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Brian Tora – Brexit; the impact on bonds

 

With the fallout from Brexit focussing mainly on equity and currency markets, Brian Tora considers the impact on bonds as we start to come to terms with what life might be like outside the EU.

Go on, admit it. Did you really expect the referendum result to turn out the way it did? More important, would you have expected the markets’ reactions to be quite as they were? There is little doubt that the Leave vote caught a lot of people unawares. The knee-jerk reaction which saw shares and the pound in a tail spin was, perhaps, the expectation of most. The Footsie’s sharp recovery, which brought it into bull market territory again, was rather less predictable.

With the benefit of hindsight, the rebound of an index heavily weighted towards global businesses generating the bulk of their sales and profits outside of the UK appears consistent, given the beneficial effect translating the numbers into a devalued sterling would have. In contrast, the pound stayed down against both the US$ and the euro, while European bourses also took hit. And our more domestically biased FTSE 250 Share Index had also failed to make up much lost ground in the immediate aftermath of the Brexit reaction.

Bond yields have collapsed

The positive way in which bond markets took the news is deserving of further consideration. Perhaps it should not be too surprising that, at times of stress, investors should opt for the low risk option of Sovereign debt, but with the weight of money driving yields down so far, risks are now emerging in this asset class. Ten year bonds now yield less than 1%. While this does not seem too bad compared with cash at present, it is worth reflecting on what might happen in the future.

In the shorter term the risks look minor. The US Fed has already indicated that Brexit is likely to result in the anticipated rise in interest rates being deferred further. And the Governor of the Bank of England has announced that a further cut in interest rates here will be considered to ward off any undesirable economic consequences of the referendum decision. Cash doesn’t look as though it will be competing for investors’ loyalty on a return basis any time soon.

A weakening pound

But the one major victim of the surprise result has been our currency. This is a reflection of the added layer of uncertainty now present in our economic outlook than anything, but knowing that an interest rate rise is no longer on the cards does not help. A cheaper pound does carry some advantages. Our exporters should be better placed to compete on world markets for a start, though this might take some time to flow through, given the complex nature of trade negotiations that need to be concluded in anticipation of our departure from the European Union.

Of more pressing concern is that our imports will cost more. Some, like oil, are priced in dollars, so the effect of a weaker pound will be felt across a whole range of sectors, including transport, which will influence the cost of distributing goods, pretty much straight away. This in turn will impact on inflation, which ultimately may mean the Bank of England will need to reconsider its low interest rate approach. Rising interest rates, should they occur, will influence the outlook for the bond market.

Belt and braces at the ready

While none of this is likely to make a major difference in the immediate future, it does raise the question of how best to play the bond market during the period of readjustment that is necessary as we come to terms with life outside the EU. Bond funds are, of course, wide and varied in nature. Bond managers themselves will doubtless be adjusting their portfolios to take account of the new circumstances facing them. And we must not forget that other influences will come into play, not least general elections throughout Europe, a Presidential election in the US and the parlous state of the Italian banking system.

Investment is never an easy or straightforward matter. The next couple of years promises to throw up plenty of challenges for those managing portfolios or assembling them on behalf of clients. In such times the old maxim of being paid to hold an investment makes good sense in my view. Sovereign debt here and in the US does not meet this criteria at present. But care on quite where to place your bond bets will be crucial.