Following the initial shock of the Brexit, the critical issues for markets will now be the path that the UK will choose for exit and how the vote will affect the political backdrop in other European countries. We expect to see a continued ‘flight to quality’ in the fixed income market while uncertainty prevails. Risk premiums will likely remain high while the uncertainty of leadership in the UK remains an overhang. In the shorter term, emerging market debt seems relatively insulated; however, there are concerns over the potential for longer term problems. Global credit markets have reacted negatively, as might be expected, but this may provide investors with attractive buying opportunities.
UK growth likely to weaken, with interest rate cuts expected
In terms of the UK economy, until there is confidence in the UK’s position, there will be a drag on business confidence. This will see business investment and employment slow, which will inevitably be a drag on UK growth. As a result, we expect economic data in the UK to weaken in coming quarters. The Bank of England could react to this by reducing interest rates from 0.50% to possibly as low as 0%, but it will likely need some concrete evidence that the economy is being negatively affected before acting.
Most forecasters are still in the process of reassessing their outlooks, but Bank of America now expects the UK to have a mild contraction lasting three quarters, reducing its forecasts for UK growth to 1.4% in 2016 and 0.2% in 2017. Inflation will be affected by the move in British pound sterling, but further falls would be needed to increase inflation to a level where the Bank of England would potentially worry given the very low current levels.
Flight to quality in developed fixed income markets
We expect the uncertainty premium to persist for some time as the exit process will be negotiated over an indeterminate period. Overall, we have observed an initial flight to quality, with Gilts leading the bond market on an over 30 basis point (bp) rally in yields, while US Treasuries were a close second, rallying over 20 bps on the day after the vote. Gilts have continued to rally despite the indication that S&P will likely downgrade the UK’s credit rating. The European periphery was the hardest hit on the news, with Spanish and Italian government bonds selling off more than 15 bps.
A July rate hike for the US Federal Reserve (Fed) now seems very unlikely, with market implied expectations of a rate cut now exceeding the probability of a rise. The Bank of England will likely remain on the sidelines until the dust settles, but remains in play with increased market implied expectations for a rate cut within the next several meetings.
In currency markets, the British pound fell over 7% as of mid-day trading on June 24, and is off more than 3% mid-day on June 25, while the broader foreign exchange (FX) market sold off versus the US dollar. The Yen remained the top performer on the day, up over 3.5%.
Emerging market debt relatively insulated
The impact on external debt has been limited so far. Spreads are 30 bps wider but US Treasuries are 20 bps tighter and overall the JP Morgan Emerging Markets Bond Global Diversified Index lost only 0.6% on 24 June. Local rates were 10 bps tighter in Asia and 10 to 20 bps wider in Latin America and Central & Eastern Europe, the Middle East and Africa (CEEMEA).
Most of the initial risk aversion shock was felt in the FX market and EM currencies are on average 2.75% weaker versus the US dollar.
Overall, as an asset class, emerging market debt has been relatively insulated from the initial Brexit surprise. However, in the long term, Brexit could have an impact on EM fundamentals through other channels, particularly for central and eastern European countries. Indeed, the UK is a significant trading partner and foreign direct investor in the region. Romania is the most exposed when we consider exports to the UK, while Russia, Poland, Czech Republic and Romania are exposed in terms of imports from the UK.
Beyond trade and financial considerations, we can also envision a rise of political risk in the region. Poland and Slovakia are already openly criticising the EU and the anti-EU rhetoric is likely to increase further. The Euro adoption process will likely be stalled as well. Ultimately, increased political risk may further delay the absorption of EU funds and Poland, Hungary and Romania are the biggest net beneficiaries from the EU budget.
Global credit has reacted negatively, but could provide opportunities for investors
Credit markets reacted negatively to the UK’s decision to leave the EU. It started with Asian credit, but European markets soon followed suit, with credit default swaps (CDS) as well as cash and bonds trading down. Sterling credit issuers were most affected, while price effects for Euro credit were more muted, given the ECB’s bond buying programme. The basic resource sector and banks suffered heavily. We expect trading in US credit to take its lead from European markets. In our view, the correction in valuations and market volatility could provide buying opportunities in some fundamentally strong credits.
Andre Severino is Co-Head of Global Fixed Income at Nikko AM.
