volatility is something like 0.1 basis points. Okay. And this week it went up 120 basis points and has now come down by 120 basis points. And so It literally is just quite unprecedented, the distance through which price and therefore yield changed on these bonds. And then, yeah, on the currency side, because that was kind of where we saw the action first and the pound collapsing down to the kind of 103 handle. And yeah, lowest, lowest. The pound's been killed. I think it was 5% down on the week, 25% down on the year. It's— but this is like emerging market type price action, both on the currency side and the bond price/yield side. This is literally what an emerging market— an emerging market economy in real trouble. That's kind of what we see.

Yeah. And maybe just if you could just talk us through the kind of dynamics and the reasons behind the yield spikes coming off the back of Friday's mini-budget.

Yeah, yeah, yeah. I mean, and so this is a tricky— I'm often tasked with trying to explain stuff in simple terms, and I have to say what I'm about to attempt is probably the hardest thing I've had to try and explain in simple terms probably ever. When we get into the get to in a minute, the LDI side of things. But if we can kind of start a little bit more top level, I mean, ultimately the issue here, and I'm sure the listeners would have been reading about this kind of stuff, but ultimately the issue is, and the spectacular execution fail from the government was that they've not only obviously agreed to prior, like prior to the budget, they already stepped up and said we're going to spend up to £150 billion on freezing energy prices, right? Up to— I mean, we don't know how much that'll cost. Obviously very much depends on the gas prices over the next, uh, 12 months or whatever. Um, so it could be up to £150 billion. Now they've said, right, £45 billion of tax cuts, and they said, we're, we're going to borrow money to fund this. Okay, so that's what they've said, and they've set that out. And the problem, the execution failed. Really comes from them not setting forward a very detailed plan of action as to how this will be paid for in the long term. How will we as a country manage our debt levels? Because this is going to result in debt levels spiking. Right? And now here comes the issues, right? Debt levels spike with no plan to kind of pay down that debt on the longer term. So now you go, right, well, debt levels spike. Okay, well, that's going to cost us more money to fund that debt just as interest rates are ramping higher. And so, right, the— so therefore you start to think, well, actually they haven't set out a plan on the long term, so is this even affordable? Okay. And then you start thinking, well, maybe it's not. And so this is where the markets start to kind of kick into panic mode. You know, they're— they've got, they've got half a plan, a half-cocked plan about tax cuts without thinking carefully about how we're going to deal with it in the longer term. So the pound starts collapsing, continues to collapse. All right. And this is because part of this is that it's inflationary, this fiscal policy. I mean, Trump did it when he came into power back in 2018. But it's inflationary because in theory, tax cuts, energy price caps, in theory, this means the average person's going to have more disposable income. To get out on the high street and spend it. We'll come back to that point because ironically, they may well have less income to spend on the high street given what's happened to interest rates and therefore— well, sorry, what's happened to bond yields and therefore mortgage rates and so on. We'll come back to— we'll circle back to that point in a minute, but it's inflationary because people have more money to spend, so demand goes up, so therefore inflation rises. It's also the pound falling is also inflationary because gas prices become more expensive, the very thing that's driving this inflation crisis in the first place, right? So, um, it's, it's inflationary, which is exacerbating the crisis we already have. What— and then the Bank of England are going to have to raise rates more in order to contain that inflation, okay? And so this is where you kind of start to get this domino effect that you were talking about. If Guys listening, if you haven't been on our YouTube channel, then hit up the YouTube channel where Stephen put out a great 6-minute summary on this kind of domino effect as, as to the sequence of events where one reaction leads to another reaction, which leads to another and another. And basically what's happened here is this general top-level fear that the UK can't afford its debt. And the, the actions the government have taken will drive inflation higher, which is the very thing that has put us in a crisis in the first place, um, kind of rolls up into this snowball effect. Okay, but what happened in the bond markets was a very particular, um, situation, um, involving pension funds and how they behave and how they operate And it's kind of quite a— it's like a market structure, sort of microstructure thing. And basically, this is another kind of massive gaffe from the government and a schoolboy— literally a schoolboy error, where they've plowed in with this massive decision without consulting and advising all of the different players that might be impacted by it. So they've gone piling in with these tax cuts entirely forgetting, oh, hang on a minute, we need to think about how markets might react to this and we need to therefore think about the different players in those markets and make sure they're prepared and ready for this. Because what happened was they were not prepared and they were not ready. And what took place was one of the biggest moves in UK bond markets that we've ever seen. I don't know, is it time to tackle LDIs or—

Yeah, well, let's, let's, let's park LDIs just for a second, kind of just to let that bit of jargon settle, uh, for a minute. I guess one of, one of my questions with regards to the increased perceived risk of holding UK government debt, yeah, is it realistic to actually think that the UK could be at risk at some point in the future of defaulting? Are we Greece? Are we Venezuela? Are we Lebanon?

