A week on, where are we?
Friday 24th June feels like a long time ago – so much has happened since then. Sterling has dominated the headlines here in the UK. It has risen a little from the initial post-Brexit low of 1.312 against the dollar, but is still down a lot from the 1.50 level it traded at before the news.
The FTSE100 fell sharply on the initial news (around 8%), but has since made up all the losses. As of 1st July it is up over 4%. The FTSE100 generates around 75% of its revenue from overseas, so a weaker currency is helpful. The more domestically orientated FTSE 250 and FTSE Small Cap indices are down by around 7.5% and 3.5% respectively.
Government bonds have rallied with the 10 year yield moving to new all-time lows just after the Brexit news.
Spreads on UK corporate bonds widened after the Brexit news – by around 50bps on the sterling BBB index and by nearly 100 bps on the high yield index. Both spreads have since narrowed but only by a tiny amount.
Interest rate expectations have moved since the Brexit news. Markets had previously expected that the Bank of England might be tightening rates within a year. But now the expectation is that the next move will be a cut, and this view was strengthened by Mark Carney yesterday. Given that the vast majority of economists had stated that they viewed a Brexit vote as negative for the economy this makes sense.
Away from the UK there were ripples across the risk spectrum with the Japanese Yen and western government bonds rallying initially and the more risky areas of equity markets selling off. Moves over the past week are mixed. Italian equities are still down by around 10% whereas other markets experienced a wobble and have since recovered – Brazilian equities for example. Sector-wise, financials have underperformed while utilities, healthcare and consumer staples have outperformed. These sector moves go some way towards explaining the relative country moves. Emerging markets also benefits from the perception that major central banks around the world were more likely to ease policy in the wake of the UK news.
What does this mean?
With so much news, and noise, over the past week it is difficult to make sense of things. We would make a few observations.
- The genuine economic impact of the Brexit vote is very difficult to discern, ultimate outcomes are not known – by anyone! Politicians have a lot to sort out – can they delay triggering article 50? Do we remain members of the EEA, like Norway, or exit that too? What are the timescales involved in negotiating new trade deals with around 50 countries? The reality is that we know little about the event – all that has changed is the market’s confidence level about certain outcomes.
- Have we had enough new information to change our conclusions about the medium term attractions of various assets? Have financials markets become cheaper or have we had new information? It is hard to say that we have enough new information to make a decision as prices of equities are lower (less so now) but prospective fundamentals could be genuinely worsening. Our inclination is to think that a risk premium has begun to build in some areas, implying that markets may be exaggerating how bad the outcomes are. But we cannot be sure.
- Could the changes be significant enough to shift the political pendulum towards protectionism and away from free-markets? We would argue that it is too soon to know, but that the Brexit vote is consistent with dynamics across the world. These types of events can have the impact of loosening peoples’ views about what is possible politically, and with regards to policy. There becomes a far greater sense that ‘anything can happen’ and it feels like the range of possible outcomes has increased. A shift towards protectionism and trade barriers would be very negative indeed and could be the ultimate cause of inflation.
- Perhaps the most interesting development in markets is in developed government bonds. Many have been performing as a safe-haven asset, which is totally understandable as a knee-jerk reaction. Investors may be enjoying the journey and forgetting that high recent returns are effectively stealing from the future. At a nominal yield of around 1% the UK market is not offering a great prospective return distribution. For all the reasons cited above, we do not know what will happen next. But a bond yielding 1% can only deliver a decent investment return by moving to an even lower yield. We have seen yields head negative in other countries, which in the short term can deliver a positive return, but how sustainable is that? Interestingly, bonds have ignored some of the potential bond-unfriendly news such as the sovereign downgrading of the UK by ratings agencies and the possibility that inflation could be higher in the future.
Overall, despite the stabilisation in prices of some risky assets, it has been a traumatic week. It would be easy to conclude that levels of uncertainty have risen, but actually all that has happened is that we have been reminded that uncertainty is a permanent feature of the landscape. Arguably the greatest level of uncertainty occurred on 23rd June when the referendum took place. Since then market participants have experienced a wide range of emotions including shock, denial, anger and the beginnings of acceptance. No-one ever said it was easy.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.