Our Thoughts on Brexit
With the United Kingdom (UK) voting to extricate itself from the European Union (EU), market observers may be wondering what, exactly, investment managers are watching. While the extended implementation period means much is yet to be determined, there are some themes emerging in our thought process that we would like to share with our clients. Of course, this list is not exhaustive and new developments are likely to impact our thinking. To that end, as material events arise over the coming quarters, we will keep you updated should our views change. For now, our considerations include the following:
- Subject to potential Bank of England (BOE) / European Central Bank (ECB) action, sterling will likely remain weak against the euro and dollar, with further downside risk as political, economic and structural uncertainty are expected to drag on confidence, gross domestic product (GDP) and private investment.
- We expect a risk-off trade to persist globally, keeping the dollar strong, safe-haven security yields low (i.e., U.S. Treasuries) and spreads relatively wider. Volatility should remain high as a function of news flow, placated somewhat by central bank activity.
- We currently see a long tail, as UK leadership is fragmented, Article 50 has not yet been invoked (Article 50 is the provision in the Lisbon treaty that sets out how an EU country might voluntarily leave the union) and agendas will be multidimensional. The agendas potentially include those of the 27 members that must ratify the UK's exit, creating complexity. The long period of uncertainty is itself a risk factor that delays consumer, business and market confidence and restrains demand, capital and labor investment. 'Next-it', the idea that other EU member states may also vote to leave, is an outside risk in our view, but we do believe it will contribute to volatility.
- The UK financial sector has vulnerabilities but is fundamentally sound. In the near term, wholesale funding conditions externally may tighten, but BOE / ECB operations will provide liquidity support. Over the longer term, there is uncertainty as to the impact on operating structure, competitiveness and cost structure driven by potential loss of passporting rights, as well as likely economic slowdown and the potential for increased UK unemployment.
- Nonfinancial UK corporations will be impacted in different ways, but for our coverage of diversified companies, we view the impact as primarily an equity story. Cost of imports will rise in sterling terms, while exports will benefit from weak sterling, offset by uncertain change to continental trade terms. Confidence will drag consumer demand. Domestic UK industrial activity should slow on weak consumption and marginal trade friction, which should leak further into lower capital investment. Labor inflation may accelerate as free movement of labor restricts.
- S&P and Fitch each downgraded the UK to ‘AA' with Negative Outlook, with S&P also noting concern for the future reserve currency status of sterling. Moody's Outlook is now Negative. We don't anticipate corporate rating actions as a direct result of Brexit or the sovereign downgrades, although negative outlooks should not be surprising.
Investment Implications for Portfolios
We expect that the risk of further dollar strengthening and the general tightness of global financial conditions will delay a Federal Reserve (Fed) rate hike, keeping Treasury yields range bound. We believe the general backup in spreads overstates the change in credit risk, view the current pricing to be attractive and will continue to be in the market to the extent valuations reflect the elevated political risk and expected volatility in financial performance. We expect the domestic issuer impact to be muted vs. foreign issuers; however, our call for two rate hikes in 2016 and the resulting higher bond yields we had been hoping for earlier in the year have been reined in by Brexit.
Robert Boucher, Director of Credit Research, is responsible for the firm's credit research efforts. He chairs the Taxable and Tax-Exempt Credit Committees. In addition to managing the credit research team, Robert is actively involved in credit research within a number of sectors. Robert began his financial industry career in 1999. Prior to being named Director of Credit Research for the firm, Robert was a principal credit analyst with responsibility for credit research within the industrial sector. He was an active participant in the Taxable and Tax-Exempt Credit Committees and a key contributor to the firm's broader investment process. Before joining U.S. Bancorp Asset Management in 2010, Robert was vice president of private placements with ING Investment Management. Robert earned a B.S. in finance from Saint Cloud State University and an M.B.A from the University of St. Thomas. Robert holds the Chartered Financial Analyst designation and is a member of both the CFA Institute and the CFA Society of Minnesota.
Subject to its fulfilment of conditions under the relevant single market directive, a firm authorized in a European Economic Area (EEA) state is entitled to carry on permitted activities in any other EEA state by either exercising the right of establishment (of a branch and/or agents) or providing cross-border services. This is referred to in Financial Services and Markets Act 2000 (as amended) as an EEA right and the exercise of this right is known as ‘passporting'.
Source: Bank of England.