I'd say no. But I mean, we're in extraordinary times. So let's get this straight. It's not impossible for that to happen. It's not impossible for the UK's finances to really go on a journey to unsustainability that ends us defaulting. It's not impossible, but the likelihood is fantastically small. I think what happened this week, the media kind of— they feed this narrative. And the media love nothing more than a crisis. And it's like, oh my God, we're going to default. It's literally the whole world, the whole country is going to collapse, blah, blah, blah. But actually, the big move in the bond markets that led to the media going, oh my God, mortgage rates are going to go up and everyone's going to go bankrupt, The big move in the bond markets was due to these LDI— this LDI strategy that pension funds use, which we'll come on to in the nitty-gritty of that in a second. But are the UK going bankrupt? No. The UK's debt-to-GDP level, even with all of this fiscal plan, gets it up into like the mid-90s. Right? So they're like 90% of GDP. Um, there's plenty of other countries that have got way more debt. The US, they've got more debt from a debt-to-GDP perspective. Um, Italy, they've got 150% debt-to-GDP, right?

I think the winners are Japan, right? Well, Japan are up 250% or something.

Yeah, exactly. So, um, it doesn't put the UK wildly up into realms that are unaffordable. I think the risk is that, yes, it increases our debt-to-GDP just at the time where we've got a record current account deficit at the moment, which doesn't help. And that deficit is in conjunction with a sharp increase in your debt levels. And then the most important thing is the increase in interest rates, right? Um, and I think all these together combined a little bit of a mini panic that led to this monster move in bond markets that the media then jump all over and start to portray a picture that's not really reality. So the UK is not going bankrupt.

That's good to know. Uh, but let's— yeah, let's bring this down to the high street. I, I read a stat the other day, I think on Wednesday, 935 mortgages were pulled from the market just in that one day alone. Very, very difficult to get a mortgage for love nor money at the moment. Can you just explain what's going on there? Why are so many mortgages being pulled?

Yeah, so mortgage rates are linked to long-duration government bond yields. Well, they're linked to government bond yields just because, and they're linked to interest rates. I mean, I guess it's the Bank of England's interest rate on which variable rate mortgages are based, right? So if the idea is that the Bank of England are going to have to raise rates sharply, and don't forget, middle of the week, and this is where I get very frustrated with the media. The middle of the week, the media are going, right, what's the Bank of England doing? Why aren't they organizing an emergency meeting? Why aren't we having an emergency meeting? Emergency interest rate hike now? You know, why aren't rates being doubled? And it kind of feeds this panic. Raising interest rates at this point in time, in my opinion, um, wasn't going to be the solution this week. I mean, fine, they're going to raise rates at their next meeting, sure, but you know, an emergency rate hike? No. I mean, they made a huge emergency kind of intervention that we'll talk about, but that's because of the LDI situation, which we'll come on to. But banks panicked because interest rate expectations ramped through the roof. And it's very hard for banks to be fair, because if they offer mortgage— if they offer people a mortgage rate, the way it works, right, that mortgage rate is valid for 6 months, right? If you're applying for a mortgage and you want to buy a house, then you apply and the bank offers you a mortgage at an interest rate. And that interest rate is locked in for you for 6 months, right? You've got 6 months to say yes or no. And I could wait 5 months and 3 weeks and I can say, right, I'm now buying the house and I'm now going to go ahead and execute that mortgage. And you, bank, you've got to give me the rate that we agreed 5 months, 3 weeks ago. So if you think about it from a bank's point of view, they've got to set interest rates on mortgages now that they think they're still going to make money on, even if that deal gets done in 6 months' time. And all of a sudden they panicked because interest rate expectations suddenly radically increased. And they were like, oh shit, all the rates we've got out there in the market, they're too low, let's pull them in. And again, this is where the media had an absolute field day because it just feeds the panic, right? Because it's quite— it's a very— don't get me wrong, it's a very, very radical, unusual thing to happen. And definitely highlights the kind of chaos that was going on in markets. But it's not that the country's collapsing.

