For the second time in a little over 12 months, a UK vote has surprised analysts and commentators. The betting markets, often more accurate than the pollsters, also got it wrong on this occasion. While a lot has been said on the origins of this result, we will focus on the implications.
Firstly on gilts, the initial reaction has been for prices to rise and yields fall. This is understandable, as investors seek safe havens and avoid riskier assets. In addition, the UK bond market still offers positive yields, whereas in many other developed markets yields are zero or negative.
The assumption that UK economic growth will now be weaker, at least in the short term, means expectations for interest rate rises get pushed out further into the future, indeed the short end of the rates market is now pricing in further monetary easing by the Bank of England. Whether or not to cut rates or do more QE will be a tricky decision, with the need to balance growth and inflation carefully. Brexit throws up a difficult conundrum, with risks of lower growth and higher inflation than previously expected.
The Bank of England has announced it stands ready to provide liquidity to the UK banking sector should it need it. This is a sensible priority in the near term, as the country must avoid another credit crunch. Banks will hopefully not need to avail themselves of BoE liquidity, as the sector has substantially boosted capital and reduced reliance on wholesale funding over the past five years.
While corporate bonds spreads were initially pushed considerably wider, it was met with institutional buying, leaving investment grade spreads around 20bps wider on average. With political uncertainty and sterling volatility, it is likely we continue to see international companies shun the sterling market as a source of raising funds – keeping bonds in short supply. We expect the sterling corporate bond market to be quite illiquid over the summer, which means it remains vital to be invested in good quality stable companies.
In terms of winners, corporates with sizeable overseas sales and earnings should benefit – for example companies in the pharmaceuticals and natural resources sectors. We continue to be bullish on regulated UK utilities, due to the sector's stable nature. These companies may also receive a boost from higher inflation.
The most prominent loser appears to be the financial sector, where the prices of shares and corporate bonds have been hit hard. Lower for longer rates will weigh on earnings and there is a risk of rising bad debts should we witness a substantial near-term hit to growth. However, UK financial institutions have strengthened balance sheets considerably since the financial crisis and some underperformance was already priced in prior to the referendum.
We also believe that retailers could be negatively impacted, as the lower pound increases the costs of imported goods. Given the intense competition in the UK retail sector, it may be difficult to pass on these price rises to the consumer.
Looking more broadly, it is easy to see why risk premia for all UK assets may rise. The UK has just lost its AAA rating from S&P and there remains considerable political risk. There is no guarantee a new Prime Minister can unite the Conservative party and command a parliamentary majority, while the SNP is pushing for a second Scottish independence vote.
In addition to this, the UK still has the largest budget and trade deficits amongst developed nations. It will be of key importance for the UK to maintain a flexible competitive economy, which can help investment return once confidence is re-established.
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.
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