Peter Wilson, Global Fixed Income Strategist
Brexit and Bonds — What Now?
- Though the UK’s Brexit was unexpected, initial moves were generally more contained than had been feared.
- Looking ahead, the keyword now is “uncertainty.” The process of negotiated European Union (EU) withdrawal may not even begin until new political leadership is elected in the UK. This may take months.
What it may mean for investors
- We would expect those markets closest to the epicenter of the vote to be most negatively affected and for longer. The pound and UK gilt yields may have further to fall.
The result of the Brexit vote was a surprise. Now that it has occurred, what can we say about the coming weeks and months? The future becomes murky for two principal reasons:
- First, because it is not known how (or even if) the UK’s exit from the EU will actually take place. We believe the timescale here will likely be years rather than weeks and months.
- Second, the Brexit vote potentially closes one chapter, but opens up other possibilities of adverse political events in the next year or so, both for the UK and within the EU and Eurozone.
In theory, the legal process by which a country ends its membership in the EU is clearly defined. In practice—especially given that such an event has never happened before—it is anything but. EU Article 50 of the Treaty of Lisbon (2009) defines the process. Article 50 says that the country (state) wishing to rescind its EU membership should notify the European Council (i.e., the collective heads of state or government of the member states) of its intent. This act (Article 50 notification) sets the clock ticking on a two-year period during which the leaving state (here the UK) would negotiate the terms of its EU withdrawal (unbundling of trade agreements, status of EU-related legislation, treatment of expatriate nationals, etc.). The vast scope and potential complications of such a negotiation should be clear. Also, the situation is further confused by the fact that Article 50 notification is not likely to occur until the UK has new political leadership. Prime Minister Cameron—who supported the “Remain” camp—has announced his intention to resign, staying on only to “steady the ship” until a new leader of the Conservative Party (who would be the new Prime Minister) can be elected by party members. This leadership contest alone is expected to take months (an expected date of September 2 has been announced). Further, given the disarray of the Conservative and Labour parties in the UK, and the extent of opinion polarization caused by the referendum, we should not rule out other scenarios. One is a new general election, which might be fought as a proxy “second referendum” on whether to implement the result of the “Leave” vote. This raises the possibility that the UK might not leave the EU after all.1
A second uncertainty is the possibility of “copycat referenda” on EU membership in other European countries. (We will not cover this topic in detail here—but we have discussed it in other recent reports.)2 Yet it is also possible that the spectacle of a bitter and polarizing UK Brexit debate, and an outcome in which the promises of the “Leave” campaign do not live up to economic reality, may serve as a chastening example of the dangers of flirting with populist alternatives to the status quo.
The Risks are Concentrated Closer to the Epicenter
In terms of currencies and bonds, where does all this uncertainty leave us, as we look at what to expect in the coming weeks and months? Monday’s second wave of post-Brexit market reactions gives us some clues. We would continue to expect that markets closer to the epicenter of the vote—that is, the UK—would see the largest moves, and those further removed will provide greater stability. Thus, the pound sterling, despite spiking to 1.32 dollars per pound on Friday, has evidently not yet found its bottom, and moved lower again this week. There may be a slow grind lower in coming months as the uncertainty continues to take its toll on business investment and consumer confidence. Likewise, UK sovereign bond (Gilt) yields moved lower still on Monday, below the one percent floor that held on Friday. Further falls in yields are foreseeable, if stocks continue to weaken, and the Bank of England stands ready to ease monetary policy to support economic activity if necessary. But Gilt yields are likely to lose attractiveness well before approaching zero—these are not German bunds. This point is underlined by the credit-rating-agency downgrades of UK sovereign debt that took place on Monday (Standard & Poor’s lowered its rating from AAA to AA, while Fitch reduced its rating from AA+ to AA).
The Spanish election result on June 26 (which, contrary to expectations, showed the establishment parties increasing their vote share) surprised many euro-pessimists and sparked a quick reversal in spread widening of Spanish bonds. Even so, it is hard to see further strong gains in either core or peripheral Eurozone bond markets in coming months. Core yields should be limited by extreme (near-zero or sub-zero) absolute levels, and further peripheral tightening is likely to be constrained by the real political risks that remain. The outlook for the dollar against the relevant developed-market currencies (euro, yen and pound), remains, in aggregate, neutral to slightly positive. These two considerations keep us underweight in developed-market bonds for now.
Further away from the epicenter, emerging-market credit—that is, dollar-denominated sovereign bonds rather than local-currency government bonds with attendant foreign-exchange risk—should remain relatively attractive on a yield and spread basis, and we remain evenweight here.
1 Gideon Rachman, “I do not believe that Brexit will happen,” Financial Times, June 28, 2016.
2 “What Brexit May Mean for Bonds,” Global Fixed Income Strategy Report, Wells Fargo Investment Institute, June 21, 2016.
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
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