Government bond markets to remain supported after Brexit

Government bond markets after Brexit

 

After months on the campaign trail and reams of newsprint, the UK referendum on the country’s membership to the European Union finally delivered its outcome. Against financial markets and bookmakers expectations, 52% of the UK voters opted to leave the EU with a relatively high turnout of 72%.

This result took most market participants by surprise and the initial reaction saw global stocks and government bond yields fall sharply, while sterling hit its lowest level since 1985 against the US dollar. Investors are now dealing with the uncertainty surrounding the UK exit negotiations by dumping risk assets and resorting to the safe haven nature of government bonds.

The short-term consequences for the UK economy and its European partners include a hit on consumer confidence and a further deferral of corporate investment until a stabilisation of financial conditions, as well as inflation spiking on the back of the sharp currency depreciation.

Economists expect this combination of factors to trim 1% to 2% from UK GDP growth over the next two years, and some 0.5% in Europe. Policy uncertainty stands out as the main channel to weaken the UK growth outlook. External trade will also suffer, as UK access to its major export markets is reduced or made more costly by the implementation of new trade tariffs.

The deterioration in the UK economic outlook in the medium term may prompt the Bank of England to take supportive measures, such as rate cuts and/or resuming its quantitative easing programme. The impact on the European and US economies is more uncertain, but should be more moderate.

Besides the immediate hit on UK growth, the main consequence of this 'Leave' vote is a severe political crisis in the UK. It also raises broader questions about the viability of the EU project. Anti-EU forces are on the march and this poses much greater risks to the future of Europe than debt problems in peripheral nations, which have shown no desire to leave the monetary union.

With upcoming key elections in Italy, Netherlands, France and Germany, most European countries are now dangerously exposed. In the wake of the referendum result, Prime Minister Cameron announced his resignation, effective by October 2016, and the Conservative government will have to appoint a new leader who will run the exit negotiations with Europe over the next few years. In the meantime, we could see a revival of the Scottish independence issue, with Scotland widely supportive of EU membership.

Overall, this 'Leave' vote paves the way for a period of political and economic uncertainty, which we expect to have a negative impact on UK growth and potentially spill over to other European countries. This is very negative for sterling and to a lesser extent the euro, while the US dollar and Japanese yen are already capturing the flows out of Europe.

In terms of interest rates, government bonds are benefiting from the flight-to-quality and yields are expected to remain low on the back of central bank support measures. For corporate bonds, companies with significant UK revenues are expected to suffer, while UK exporters will reap the benefits of a weak currency.

 

Past performance is not a guide to future performance. The value of investments can fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.

This information is for professional advisers only. No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness. The views expressed in this document are those of the fund manager at the time of publication and are subject to change at any time without notice. The contents of this article are not intended as investment advice. The Canada Life Investments blog page features images licensed from Getty Images International. These images shall not be downloaded, republished, retransmitted, reproduced or otherwise used in any way. Aside from the above, and unless otherwise stated, Canada Life retains copyright in and/or has a right to use all contents of this website (including text and graphics) and such contents shall not be copied, distributed, extracted or modified without the express prior written consent of Canada Life unless for private, non-commercial use.

David Arnaud

David Arnaud

Senior Fund Manager, Fixed Income

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