10 days after the Brexit vote, and markets appear to have taken the result in their stride. As of 4 July, sterling had stabilised around the 1.33 level against the US dollar and 83.5c against the euro.
The FTSE100 has recovered all of its losses suffered in the immediate aftermath of the result, and is now higher than the day before the vote. But looks can be deceiving and we certainly do not think the UK or financial markets are out of the woods yet.
Our view is that sterling’s rally this week is a temporary phenomenon, most likely caused by the closing of hedges and short positions built up in advance of the vote. With tremendous political uncertainty in the UK, and the prospect of a mild recession (see more below), we expect further weakening of GBP against US dollar and duro.
UK gilts are expected to keep pace with other international bond markets and will be supported by accommodative monetary policy and “safe-haven” flows from other UK assets. By now, the consensus appears to be that the effect of Brexit will reduce UK economic activity by about 1.5%-2% per annum over the next 12 months, thus pushing the UK into a technical recession in early 2017.
Certainly, Standard & Poors were sufficiently concerned about the outlook to reduce the UK’s sovereign rating by two notches last week, from “AAA” to “AA”, and left the outlook on Negative watch. Some investors have pointed to the FTSE100’s performance as indicating that equity investors are taking a different view. We will leave that point to our equity colleagues to debate, but will point out that 75% of the FTSE100’s earnings come from outside the UK, and are now more valuable due to the fall in Sterling. The FTSE250 and FTSE350, which are more domestically focussed, are still lower than where they were pre-the referendum.
Global monetary policy – the start of a new easing cycle?
In our meetings with clients we continually get asked how we can justify negative bond yields?
Surely, the idea of receiving a smaller amount when the bond matures than you paid for it initially just doesn’t make sense? But a lot depends on where you think interest rates and bond yields will move to in the intervening period. Last week the course of global monetary policy began to shift, and in a direction that would help support current bond market valuations.
In an unusually forthright speech (for a central banker), the governor of the Bank of England Mark Carney noted “the economic outlook has deteriorated and some monetary policy easing will be required over the summer”.
Most market participants are now pencilling in 50bps of rate cuts in the UK by end-2016, along with a re-starting of the UK’s Quantitative Easing (QE) programme of purchasing both sovereign and corporate bonds. In Europe, although ECB president Mario Draghi and the ECB never pre-commit to any monetary policy actions, it is likely that the ECB will vote in September to extend their QE programme by another six months – from March 2017 to September 2017. They may also increase the monthly purchase size from the current €80bn to €90bn or even €100bn.
In Japan, expectations are that the Bank of Japan (BoJ) will increase its Quantitative and Qualitative Easing programme as well at the next BoJ meeting at the end of July. This could also be backed by the announcement of a major new fiscal stimulus plan by Japanese prime minister Shinzo Abe in September.
In addition, the view of the European Investment-Grade Fixed Income team is increasingly that any hikes from the US Federal Reserve will occur towards year-end. In fact, globally we see very few countries where monetary policy settings are likely to move higher. As investors adjust to this new state of affairs, we are likely to see bond yields remain lower for longer and yield curves continue to flatten.
Italian sovereign bonds – change of view
For the last couple of quarters, we have maintained an underweight position on Italian sovereign debt, concerned about the close relationship between the under-capitalised Italian banking system and the Italian sovereign.
But three pieces of news last week saw the situation change, and as John Maynard Keynes famously said – “when the facts change, I change my mind”.
So we have now changed our outlook on Italian sovereign debt and last week started implementing an overweight position.
What were the three new pieces of information?
Firstly, we were impressed by the amount of buying of Italian sovereign bonds by the ECB early in the week in the aftermath of the Brexit vote. Obviously, the ECB are determined to support the European bond market, and do not wish to see a significant widening in peripheral European bond spreads.
Secondly, there were press reports about a €40bn injection of funds by the Italian government to the Italian banking sector, in an attempt to increase the capital levels of the banks. Although this was swiftly rejected by the ECB and EU authorities as breaching the rules on state aid to banks, it does appear to signify that discussions to address the issue are happening and plans are being made.
Finally, a press story last Thursday talked about ECB discussions to change their QE bond buying from a capital key basis to a market capitalisation basis. This would benefit Italy significantly, as it has the highest weighting in European bond indices based on market capitalisation. The three factors above suggest that it will be difficult for Italian sovereign spreads to widen against German Bunds, and thus an overweight position is justified.
Tanguy Le Saout is head of European Fixed Income at Pioneer Investments