Still here…

Britain was supposed to have left the EU today. As you may have noticed, it hasn’t. The future remains uncertain, especially as there will be more political change. The real work will begin once the withdrawal has taken place but with a new UK prime minister, possibly a new UK government, and wholesale changes in the European Union and Commission this year, who knows how that will go? Are you ready for Brexit 2.0?

Should we stay or should we go?

To paraphrase Oasis, “today was gonna be the day that the UK left the EU, by now you should’ve realised that this Brexit is not going through”. It’s March 29th, the British parliament has still not ratified the Government’s Withdrawal Agreement and the precise terms on which the United Kingdom leaves the European Union, and on what date, are still not known. At the time of writing the government was trying once again to get cross party support for the Withdrawal Agreement and it was looking as though it may have a better chance this time with several MPs previously opposed to the deal saying that they will now support it. They are being driven by the realistic alternative of there being no Brexit. We have learnt that with Brexit, little can be taken for granted and things change quickly, so whatever I write just now might be irrelevant by the time most of you read it. However, for “Remainers” every day from now on is a bonus, as the UK continues to be a member of the Single Market and the customs union, the European Court of Justice continues to be the highest court, and travellers can still pass through the “EU Citizens” line at passport controls throughout the continent - even if most know that this is going to be a limited state of affairs. For “Leavers” every day from now is a betrayal of the results of the June 2016 referendum meaning that the UK still does not have control of its borders, its money, and its laws. For the majority of British citizens some level of closure is desired. All political outcomes remain possible at this stage and, after Prime Minister May tried to horse trade her own destiny for support for her deal, it is clear the UK will have a new leader before 2019 is done with. What political make-up the House of Commons will have at that stage remains anyone’s guess. Remember that the precise details of the UK’s future relationship with the EU will only be determined once the UK has left and could take a very long time to agree. Those discussions will likely take place with a very different cast of characters on both sides.

Sterling markets have done well

With the Brexit path still highly uncertain it continues to be very difficult to construct investment strategies around that theme. As I have discussed before, there is no identifiable Brexit premium in the UK credit market. The performance of the UK gilt market has been similar to that of other core government bonds and its future evolution will depend a lot on what the Bank of England does in response to the economic consequences of whatever kind of Brexit we eventually get. The first quarter has been great. The gilt market index has generated a total return of 3.2%, with the inflation-linked index posting a massive 6.7%. There are particular UK technicals at work – the indices are much longer in duration than in the Euro or US government bond markets and there continues to be very strong demand for the long-end of the market. At the 10-year maturity, the benchmark yield has fallen below 1% and the interest rate market has no Bank of England tightening priced in. Sterling credit has done well as a result, generating 2.5% return so far in 2019 with spreads narrowing by 25 basis points (bps) since the beginning of the year.

There remains a slight risk

It is probably highly unlikely but a “no-deal” exit continues to be the tail-risk scenario that could really disrupt the UK economy and markets in the short-run. The potential impact on trade and movement of people is obvious and the knock-on effects for growth and corporate earnings could generate some divestment from the UK by foreign investors. Banks are well capitalised in the UK and have plenty of liquidity, but one could imagine some funding squeeze if there was a deposit flight under an extreme Brexit scenario. The consensus trade on that scenario is clearly a weaker pound. But I am not sure how much to worry about this as a no-deal seems to have been ruled out by parliament and the only way it can happen at this stage is through either a political vacuum within government or the concerted failure of government and parliament to agree on an alternative, be that delaying Brexit further, agreeing on May’s deal, including the future relationship, or revoking Article 50. I guess if one had to hedge it would be to buy some foreign currency assets to protect against both valuation and liquidity issues.

No rate hikes, buy bonds

In the broader fixed income world we are ending the first quarter of the year with very strong total returns across all sectors. The changed monetary outlook and the increased risks of a more pronounced economic slowdown over the next year have already led to a significant flattening of the US yield curve. According to market pricing, the next policy move from the US Federal Reserve will be to cut interest rates. I don’t buy into that on a purely macro-view as the balance of economic data remains positive and financial conditions have eased considerably since Q4. However, the barrier to further Fed rate hikes is a high one. So, on balance I can understand why there is still a preference for long-duration strategies in the US curve. If the Fed were to cut because the end of the cycle was starting to be confirmed by rising unemployment rates and slowing activity, then the cuts would be significant. This is particularly so if inflation continues to trend lower. To underpin inflationary expectations in a quickly slowing economy, the Fed would need to be very aggressive so that even a 10-year yield at 2.4% would look attractive. This is not my base case and I am still open to a scenario in which rates go up again, but one can see the option value in holding long-dated Treasuries as a hedge against the recession coming sooner rather than later.

Value? Yield?

In the meantime, where can we find value in fixed income markets that have generated abnormal returns over the last 3 months? Risk spreads are back inside the pre-Q4 2-2018 trading range and government bond yields are heading towards the 2016 lows in Europe and to below the level of policy rates in the US. For us the credit markets still offer some value. Investors continue to be rewards in terms of higher yield for taking on additional ratings risk and additional maturity risk in credit markets. In other words, the credit curve is far from inverted. Take the extreme in the US investment grade space. The yield on the 3m Treasury bill is 2.42%. The yield on the BBB-rated above 10-year US corporate bond index is 4.9%. Experienced investors in credit markets will retort by saying that this spread used to be much higher – it was 600 bps after the financial crisis and as high as 400bps in 2016. That may well be but over time risks in credit markets have diminished by reduced macro-economic and monetary policy volatility, and increased structural demand for fixed income. The point is that if investors want yield for income, they need to take on more credit and maturity risk. This holds true for the US and other markets. And if you want to really boost yield then the sub-investment grade market provides yields above 6.5% in the US for around 2 years of duration (over 3.5% for the same in Europe).

Bar-bell

So the trick in fixed income portfolios is to take risk to get higher yields but also to have some hedge against a worse economic outcome. That is achievable in an unconstrained broad based fixed income strategy but could also be constructed in a multi-asset portfolio with duration sitting alongside credit and equities. Long government bonds provide the recession and reversion to monetary easing hedge, long higher beta credit provides the potential for return enhancement, even if we have to admit that everything is getting a bit “Stella Artois” – reassuringly expensive.

At the wheel

When Jose Mourinho was relieved of his duties at Old Trafford, Manchester United’s season was going nowhere and a top-four finish looked very difficult to achieve. The decision to appoint Ole Gunnar Solksjaer as interim manager in December was a brilliant one. The decision to appoint him permanent manager yesterday was even better. United are still not in the top four of the Premier League but with eight games to go they have a very good chance of securing entry into next season’s Champions League with games against City and Chelsea still to come. It is probably one of the most competitive Premier League competitions for many years and to finish in the top six, never mind the top four, after the start that United had is quite an achievement. All United supporters must now hope that the management of the club fully backs Ole in the transfer market because there is a clear need to strengthen the squad, especially in the defence and midfield positions. Despite Brexit, I feel that a number of new players could be joining the English league this summer given the strength of the game, represented by four English clubs in the quarter finals of the Champions League and the excitement around Gareth Southgate’s young England team. Ole became in legend in the Camp Nou in 1999, hopefully his team can do the same against Barcelona in the quarter finals.

Have a great weekend,

Chris