It's very interesting to think about these dominoes and think about how much quicker we spiral down, we spiral into panic, and dominoes get knocked over relative to a piece of good news we never spiral up in the same way as we spiral down. It's like a game of snakes and ladders. Unfortunately, the snakes are far more dangerous than the ladders are productive.

Yeah, I mean, that's, that's humans, it's behavioral. And again, I don't want to keep coming back to the media, but I will. Um, the media love, you know, they— it's statistically proven that there's way more clicks on a sensationalist, you know, crisis-type headline than there is on a, you know, kind of positive story-type headline. And it's always been the case in markets, you know, we always say markets go down in the elevator and they go up the stairs, a bit like your snakes and ladders analogy. And it's true, and it's just human behavior, that's why. Because it's kind of panic. And panic, when you're just panicking and it's kind of— you're in flight mode where it's incredibly irrational. And then it's just sell everything immediately because I don't know how bad this thing's going to get. And I want out now before the worst-case scenario materializes. Okay, so that kind of panic is way more powerful, an emotional kind of driver, than the opposite. I mean, what is the opposite?

Animal spirits buying, you know, uh, uh, probably, you know, a crypto rally, uh, post-pandemic, right?

Yeah, exactly. So yeah, for sure, it's all— and that will always forever be the case that A crisis-driven market is going to move and shift in price way, way more radically than the opposite.

And I think this is— the last week I think has been a really good case study in just how deep the tentacles of the financial system go into everyday life, from high street mortgages to the price of imports for manufactured goods through to pension funds.

Right.

So let's segue into our latest bit of jargon that we need to know a little bit about— liability-driven investing. And I'll just start with a quote just before we kick off. So some executives told the FT that markets barely dodged a Lehman-like collapse. Now, again, this could be your clickbait. This could be the sensationalist media that you're not that you're not loving at the moment. Just explain what was going on here.

