Across our fixed income portfolios we lightened up on risk in the run-up to the EU referendum and maintained hedges. We went into the vote long high quality duration, namely UK and US, and reduced our positions in peripheral sovereign debt.
The leave vote and the uncertainty it brings will have negative near-term economic implications for the UK, but medium-term implications are less clear. UK and other-EU risk assets will be negatively impacted, as will global risk assets. Financial market stress will remain high and liquidity may be a concern going into the summer months.
The Bank of England and other central banks are likely to ease further in order to stabilise markets. In our view the Monetary Policy Committee should help to reduce uncertainty by immediately lowering the base rate to 0%, as that would remove any funding friction and ensure continuation of a very accommodative borrowing environment.
Before the referendum results were known, globally there was a strong bid for bonds given the net negative supply situation caused by economically insensitive buyers in the form of global central banks which have been hoovering up supply. That hasn’t changed, and therefore we expect yields to remain near historic lows or go lower from here. We think UK Gilt yields could continue downwards by as much as 50 basis points in the medium-term. We also expect the European Central Bank to take further accommodative action, to potentially further cut the negative deposit rate and to increase their bond purchase programme. These actions will be beneficial for European sovereign peripheral bonds.
We think the flight to quality trade will continue through the summer months, as prolonged uncertainty weighs on the markets, particularly in the UK. In reflection of a rising probability of recession, we may see some derisking in parts of the credit market that have done well since February, including high yield debt. However, we would be buyers on any significant spread widening. For example we might look at stepping into European high yield if yields move beyond 5%, as that could present attractive value. We’ll continue to approach bank debt selectively given the combination of ongoing regulatory and potentially new economic pressure on banks.
We think high quality credit will continue to be compelling for investors, who will be increasingly seeking companies with a secure earnings profile that would be resilient to revenue declines.
This is not the time for investors to take outsized risk. We expect parts of the bond markets that central banks are buying – including government bonds and investment grade credit – to be prudent defensive investments in the near-term.
Robert Michele is global head of Fixed Income at JP Morgan Asset Management
Asset Allocation for a post-Brexit world
Markets are entering a period of unchartered territory. Last week we saw the biggest one day Sterling fall in three decades, but the playbook it followed was not dissimilar to Black Wednesday in 1992. Meanwhile, Gilt yields have followed a risk-off pattern. There’s scope for gilt yields to fall further as the markets price recession risk, but we have to keep this in context to global forces.
Volatility in sterling relative to other currencies represented the biggest single day move in three decades in the Brexit reaction. When you get a Sterling crisis like this, it takes some time to play out. We could be looking at a top to tail move of 15-20% as the sterling reprices. Hedging costs implied by the FX options market are still elevated, suggesting that significant level of uncertainty remains. It’s likely to be at least another quarter of heightened uncertainty from this point forward, during which Sterling will bear the brunt of the impact. Our best estimate is that we may settle on a target of around $1.25 for sterling/dollar.
On the bond markets, on the one hand, in an exit scenario, economic uncertainty brings down bond yields. However, foreign holders make up about one quarter of UK gilts. We’re not sure gilts can continue to rely on this wholeheartedly. Nevertheless, bond yields globally are falling; partly because of sluggish global growth, but also in response to the yawning $700bn hole in net supply of government bonds globally this year, which is akin to a big gravitation pull downwards in yields. We’d expect 10y gilt yields continue downwards after breaking through the 1% level; as recession risk gets priced in yields could certainly fall another 20-30bp from here, especially if the Bank of England elects to lower base rates. As we move into the Autumn, the idea that gilts can continue to outperform other global markets could wear thin, particularly if foreign holders may start to rotate away – the path of UK inflation, which now looks set to pick up in coming months, may ultimately limit how low Gilt yields can go.
When we think about UK stocks, markets last week were surprisingly well behaved, but we’re not out of the woods. In the event of a full blown recession, we would expect UK equities to be down 20- 25 percent top to bottom. We’re currently 12 percent below the 2015 market high, so there is scope for further downside. We know markets dislike uncertainty and as a result we expect UK stocks to remain under pressure. It doesn’t necessarily extend to other global markets, except of course for Europe. US equities on the other hand could benefit from a flight to quality.
