Russian roulette

The latest round of Brexit negotiations ahead of 31 October, the supposed date on which the UK will exit the European Union (EU), does not appear to be going well, with neither side seemingly willing to compromise. This lack of progress has put renewed downward pressure on sterling and gilt yields, as a ‘hard’ Brexit is deemed to be positive for gilts but negative for the UK currency. Yet the British Parliament has, it believes, taken ‘no deal’ off the table via the so-called Benn Act agreed last month, which compels Prime Minister Boris Johnson to seek an extension if ‘no deal’ is forthcoming by next week.

In my view, the market reaction we are witnessing reflects two things:

First, a further extension is not in the gift of the UK Parliament, but in the hands of the European Union’s 27 other member states, and there is a risk that one or more of them will reject the request, given there is no sense of a purpose or obviously better outcome from a further delay; purgatory is not an appealing prospect.

Secondly, another delay may avoid the worst effects of an immediate ‘cliff-edge Brexit’, but more months of uncertainty are likely to inflict further damage on investment activity and consumer confidence, weigh on economic growth as well as on the pound, and support gilts. The Institute for Fiscal Studies (IFS) estimates that private-sector investment has been 15-20% below the pre-EU referendum trend since mid-2016.

Gilt investors have so far benefitted from the never-ending story of Brexit (over-15-year gilts returned more than 22% in the year to 30 September 2019, for instance). Even previously hawkish members of the Bank of England’s Monetary Policy Committee, such as Michael Saunders, are now acknowledging that rate cuts may be needed even in the event of a deal being reached, such has been the loss of momentum.

From here onwards, risks seem to outweigh opportunities, however. Indeed, one could argue that gilt investors are facing a game of Russian roulette in which there is not just a single bullet in one chamber of the revolver’s cylinder, but multiple bullets. We list the potentially damaging ‘bullets’ below:

• If, against the odds, an orderly exit is agreed, multiple rate cuts will need to be priced out of the gilt market, as the economy is operating close to full employment and investment should pick up.

• The UK remains reliant on ‘the kindness of strangers’ as Bank of England Governor Mark Carney put it, with overseas investors owning approximately 28% of the UK gilt market. A disorderly Brexit could cause them to reconsider their exposure to gilts. The central bank could increase asset purchases and domestic investors may increase their gilt weightings as a ‘flight-to-quality’ move (versus other domestic UK assets), which would take up some of the slack, but a large buyer turned seller could well push gilt yields up.

• 
  Austerity has left the building. The UK’s Institute for Fiscal Studies (IFS) notes that as a result of prior announcements from former UK Chancellor Philip Hammond and more recent ones from his successor, Sajid Javid, in the next fiscal year spending will be £27bn higher than pledged in the governing Conservative Party’s 2017 manifesto. It will also not be far off the opposition Labour Party’s then spending plans, despite growth (and therefore government receipts) weakening in the intervening period. Even with a deal, the IFS estimates that the UK’s deficit will nearly double to £50bn, and the debt/GDP ratio is headed towards 90% (a level not seen since the mid-1960s). It predicts that the deficit will double again (to over £100bn) in the event of ‘no deal’, even if disruption is kept to a minimum.
  

• With a minority government in place, a general election looks almost certain, The outcome is unusually hard to predict, given the fact that Brexit cuts across traditional party lines and has led to the emergence of more ‘minor’ parties. A Labour government led by Labour Party leader Jeremy Corbyn would probably spend even more, and, if enacted, its more radical policies around nationalization might further erode the UK’s ‘safe-haven’ status.
  

• Rating agencies have already downgraded the UK since the 2016 EU referendum, and have indicated they will cut the rating further in the event of a disorderly Brexit. Nor will they look kindly on unfunded spending commitments. As we have seen before, small sovereign downgrades from very high levels do not necessary lead to higher government borrowing costs (indeed, the reverse was true in the US and Europe over recent years). However, the relationship between ratings and spreads for risk is not linear, and subsequent downgrades may have increasingly negative effects. In the event of a botched Brexit, a fractured political system and a debt/GDP ratio heading towards three figures, the UK would arguably resemble ‘Italy-on-Sea’ rather than ‘Singapore-on-Thames’.

All of the above factors ought to require higher bond yields as compensation for higher risk and/or greater gilt supply. In fact, the only ‘empty barrel’ in this ‘six-shooter’ appears to be a further extension, leading to a continuation of the status quo of low growth, low appetite for risk, and ultra-low gilt yields, but with the certainty that the ‘gun’ will be pointing at the UK’s head again in a matter of months…

Authors

Howard Cunningham

Portfolio manager, Fixed Income team