I would say that headline does sound sensationalist, but it's actually not far off the truth. And this is why that kind of, you know, the government's just schoolboy-ness, their kind of blinkered, almost blind, blindly stumbling their way through. Almost created a disaster. So look, let's talk pensions. And this impacts, um, every adult in, in work, all right? Because these days it's actually a legal requirement— well, I guess it's still optional, but it's a requirement for companies to provide a pension scheme for all staff. Now the employee can opt out, but the— you're automatically opted in, and then you have to physically make an effort as an individual to opt out. Which means, again, this is back to some behavioral, uh, studies, by the way. But anyway, um, the point is that it impacts a huge portion of society, and, and what's in your pension funds will ultimately pay for your day-to-day living when you retire. OK, now pension funds, well, these are huge financial institutions and they are managing money. And basically there's money coming in from people who are still working because they're paying into their pension pot once a month and then companies are contributing to that pension pot as well. So pension funds, they have money coming in, but then of course they've got money going out. And the money going out is paying for those people that have retired and they're getting their monthly incomes. OK, and it's that. And it's the liabilities side of a pension fund that's key here, right? Because in the end, a pension fund has a liability, it has a future liability. And that future liability is paying out the money to their customers when they retire, okay? So it's a future liability. Now that's an issue, that's a— That's a known fact that the pension fund has to manage because they've got to make sure they're definitely going to have enough money to meet those liabilities in the future. OK, now old-school ways of doing it were, OK, well, let's invest, let's have an investment strategy that will try and allow us to meet our liabilities in the future, but The investment strategy is going to be super low risk, super safe. We want to invest in some fixed income type products like government bonds, which are safe and provide you with fixed income. And as long as we get our fixed income kind of investment strategy right, and as long as nothing kind of crazy happens in the bond markets, then great, we're going to have— the amount of money we have will be growing, and this will enable us to meet our pension liability in the future. That's the old-school way of running a pension. The new-school way is going, well, can't we be a little bit more clever about this? Can't we use some derivative products to help us not only ensure— well, to help us have a higher certainty of meeting future liabilities? Because that old way of investing in bonds Whilst it sounds good, there is still risk because the bond markets might do something you weren't expecting, ending up you having less money than you thought you were going to have. And oops, I can't meet my liabilities disaster, right? So can pension funds use derivatives, derivative products to increase the likelihood that they'll be able to meet their liabilities in the future? And these derivatives Well, this is called liability-driven investment, where it's a focus on meeting your liabilities in the future. And here, this is where they use derivatives called swaps, interest rate swaps. And part of the LDI kind of investment strategy is using some of the money that you have in your pension fund— well, there's different ways of going about it. You could use all of your money in the pension fund and put it into these swaps, which would 100% guarantee that you're going to meet your liability in the future. Okay? But pension funds have gone a bit further and going, well, can't we use leverage in order to have the best of both worlds? Can we use the leverage strategy in our swaps trade so that we don't have to put all of our money in the swaps, but we're still getting 100% kind of coverage on meeting future liabilities. And then this leaves us with— so let's say we're 3x leverage. Let's put some numbers on this. Let's say we've got £1,000, okay? Um, and we want to cover our future liabilities. I could say take one-third of that. I could take £333 and invest it in a leveraged swap strategy, which would give me 100% coverage of my future liability. But then I've still got £667 in cash left. Great. I can now use that to invest in bonds. So you bet— you basically do both. You can take care of your future liabilities in a leveraged manner using derivatives and still invest in bonds to try and grow my fund. Okay, so this is the kind of principle, um, of it all. And it all sounds good and all makes sense and, and, and fine. And it's all fine until it's not. And when it's not, then we have a massive situation, which is what happened this week. So with these swaps, let's maybe just talk very briefly about that. An interest rate swap is where you've got two counterparties Okay, and both have some kind of interest rate exposure, and usually one counterparty has got a fixed rate of interest that they have to pay, and then the other counterparty's got a variable rate interest that they have to pay. And for lots of different reasons, it may be that both entities would like to swap. So the entity that has a fixed rate, they might take the view that actually they think interest rates are going to go down, but they're stuck with this fixed rate liability. So they could go, well, hang on, can I do a swap where I swap with someone else's variable rate? And if I think interest rates will go down and I swap for someone else's variable rate, great. I might have to end up paying less interest than I would have done if I hadn't swapped. And it could be on the other side, you might think, well, Why would the variable rate entity— why would they want to swap if, if interest rates were going to go down? Well, they might think interest rates are going up, number one. Number two, they might need a fixed rate of interest to have a fixed amount of outgoings in order to raise more capital. Sometimes investors who are potentially investing in companies who already have debt, they want to know the— they want that debt to have a fixed cost that's a known cost that won't change. Before then, they're prepared to lend that company anymore. Right? So look, there's various reasons why you might want to swap on either side. Okay? But the point is that these swaps deals, right? You do the deal, let's say it's for 5 years, 5-year swap. Okay? And then time goes on. And it depends what happens with interest rates as to whether Entity A on one side of the swap deal has to pass money or cash to Entity B, who's on the other side of the swap deal. OK? Depends what happens to interest rates. If interest rates go down, then it's the fixed rate person that's better off. And the variable rate person is having to send money across. OK? And if interest rates go up, the opposite. Now, what happened this week? Was— and a lot of these swap interest rates are linked to government bond yields, okay? So what happened this week was bond yields spiked super aggressively, the, the biggest move we've ever seen, which meant that the cash liability that needed to be transferred from Entity A to Entity B within this swap arrangement, the amount of cash suddenly jumped to being massive. Way, way, way bigger than they had ever expected and definitely weren't prepared for. And they didn't have enough cash. And so they had to make a choice. And the choice was, right, well, we're going to have to go to our investment side of our portfolio where we invested in government bonds. And we're going to have to sell government bonds in order to raise cash to meet this interest rate swap liability. Okay, but the problem is, and the vicious cycle here that this kicks off, is that selling the government bonds, that means the prices go down and the yields go even higher, which means that then their cash liability on the swap deal is even greater, which means that they then need to sell even more bonds, which means yields go up even higher, and you get this, obviously, this negative kind of vicious spiral. The other point to make is right in the middle of all of this, BlackRock, who sit really as a kind of broker in between these two entities that are part of this swap deal, BlackRock sat in the middle. They said, and they sent a, um, a memo to clients who, who were using their LDI investment strategies, and they sent the memo and it said that they would freeze funds more at risk of assets being exhausted and move the assets to cash, basically meaning that they were locking everyone out of the market and no one can buy or sell. And this is really where the Bank of England had to get forced in. BlackRock, the broker sat in the middle, said stop everything because we now, BlackRock, have a responsibility to our clients. Because if we allow one of these entities on one side of the deal to go bankrupt, well then actually that's going to impact us and impact our clients. And so they went stop, and all of a sudden everyone's locked out of the market, um, yields are spiking because panic's set in. And this is where the Bank of England came in. It was the lender of last resort basically stepped up and go, "Oh my God, if we don't act, actually these pension funds could well go bankrupt." I mean, it's literally that kind of dramatic. So that headline in the FT is not far off true. And so the Bank of England stepped in and forced bond yields back down. So they basically— yeah, go on.

