Global markets are in shock at Britain’s decision to leave the European Union. German 10 year bund yields hit a record low of -0.18%. Spanish and Italian 10-year debt have also fallen and are trading well below the highs seen in February 2016.
Over the long term, how will the fixed-income market cope with the Brexit aftermath? Citywire Selector asked leading bond managers what Britain’s departure from the EU would mean for the asset class.
'Capital markets will become more inward-looking. Overseas investors will be less likely to invest in UK corporates, making it harder for those companies to raise debt. UK companies’ access to global capital is likely to be reduced, meaning they’ll have to raise more from the UK market.'
'The EU will want the contrast between membership and non-membership to be as stark as possible. In practice this will mean propping up the European market using any means at its disposal in order to make life rosy for the remaining members—it will also mean making life hard for the UK.'
'Global investors may look towards the US, even though it is further through the credit cycle and potentially faces more defaults than the European market. This will negatively impact European high yield, but it will also create a buying opportunity. Our aim is to look beyond the broad sell-off and identify those names where we believe there has been a negative overreaction. For example, UK companies that do not need to import from overseas will be less affected by the decline in sterling and will be more insulated against the downturn.'
Head of European fixed income at Pioneer Investments Tanguy Le Saout thinks that central banks will wait and see how markets trade before offering to support them. He said that there will be wider political implications across Europe which could lead to a recession in the worst-case scenario.
'Despite a decrease in market liquidity conditions in the run-in to the vote, market liquidity so far has been better than perhaps anticipated. Initial indications were for significant movements in many markets from pre-vote levels, but as markets opened on Friday morning, there were no significant disruptions to liquidity and most markets appeared to function well.'
'In terms of market valuations, it played out much as we had expected – core sovereign bond yields have rallied, peripheral sovereign bond spreads have widened, credit has also widened but is relatively well-contained and FX movements have also been as anticipated – a significantly weaker British pound sterling and a stronger US dollar and Japanese yen. We would anticipate that markets will settle down at current levels, but that these trends will continue (but at a slower pace) over the coming months, for all the reasons referred to in the comments above. The lack of clarity in both the political and economic outlook for the U.K. and the E.U. may lead to international reserve managers changing their asset allocations away from these areas, which could put further pressure on valuations.'
'We expect Brexit will cause a rally in German Bunds, accompanied by an under-performance of other markets, but especially peripheral markets such as Italy and Spain. A sharp “risk-off” environment, accompanied by widening spreads in peripheral and credit markets could cause Central Banks to intervene. The Central Banks immediate focus will be on stabilizing the markets, and they are ready to provide them with liquidity. We believe that monetary policy adjustments will be made, initially through measures of credit easing and broadening of the asset buyback program, but ultimately rate cuts may be implemented.'
Mike Amey, who is the head of sterling portfolio management at Pimco and runs several UK focused fixed-income funds, thinks that the medium term outlook will be calm as the UK gets a new prime minister and navigates life outside the EU.
'The shock of the vote will dominate initial market moves, and will clearly provide risks for the medium term. Near term, the UK economy will be pulled lower by the uncertainty created by the referendum vote. As a result we expect the Bank of England to cut the official interest rate to zero, from 0.5%. If they feel the need to do more, we expect a reintroduction of quantitative easing rather than a move to lower the official rate into negative territory.'
'For the medium term we expect a period of greater relative calm, not least because the transition to life outside the EU will take time to negotiate. Furthermore, the leadership of that negotiation needs to be resolved. David Cameron has announced he will step down as prime minister by October, meaning that a leadership contest within the conservative party will take place over the summer. Only after this is settled – and the UK has a new prime minister – will negotiations around the EU separation begin. The time for these negotiations would likely be up to two years, under Article 50 of the Lisbon Treaty. However, we would expect informal negotiations to start ahead of the UK government formally initiating the exit process.'
'In short these things take time, and time can heal what at this moment may seem like a raw wound. However we should all recognise that periods of political instability create significant risks at a time when the global economy is vulnerable to unexpected shocks. In the short term this increases uncertainty in the outlook for the UK and it underlines our secular themes of rising political risk and insecure stability for the global economy.'
'We have been happy to run a meaningful duration going into the vote, based on the premise that the reaction in government markets is likely to be asymmetric, with government bonds rallying more in a Brexit scenario than they would sell-off in a Remain circumstance.'
'That said, we own no exposure to gilts, due to heightened volatility and concerns around impact on longer-term credit rating. In Jupiter Strategic Bond, we hold a very modest long dollar position but have pared this back to a modest level. Our exposure to the UK comes through the ownership of sterling-denominated corporate bonds, largely in the financials sector.'
'That said, much of our exposure is to financial companies that are more domestically oriented such as building societies.
We expect to see some further weakness for the UK financials sector in the weeks to come, but would view this as an opportunity to top up exposure where we have a favourable fundamental view. Our more defensive positions in our portfolio in areas such as government bonds, credit hedges and gold convertibles should all prove positive in this environment of heightened uncertainty.'