24th June 2016 by Chris Iggo
The markets and the bookies got it wrong. Britain voted to leave the European Union. As expected, the decision triggered a huge risk-off move in financial markets with the pound sinking to its lowest level against the dollar since 1985. Bond yields are lower because of the flight to safety. In the credit markets, spreads are wider because of the political and economic uncertainty that flows from the vote. There will be buying opportunities. Central banks will provide liquidity, rate hikes are off the cards, and bonds have better capital preservation characteristics than equities that face an uncertain earnings outlook. Although “Leave” was not our central expectation, the views on fixed income don’t change that much. Investors still need yield, it will take time for the economic implications of “Brexit” to become clear, and there is a lot of cash to be invested. Higher yields in credit and emerging markets won’t last for long.
Exit – My memories of the 1970s mostly consist of playing football, school, living in a pub, going to Mallorca for the first time and the Bay City Rollers. I also remember the 3-day week, power cuts and there being lots of elections. I don’t particularly remember the 1974 referendum on whether to stay in Europe but I know for sure that my family has enjoyed a steady improvement in living standards since then. Britain has been a member of the European Union all that time and now it won’t be. As a citizen, that makes me incredibly sad. As an investor it fills me with trepidation. Things will change on both the economic and political fronts. That is, after all, what people have voted for. There will be political change in the UK, perhaps constitutional change, and there may be changes in the rest of Europe. There will be economic changes too. After all, that is what people have voted for. The problem is we don’t know what the implications of all those changes will be for growth, inflation, jobs and financial markets. Hence the initial reaction in the markets – risk free assets strongly bid, risk premiums massively higher, volatility up. Markets will overshoot, they always do. But the problem is we don’t know what future economic assumptions to use in determining fair value. Where should the pound trade now? In my career it has been close to 1 to the dollar and 2 to the dollar so at $1.38 it could go either way. A currency is a bellwether for sentiment about a country’s economic prospects and when we now look at the UK it is reasonable to assume that growth will be weaker rather than stronger. Private investment is surely not going to be strong. The housing market may get hit. Consumers could be more risk averse. Rates lower for long, a weaker pound and a lack of a driver for GDP growth. The UK runs a large current account deficit as well. Capital inflows to fund that may not be as strong in the future if the financial sector starts to relocate. Having rejected the EU, more Britons will be holidaying at home going forward.
Credit markets not likely to be the major losers – Uncertainty in the context of low prospective returns is not a mouth-watering prospect is it? What can we guess about what happens to the UK? Inflation will rise because of the sharp drop in the pound, so index linked bonds should do well. The translation effect for dollar and euro earning companies could temporarily boost earnings, but domestic businesses will suffer. The consensus is that there will be a recession. For bonds the capital preservation aspects I discussed last week will provide support – gilts were up 3 points this morning despite talk of the rating agencies cutting the UK’s sovereign rating. In time there will be buying opportunities. Economic uncertainty works against any increase in leverage in the UK or the rest of Europe, so corporate bonds remain relatively safe. Uncertainty means investors should require a higher risk premium and that is what we are getting right now. The European investment grade CDS index has moved wider today although this has been largely offset by declines in underlying rates, leaving yields more or less unchanged. To be honest, writing this only a few hours after the result, nothing is really trading. When calm, prevails, it is unlikely to be the credit markets that are the major losers.
Eyes on Europe – Investors do need to consider the risks. We and others have argued that a “Brexit” is not just bad for the UK economy but it is bad for Europe as well. The uncertainties surrounding future trade arrangements cut both ways. On the political side we may see others wanting to follow the UK. Without doubt the European Union will have to change and maybe it changes in a way that cuts red tape and fosters investment and productivity. Who knows? But if it takes more of a crisis to trigger fundamental changes the crisis will be an existential one and that means that weaknesses might be exploited – peripheral government bonds being a possible victim. Those bonds trade with a spread of more than 100bps relative to Germany for a reason – that reason is there is a risk of another debt crisis even if the European Central Bank (ECB) has keep that risk to a minimum in recent years. Spain goes to the polls again this weekend, there have been secessionist voices in the Netherlands and France, and it would be naive to think that a political union can lose one of its more powerful members and remain unaffected. Thus the ECB becomes even more important in propping up markets and underwriting the euro as a major currency. It’s not for nothing that the dollar has risen against the euro as well as the pound.
Buying opportunities if spreads are wider – Equities should be the asset class that is most affected by a potentially weaker economic environment. For bonds the global monetary environment will certainly remain supportive. The Federal Reserve probably won’t hike rates until much later in the year. The Bank of England’s next move may well be an easing if things get really bad while the ECB is already doing a lot in the euro area. That rate outlook and the flight to safety has seen huge drops in core bond yields today, with even the 10-year gilt yield falling to within a whisker of 1% and the 10-year German bund yield going even more negative. Bond returns are driven by changes in the term structure of interest rates and by changes in credit risk premiums. The latter are affected by the general business climate and leverage, so there is likely to be some pressure on corporate bond spreads from the downgrading of growth. This is most likely to affect high yield markets where there is more leverage and more sensitivity to the economic cycle than is the case in investment grade. However, I am more inclined to see this as a buying opportunity. My sense is there is a lot of cash in portfolios and waiting around to see what the terms of the UK’s disengagement with Europe and what that means for the economy is too much of an opportunity cost if yields go higher. Similarly we also look reasonably positively on emerging market debt given that the macro economic implications of “Brexit” on emerging economies are not that obvious and given that hard currency emerging market debt will benefit from lower US Treasury yields. We held our quarterly forecasting before the UK referendum but the conclusions remain more or less the same – investment grade credit looks safe, inflation linked bonds are attractive as even more central bank liquidity is created and emerging markets benefit from an improved fundamental picture. If the high yield sell off goes further, then this again looks an attractive buy.
Populism the great risk – The decision is raw. Market reaction has been extreme. The political fall-out has only just begun. The best piece of information I saw in the run-up to the vote was a YouTube broadcast of a lecture by a Professor of Law at the University of Liverpool. The main takeaway was that leaving would create huge uncertainty and unknown implications for the UK legal system and that it would take years to firstly disentangle the UK from the EU and then negotiate new trade agreements. That means a prolonged period of uncertainty. Markets will settle down in time but the referendum has probably put in place a series of events that will bring political and economic risk. Investors need to focus on basic principles when looking to generate returns. Bonds provide a level of safety in uncertain environments and if there is going to be a need for additional monetary stimulus then fixed income benefits. However, globally the challenge remains to boost growth, increase productivity and get us out of the debt trap, otherwise electorates in many countries will find appropriate kicking bags. Inevitably, the US election starts to become the next big political risk. If UK voters have taken their frustrations about income inequality out on the EU, American voters might revolt against the perceived political establishment. Whatever else populism might bring it tends to always bring inflation and that may in the end herald the end of the bond bull market.
Eye on the Euro’s… – I’m not really looking forward to having the “what now?” conversation with my kids this weekend. Perhaps best to keep it to rowing and football. If all goes well Felix will get to row at Henley next week as the regatta season comes to an end. As far as football goes, there is huge interest still in the Euro’s given the advancement of England, Northern Ireland, Wales and the Republic to the knock-out stage. Ireland’s late winner against Italy was a very enjoyable and dramatic moment. I hope there are more of them in the coming week. We need something to take out minds off the future.