Well, this will go— it just strikes me that it all comes back to this execution on Friday, the woeful execution. Because interest rate swaps aren't this kind of mega sexy, super complex product. And actually, LDI is not particularly sexy and super complex. We're not dealing with anything not vanilla here. And there's smart people working in these institutions that would have modeled various different scenarios, right? Various different interest rate scenarios, bond yield scenarios. So something must have gone pretty badly wrong in terms of communication and execution for their modeling to have just been exploded in the way that we saw over the last few days.

Yeah. And it's the naivety of this new government who've just come bowling in thinking, don't worry, guys, we're here. We're going to shake things up. And it's going to be awesome. And oops. Quite extraordinary. But I mean, look, the Bank of England— I mean, so let's put some figures on that because— Uh, what was it? So, and so what's going to happen next? Maybe let's, let's move on, because the Bank of England have said we will buy £80 billion worth of government bonds. So how does that make an impact? What— why does that bring yields back down? Well, this is where the government coming in, huge buyers. So when there's a big buyer who arrives, well, it forces price up. And the way bonds work, price is inverse to yield. So as price is forced up, yields are forced back down. So the 30-year UK government bond yield, which was sitting at about 3.5% before all this thing kicked off, it went from 3.5% to just above 5%. This is where, oh my God, pension funds have got serious shortfalls on cash. They're having to sell bonds. BlackRock are locking the market. So the Bank of England stepped in and bought, forcing yields back. And they forced yields from 5% back down to basically 4%. We're sat at just below 4% at the moment. Okay. So they've said, we're going to buy $80 billion and we're going to do that in $5 billion per day increments until the 13th of October. So that's only 2 weeks, right? So the next thing in this chapter is, well, what happens on the 14th of October when the big buyer that's now suppressing yields and holding them down, what happens when that big buyer steps out? Does panic ensue again and yields pop, or actually has the dust settled and things are fine, and do the government at least come out and give us some kind of idea as to how this is going to be sustainable long term.

So if you were sat in Number 11, if you were playing the role of Kwasi, and everyone's calling for you to make a U-turn on your £45 billion budget and get back to a little bit of fiscal common sense.

Yeah.

Would you do it or would you plow on?

Such a difficult one, isn't it? Because obviously if you do a U-turn, well, then your credibility is gone. Do they have any credibility anyway? I mean, but that was— it's almost like saying, we've arrived, I've got this new strategy, guys. 'Let's go.' Only then for immediately you to go, 'Oh, wait, wait, wait, wait, wait, stop.' I mean, there'd be an immediate— I don't know, would there be a vote of no confidence? Would we have to get Truss out and bring someone else in? I mean, this is just amazing for Labour. Like, literally, they couldn't even have scripted this in their wildest dreams, right? But I personally, I would not do a U-turn. I mean, I think some parts of their thing— scrapping the 45% top earners tax, that was stupid. I mean, it doesn't benefit anyone other than those few rich. And it doesn't give the government— it's such a stupid idea. I'd get rid of that. But it's kind of all part of the package. I wouldn't change the package. What I'd be doing if I was them is before the 13th of October, when your rescuer, the Bank of England, is perhaps going to sod off. Before then, you need to lay out a very detailed plan of action as to how this pop higher in debt is going to be paid for in the long term and how it's going to be sustainable and get it reviewed by an independent third party and add that to the plan, which, oh my God, they should have done last week in the first place but didn't. So that's what I'd be focusing on if I was them.

Let's see.

It's not an easy thing to plan that because Kwasi said, oh, don't worry, we're going to sort that out next year. And then he goes, oh, God, all right, pockets. Markets have panicked. Okay, fine, we'll bring forward it. We'll tell you in November how this is all going to work. And obviously they need to do it now. I don't know if they've got time to pull that off, but—

Well, a week is a long time in politics. Let's hope they use it wisely. Shall we move on? I feel a little bit depressed.

