It’s alright

Brexit is either going to happen in the next two weeks, or is going to be delayed, or is never going to happen. The British parliament is divided, as are the members representing the two biggest political parties. The country is fatigued, and some elements of economic life are suffering. Even if and when there is some certainty, the longer-term trade arrangements for corporate UK remain very uncertain, although we are led to believe that there will be a “beautiful trade deal” with the United States. The markets are not moving because no-one knows where to move to, although the pound has found some relief from the reduced chances of “crashing out”. Meanwhile, the technicals in the bond market are very supportive. There is not a huge amount of net new bond issuance this year, either from the government or from the corporate sector. Rates are on hold so UK corporate credit, which can yield north of 3% in the lower reaches of the investment grade universe, looks reasonably solid. One word of caution though – there is nothing to say things can’t get even worse as far as the political situation goes. To keep sane, my advice is to focus on the football and listen to Britpop!  

 

What a mess

You can find information on most things on Wikipedia. Now whether what you find is factually correct is another question, but at least the online free encyclopaedia will give you background information on whatever subject matter you are researching. After typing in “Britain, coups” I was relieved to see that, outside of periods of war, the last time someone forcefully tried to knock the British (English) government off its perch was in the 17th century. Specifically, it was when Oliver Cromwell became the Lord Protector and put in place military rule after overthrowing parliament in 1653 by storming the House of Commons with armed musketeers. By all accounts Cromwell had become increasingly frustrated at the inability of parliament to take some important decisions in the wake of the execution of Charles 1 in 1649. As Lord Protector, Cromwell intended to re-unite the country after years of infighting under a new constitutional framework. Different times of course, but after another week of high-drama around Brexit, it makes you think. Thank goodness democracy, however weakened, is well-entrenched and the prospect of tanks in Parliament square or armed brigadiers firing pistols into the roof of the chamber is a pretty non-existent one. Still, if we are rejoicing that a violent coup is not going to be one of the outcomes of Brexit we are still in a dire place. There is plenty of dissatisfaction with parliament, plenty of criticism of MPs, and some of that is verging on vitriolic. In the words of Elvis Costello’s “Oliver’s Army” you could not be criticised too much for thinking “…and I would rather be anywhere else but here today”.

 

Holding back

The events of the week have not cleared the outlook for Brexit. Unless this changes, then the uncertainty that has plagued the economy for the last two years will persist. Many economists estimate that UK GDP is some 2% lower since the referendum than it would have been in a business-as-usual context. The official data show that capital spending growth was negative in 2018 and has been significantly less strong than in the UK’s competitors (in what has been a period of relatively robust global growth). This week we saw another weak report from the Royal Institute of Chartered Surveyors (RICS), pointing to coming weakness in house prices. The house price balance stood at a reading of -28 in February and is closer to the lows seen in 2009 and late 2010 than it is to the recent cyclical high of +56.7 in 2014. This measure has been steadily falling since the end of 2016 and has been in negative territory since the middle of last year. Higher stamp duty on residential property transactions has surely played a role, but European citizens leaving the UK and the general lack of confidence amongst householders must have also played a role. Any long-term observer of the UK economy knows full well what an important role the housing market plays as a barometer of overall economic well-being. While there may be a suggestion from this week’s events in Westminster that a “no-deal” Brexit has been taken off the table, most private sector firms or individuals are unlikely to commit to any medium-term capital plans until this has been confirmed and until they have seen what deal or other arrangement is going to be in place. While the economy may have held up better than some thought, the lack of investment does not bode well for ability of the UK to compete in the future. 

 

Credit, relatively solid

Having said all of that, it remains hard to see where the Brexit premium is in UK financial prices, certainly in the bond market. There is no obvious Brexit premium in credit spreads. For the corporate bond market as a whole, the spread above government bonds is around 30bps higher than the same spread for the European corporate bond market. Given that the UK market has more duration, that is entirely reasonable. Moreover, it hasn’t really changed since the referendum. Comparing different sectors between the UK and European credit markets, the story is the same. There has been no clear widening of UK credit risk premiums relative to Europe since June 2016. Against the US, spreads are wider but that trend actually began long before the vote and even today, at around 30bps, is well below levels seen in the post-Global Financial Crisis period.  I suspect that the explanation for the lack of Brexit premium in the sterling credit market is that it is owned mostly by UK investors so the risk of capital flight is limited. In addition, like elsewhere, financial repression policies have forced investors into credit when government bond yields have been very low.