Nevertheless, we can’t ignore that the UK is a very international equity market. If the currency remains relatively weak, sectors like pharmaceuticals, staples, energy, mining, which have substantial overseas income streams, potentially will get a kicker from the weaker currency. Meanwhile domestic sectors, and especially the financial services sector, could remain under pressure, not just because of risks to the services sector, but because of the relatively high domestic exposure. Wait for the dust to settle but mind the rotation to international sectors that will get a boost from weaker currency.
Where do we stand today? Sterling will remain under pressure. We think Gilts in the near-term can outperform other global bond markets as bond investors reprice a lower path of UK growth, but over time Gilts may be relative losers if inflation does indeed start to pick up in the UK. For the time being, UK stocks will remain under pressure and that will be most acutely felt with underperformance in the mid-caps, financials and domestic oriented sectors.
In terms of how we think about the international exposures in portfolios, our “up-in-quality” bias and geographical preference for the U.S. are reinforced by the events in the UK. Ultimately this is a local issue with the epicenter in UK assets and specifically the pound. The ripples outward are clearly felt in Eurozone assets, as the slump in bank stocks showed on Friday, and political uncertainty will surely weigh on the Euro to a degree. But further afield, this is unlikely to stoke a significant negative reaction in the U.S. economy or U.S. asset markets.
John Bilton is global gead of Multi-Asset Solutions at JP Morgan Asset Management
Brexit – a shock for markets, or a crisis?
Investors have been seriously wrong-footed by the result of the UK referendum. But the shock of City traders this morning is nothing compared with the stunned response of the people who thought they ran the country. The economic and political questions raised by this vote will not be answered for years, possibly decades. But the immediate questions for investors are how long the “risk-off” mood in markets will continue and how much damage it will do in the process.
Our first assessment is that this is a large shock but, ultimately, a local one.
- The UK economy will slow sharply. Our best estimate is that growth will slow from an annualised pace of 1.6% to around 0.6% in the second half of 2016, with a similar growth rate achieved in 2017. We can expect inflation to jump to 3% or 4% by the second half of 2017, as a direct result of the decline in sterling. That compares with a previous forecast of around 1.7%.
- We expect the Bank of England (BoE) to look through the rise in inflation. Policy will surely be looser than it would have been under Bremain. The BoE will make clear its willingness to offer emergency liquidity to the market, but it may well wait to gauge its response to the slowdown in economic activity. We also expect it will think hard before intervening to defend the pound. The fall so far today has been dramatic, by any standard, with the pound at one point falling to its lowest level against the dollar in 30 years. But the scale of the fall has been exaggerated by the rally preceding the vote. Arguably, a double digit decline in the currency is not an over-reaction to a policy change of this magnitude.
- The interplay of domestic and global factors is highlighted by the UK Gilt market, where long-term government bond yields barely moved in early trading. This may have been because domestic “risk-off” flows into bonds were being offset by foreign sales of Gilts. But Gilt yields moved sharply lower after the prime minister, David Cameron, announced his resignation. We would expect Gilt yields to be lower, over time, than if voters had opted to remain in the EU, given the “lower for longer” view on short-term rates outlined above. Put another way, we do not think question marks about sterling will turn into questions about the creditworthiness of the UK government.
- Further afield, growth in the eurozone will be dented, possibly strengthening the case for the European Central Bank to expand its quantitative easing – bond purchases – in the autumn. If there is a prolonged decline in global market confidence, the US central bank could find it more difficult to move forward with higher interest rates in the second half of 2017. Central banks in countries with “safe haven” currencies, notably the Japanese yen and the Swiss franc, may also come under pressure to ease policy to prevent these currencies rising a lot further.
These are significant consequences. But right now we do not think the Brexit shock poses an immediate threat to the global recovery. Over time, we would expect this reality to be reflected in asset markets outside the UK, particularly in the US, where the stock market has reacted sharply to a result which would be expected to have only modest direct consequences for the US economy. However, it could take some time before the dust settles and investors should expect plenty of volatility, as UK policymakers and the wider world come to grips with the consequences of this historic vote.
This immense shock for the UK will have an economic and financial impact on the rest of the world, but we believe that the fallout should be manageable, if policymakers respond appropriately and investors keep their heads. Whether the political implications will also be containable, particularly in Europe, is another matter.
Stephanie Flanders (pictured) is chief market strategist for Europe at JP Morgan Asset Management