Yeah, let's move on. Should we move on to Porsche? Depressing. Yes, much more interesting.

Yeah, convertibles driving down sunlit, you know, Let's be a bit more positive. So Porsche's long-awaited IPO launched yesterday. They managed to get away the IPO valued at €75 billion. It was pretty flat by the end of trading yesterday. It popped a couple of percents. But just to give listeners a bit of a background, so VW the ultimate owner of Porsche. And VW, by the way, are controlled by the Porsche family. So this is what makes it slightly incestuous. But VW listed 12.5% of Porsche AG in Frankfurt yesterday. And that's raised €9.4 billion, 49% of which went to VW as a special dividend. And the rest actually went to VW to build out their EV war chest. So just to be clear, this wasn't a fundraise to line the pockets of Porsche. It was a fundraise to line the pockets of its parent VW. Now, the other thing worth noting about this IPO was they IPO'd— Porsche have got two different classes of shares, ordinary shares and preference shares. The ordinary shares come with the voting rights, the preference shares don't. And they only listed preference shares. So if you are thinking of buying into Porsche later on today, just remember that the money raised is not going directly back into Porsche to expand its global operations or to increase its product range. And it's also not going to give you any kind of vote. So just kind of bear that in mind. But Piers, maybe what I want to talk about is this whole process of the IPO. So $75 billion range. It popped a little bit, but not really. I think a lot of people are relatively disappointed with the fact that we didn't get that 10%, 20%, 30%, 40% pop on IPO yesterday. And I guess, is this a function of a mispricing? So the book runners priced it at $75 billion. I think HSBC said, look, that's $20 billion overvalued. Or is this just a function of just terrible timing? Probably not the right time to get an IPO away.

I think that it's definitely not good timing. I mean, that's for sure. But I guess these guys, they wanted to do this at the start of the year. I think they announced back in February that they were— looking to spin off an IPO Porsche, and then obviously the brown stuff hit the fan, and 2022 kind of took a turn for the worse. And so they put it off and they put it off, and like, here they are now going. So for sure, timing is bad. Um, I think that the governance side, as you've alluded to there, is a very big reason why— is a very, very big reason why you didn't get that 30% pop. Um, it's so— you use the word incestuous, and it is definitely right, because I mean, the Porsche family, um, that basically own, uh, Volkswagen, right? And Volkswagen own Porsche, and Volkswagen have IPO'd Porsche, but the ordinary shares are the voting rights shares. Have been— they weren't sold in the IPO, but they, they were sold in a direct sale to the Porsche family. And then there's a big special dividend that Volkswagen are paying out to their shareholders, the Porsche family. So this is some kind of unbelievable sort of snake pit of a governance situation. And, and actually it's been said that the pricing of the IPO was basically, basically priced with a governance discount because of this. And the 30 to— like, one analyst was saying, look, this is 30 to 40% discounted from where it really should be, but because of the governance issue, um, that's fair. Um, so I think it's the governance side more than anything else, and the fact, as you said, none of this money is going into to invest in Porsche's growth. Um, but yeah, Porsche does— it's a bit messy because Porsche is reliant on some VW tech Um, their operating system, for example, which they're having a nightmare with— I can't remember the name of it now, but it's being delayed by a couple of years, which means Porsche's— some of Porsche's EV, um, vehicles that are in the pipeline have been delayed until 2024. So you could say that some of this money going into VW to beef up their EV push could come back and actually help Porsche get some of these products to market sooner, but Yeah, that's what I see.

Yeah, it's a little bit messy. On the face of it, it's a good company. And if it was a full spinoff, you've got 20% year-on-year revenue growth, you've got 16-17% EBITDA margins. This is a good car business, but it's just so messy. It's too messy.