Rates on hold, limited borrowing

This is not to say the sterling credit would not under-perform in a “no-deal” scenario. The economic uncertainties (most forecasts are pretty bad under no-deal) would surely lead to wider risk premiums on UK corporate debt, although, like in the equity market, there would be some compensation provided by a weaker pound (higher sterling value of foreign export revenues would support debt servicing to some extent). At the moment, the UK corporate bond market is in a way being supported by the uncertainty around Brexit. The Bank of England is on hold and we can’t really see it hiking this year. Companies are not investing, so have a much reduced need for borrowing. As such, the supply and demand dynamics in the bond market are supportive with significant negative net issuance expected over the course of this year. With the BBB-rated segment of the market providing 200 bps on average above gilts, it’s hard for UK investors to be unduly negative on the corporate bond market. That is, of course, tautologous because if they were more bearish, spreads would be wider. A 3% plus yield on a portfolio of BBB rated sterling corporates is not bad. Indeed, 40% of the BBB-rated bonds in the sterling credit market have a yield of between 3% and 4%.    

 

Inflation risk premium

Inflation is the one area where there is a bit of a risk premium. Inflation linked experts always look at the 5yr-5yr forward yield (as it removes distortions from the market). The UK inflation break-even is trading at 3.6%, compared to around 3.0% before the referendum. This is an inflation premium of 175bps versus the US and 215bps versus Europe (the current spread between UK RPI and inflation rates in the US and Euro Area is 100bps and 130bps respectively). The market is expecting UK inflation to rise significantly relative to inflation in the US and Europe. Most people think this is related to an expectation of a weaker pound (which is not of course reflected in the forward currency market where forward rates are determined by interest rate differentials). If you believe the inflation market has it right in that a weaker pound is going to drive import prices higher, and you have foreign liabilities, it makes sense to hedge the currency risk because the forward market is giving you relatively attractive rates (the forward rate for sterling against the dollar for the end of 2019 was 1.3450 at the time of writing versus a spot rate of 1.3265).    

   

Changed times

While a Cromwellian strike against the British parliament is not a likely outcome, it is difficult at this stage to see what is. There is a lot of talk of a second referendum but that is probably both a low probability and something that would not give a particularly decisive result. The most likely outcome, it seems – and I stress, at the moment – is some delay to Brexit by an agreed extension of Article 50 with the additional time used to try and get the prime ministers’ deal agreed. Meanwhile, firms will continue to hold off on investment plans, households will think twice about moving house or making big purchases. Furthermore, my own view is that the political landscape has changed permanently and the recent wave of resignations from MPs from both of the two big political parties to become independents is likely a taste of more to come. Who knows when the political landscape in the UK will allow focus to return to issues such as infrastructure, health and education, boosting productivity, and ensuring the UK is competitive on the global stage. The downside economic risks remain a concern under such a view. Holding some assets in gilts and some in foreign government bonds, notably US Treasuries, seems like a reasonable option strategy should the worse-case economic outcome materialise. 

 

Viaje a Madrid

Away from politics and economics (or maybe not), the UK is still very much involved in one European institution – the Champions’ League. Today we had the draw for the quarter-finals, a draw which involved four English football clubs. There are clearly no easy games at this stage and being drawn against Barcelona is arguably the most difficult of all the potential outcomes for Manchester United. Realistically, United are somewhat fortunate to be at this stage of the competition and to be given the opportunity to revisit one of our great European adversaries is a great honour. United are due a victory against the Catalans having lost in two finals in recent years and having won just 3 out of 11 previous meetings since the early 1980s. Our fixed income team has interest in most of the quarter-final ties given we have fans of all the English teams and Ajax. Forget Brexit, bring on the footy. 
                                                                    
Have a great weekend,
Chris

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