Asset Management: Fixed Income Insights

July 2016 Fixed Income Market Update

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“Brexit” review and observations

Outlook & Conclusions

In our view, Brexit will more directly impact the economies of the U.K. and Europe than the U.S. economy, which continues to be relatively insulated from global turmoil. However, the interconnection of financial markets remains tighter than that of real economies, as evidenced by the flight to quality in U.S. Treasuries directly after the result of the Brexit vote became clear. While notable, the impact to Treasuries and U.S. credit in the aftermath of Brexit did not deviate significantly from the mid-June levels when polling data in the UK had increased expectations of Brexit occurring. Global turmoil and low growth have pushed sovereign yields lower, with German, Japanese and British 10-year debt setting alltime lows for yield in June and the U.S. 10-year hitting its lowest yield since 2012 (and an all time low on July 1). This turmoil was acknowledged to impact the Fed’s calculation regarding interest rate hikes even prior to the Brexit vote. The outcome has seemingly pushed the next hike further forward into the future.

It should be noted that recent weaker non-farm payrolls in the U.S. had a material impact on the outlook for the Fed while Brexit was still considered a remote possibility. Indeed, Brexit is not the only story of the quarter. Ironically a quarter that will be identified with Brexit began with fear fading and a return to a more rational pricing of risk. Despite the turmoil at the end of the quarter, credit spreads ended tighter, demonstrating just how detached from fundamentals spreads had become last year through February.

The combination of a more insular U.S. economy and interconnected financial markets keep the outlook for U.S. fixed income attractive. The substitution effect, whereby non-U.S. investors purchase U.S. fixed income assets due to the meaningfully higher interest rate environment in the U.S. versus other developed markets, continues to create demand for U.S. assets. Credit spreads remain wider than historical averages offering continued opportunity in the sector. Further, globally driven volatility allows for bottom-up selection to capture securities mispriced in the current environment.

Background

The United Kingdom European Union membership referendum, or “Brexit” vote, occurred on June 23. In a major surprise to pollsters and financial markets, the British citizenry chose to leave the Europe Union (E.U.) by a margin of 52-48%. In our last monthly piece, we noted that despite ‘recent aggregates of polls suggest that ‘stay’ is leading ‘leave’ by a few percentage points… a large number of voters remain undecided.’ These late deciders came decisively to the conclusion to leave the E.U.

Interestingly, the vote which Prime Minister David Cameron had called to quell dissent within his own party – the most local of politics – turned into a global event. The Prime Minister announced his intent to resign following the result of the vote. The vote itself does not trigger article 50 of the Lisbon Treaty, which provides for withdrawal from the union, so the next Prime Minister will be responsible for implementing the withdrawal. Even once triggered, the process could take up to two years per the treaty.

Uncertainties abound as it relates to the full economic and political impact of the decision. Withdrawal terms are subject to negotiation and without precedent. There is a difficult balance to strike for the E.U. between maintaining strong trade ties and close relations with the second largest economy and setting disincentives for further departures from the union. For example, Germany has a strong incentive to maintain close trade relations with Britain as German exports to the U.K. in 2015 approached €90 billion, making it their third largest trade partner.

To date, the market response has been similar to prior versions of the European crises from recent years beginning in 2011. Those crises were centered around fears that Greece could exit the European Union (though for very different reasons) and thereby trigger a contagion of other nations exiting the union (or even a dissolution itself). After sharp reactions, the initial wave of Brexit fears appears to have been processed more quickly than past E.U. crises as perhaps markets have grown accustomed to the drama surrounding E.U. membership.

Emboldened by the success of Brexit, national movements in other parts of Europe are calling for referenda on their own membership in the E.U., which are worth monitoring. While fears around the E.U. to date have largely focused on the peripheral nations, among the current countries with movements for referenda are France (‘Frexit’) and the Netherlands (‘Nexit’), both of which use Euro. While the Brexit is messy, it follows a prescribed path and Britain benefits from having its own currency and monetary policy. There is no such path for an exit from the single currency community, which would involve the recreation of a national currency and independent monetary policy.

Financial market impact has been more orderly than some had projected. The British Pound has been hardest hit, with its value declining 8% for the month to its lowest levels since 1985. S&P and Fitch both downgraded the UK’s credit rating in the aftermath of the vote. The potential for regional independence votes (particularly Scotland) and projected negative impact to GDP growth were among the reasons cited for the downgrades.

Prior to the vote, Bank of England (BOE) Governor Mark Carney had spoken in favor of remaining in the E.U. On the Friday after the results were known, he announced up to £250 billion of loans to banks needing support. On June 30th, Carney announced that “the economic outlook has deteriorated and some monetary policy easing will likely be needed over the summer.” The markets are now pricing a 75% of a rate cut by the BOE by August; the Bank Rate in the U.K has been at 0.50% since March 2009. Governor Carney cautioned that monetary policy alone “cannot fully offset the economic implications of a large negative shock.”

Economists’ predictions for lost U.K. GDP range from 1% up to 6%. By contrast, the International Monetary Fund has predicted an impact to global GDP outside the E.U. of 0% to 0.2%. The differential impact highlights the regional, as opposed to global, nature of Brexit as an economic issue. The decline of the Pound Sterling should increase the relative costs of imports, which has raised inflation expectations in the U.K. The currency depreciation should also make British exports more competitive and attract tourists. While these are positive factors, the consensus remains for a bumpy road for the U.K in the short term.

Economic and market perspective

The combination of a surprisingly poor jobs number early in the month and the (ultimately realized) trepidations surrounding the Brexit vote made for a June Fed meeting with little suspense. As expected, the Fed did not raise rates at its June 14-15 meeting. The most notable change was to the Fed’s ‘dot plot’, which now implies three rate hikes in 2017 and 2018 versus four in the prior rendition. The longer term projections declined as well, from 3.25% to 3.0%. The plot still projects two additional hikes for this year, though Fed Funds Futures imply the market is doubtful about a single hike, with only a 9% chance priced in for a hike by December. Interestingly, the markets now project a greater chance (though still remote) of a rate cut in September and November than of a rate increase. Even by December 2017, the market is projecting a below 50% chance of a rate hike.

 

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