It's Volkswagen's— it's the jewel in their crown, easily, of all the automotive subsidiaries they own. It's easily the best, right? I mean, you saw that the demand, even though all these issues around governance, the demand was pretty decent, especially given the climate. I mean, they priced it at the price range So the way this works, right, when you're trying to IPO a company, you're obviously selling these shares or a portion of the shares to the public, right? And it's like, well, what— how do we price— what price should we sell those shares at? Because the last thing you want to do is just, you know, value the company using your Excel models, and they go, okay, that spits out the price X, and okay, that's our price. Here you go, public, do you want to buy them? Because they might not want to buy at that price, in which case you have a failed IPO, and then that's just a disaster because you waste a load of money that you've paid to all the bankers. Um, it's incredibly bad from a PR point of view, um, and you end up getting no money, and it's just a disaster, right? So instead, banks, um, investment banks that get hired by these companies that are IPOing, they run what's called a they do it to a book running process and they do, um, a, a roadshow process, okay, which is where— so the roadshow is where they get out in front of investors and with a pitch deck, literally, and the management team at Porsche will be telling investors about their story, um, what does the future look like. And Porsche have executed their, their transition to EV incredibly well easily better than everyone else under the Volkswagen umbrella. And so it's a pretty sexy, cool story. So they're out there in front of investors telling the story, getting them excited, and therefore drumming up demand. Okay, and what the bankers will then do is set an IPO price range. And actually, the range for Porsche was €76.50 up to €82.50. So after the roadshow, they're like, okay, investors, give us your kind of indicative bids. Yeah, put in some bids, you know, within this price range so that we've got some hard data on demand which we can then use to actually set a final single IPO price. Okay, and actually one of the book runners, um, said, um, and, and I'm quoting here, they basically said, after, during the book running process, they said, look, orders below the top end of the range risk missing out as indicated demand has exceeded the full deal size, right? Meaning the demand's greater than the size of the book. And they're saying, therefore, if you want to make sure you're going to get allocated some shares here in this IPO, investors, you really need to be bidding at the top of the range. And that's what happened. The demand was really strong. I think in the end it was like 4 times the book value. And so they got away at $82.50, um, which was right at the top of the range. So from that point of view, they ran a good exercise. I think they ran a good process from an IPO execution point of view. But then, yeah, it hits the secondary market, and as you say, some investors have the strategy of trying to buy an IPO and then flip it straight away. So that means buy the IPO, they're hoping it hits the secondary market stock exchange the price spikes and then they immediately sell literally on day one and book a profit. But that spike didn't happen.

Well, I'm glad to hear that you think that it was a relatively well-executed deal. I can count 11 banks that were on the ticket. So there's going to be some pretty good paydays there.

That's expensive. I mean, yeah. I mean, 11 banks. I mean, look, this was a big deal though. I mean, I think it was the second biggest European IPO this century, I think I'm right in saying, which sounds dramatic, but I do actually think that is correct. It's the second biggest deal in the, you know, since the year 2000. So that's the point, right? If the bigger the deal, the kind of more banks and the more advisors and the more underwriters that you kind of need to handle that size of deal. But yeah, I mean, expensive, right?

Absolutely. Absolutely. Well, look, should we leave it there?

Yeah, let's leave it there. I mean, that was— I'll leave it on one thing, actually, because I saw a chart, just reading up on Porsche and stuff, I saw a chart in— it was in The Economist, actually, talking about biggest carmakers by market cap. Because now Porsche is a listed company, and therefore we can measure its market cap every second of every trading day because it has a share price. And so putting it alongside all the other kind of listed companies, including Volkswagen themselves of course, and Porsche come in at 5th on the league table. Um, do you know— oh, I'm— question for you, who's Who's top?

Tesla.

Yeah. Do you want to know by how much?

5x the next highest.

Uh, oh, you're almost— it's about 4.5 times the second placed, which is— you might have heard of them— Toyota. Third place, you might not have heard, actually. Third place is BYD.

I have not heard of BYD.

Right. So they're the big China, uh, EV player that Warren Buffett invested in. BYD are the third biggest automotive company on the planet by market cap, and most people haven't heard of them, uh, which is interesting. Then Volkswagen themselves are fourth, with Porsche fifth. But actually You could add up 9 of the top 10, if you add up from 2nd down to 10th, if you add up all their market caps combined, they're less than Tesla.

That's remarkable. It's also remarkable that Porsche's come in ahead of Ford and GM as well.

Yeah. So Porsche are ahead of Mercedes, ahead of General Motors, ahead of Ford, ahead of BMW, ahead of Honda. Wow.

Yeah, so there you go. A lot to get through this week. And Ant, if you are listening to this podcast, please do come back.

Well, no, don't come back. Don't come back because then we'll just have more interesting stuff to talk about next week. If he comes back, it'll just all dull down and, uh, be super boring.

Okay, well, maybe stay on holiday. Stay in your, your lair for another week. Guys, thank you so much for listening. Please do like and subscribe, and we will be back next week.

Cool, have a good weekend.