Informative and entertaining
October 19, 2018

Chris Iggo, CIO Fixed Income, AXA Investment Managers, serves up his always hugely informative and entertaining end of the week essay.

Summary  -  Brexit is an intriguing political drama, taking up more radio and television airtime, and more online and newspaper space than any other subject (at least in the UK). Yet the markets don't know what to do with it. The outlook is so uncertain that investors are finding it difficult to price in any particular outcome. Contrast that with Italy. Even though an Ital-exit is extremely unlikely, markets have priced in a credit risk premium in Italian bonds that reflects some combination of fiscal slippage and a longer-term credit risk that is higher than the rest of the major euro member countries. With equities having a typical October, risk-off concerns have ratcheted higher in recent weeks. For all the global growth euphoria at the beginning of the year, bonds have outperformed equities in Europe and could easily do so in the US by close of play. Bonds, you "gotta love'em"!

What is the Brexit effect? –  In the year to the end of September, a period during which the political atmosphere around Brexit negotiations became increasingly tense, the local performance of the UK government bond market (gilts) was better than that of US treasuries and European government bonds. It was the same for inflation-linked and corporate bond. US dollar based investors who invested in UK fixed income during that period and hedged their exposure into US dollars would have enjoyed returns that were much stronger than those provided by US government, investment grade or high yield bonds. Over the same period, the Bank of England's trade-weighted measure of the sterling exchange rate was flat – sterling went up in early 2018 and down in the second half of the year. Again, in local currency terms, the UK stock market didn't do too bad on a relative basis, especially compared to other European bourses. So looking at market performance it is difficult to see, from a top-down perspective, what the impact of Brexit has been for investors.

Growth has been in the middle of the pack  –  At the macro-level, UK growth has not been that big a disappointment on a relative scale either. Since beginning of the recovery after the financial crisis – and remember the UK was pretty badly hit given what happened to the banking sector and given the fiscal tightening that followed – UK GDP has recovered at a pace behind that of the US, Canada and Germany but ahead of other G10 countries. Since the 2016 referendum, GDP growth has averaged 0.4 percent per quarter. That compares to 0.5 percent  for France and 0.53 percent for Germany and 0.35 percent in Italy. Conceptually it is possible to believe that investment decisions have been impacted by the uncertainties over Brexit but the evidence is not fully supportive of that view – growth has not hit some kind of Brexit brick wall. At least not yet. Moreover, as this week's labour market report confirmed, there are some positive aspects to the UK's economic performance. The unemployment rate remained at 4.0 percent (2.6 percent on the claimant count measure) and, suggesting further that the labour market is quite tight, jobs growth appears to have flattened out but average earnings growth has picked up. August saw the pace of regular pay grow to 3.1 percent on a year on year basis, up from 2.9 percent previously. Real average earnings growth is back in positive territory and, although retail sales growth fell back a little in September, the y/y growth rate has been significantly higher in 2018 than it was in 2017. Consumer spending is not booming, and there have been plenty of examples of bad news from the UK High Street this year, but neither are consumers hiding away.

No clear investment views – I've attended a number of sell-side events in recent weeks, at which investment bank traders and strategists share their views with clients. Brexit has been amongst the most common topics for discussion but unlike trade or the Federal Reserve's interest rate policy, it is a topic where no-one really has a view on the market implications of Brexit or is able to suggest trade ideas or investment recommendations. That's of course because no-one, not even in the "temples of knowledge" that exist in the City or on Wall Street, has a clue on just how things are going to unfold. As I write, Prime Minister May is putting on a brave face, suggesting that a deal is close at hand, while back home it seems a growing number of members of her own Party are sharpening their knives. Radio talk shows and twitter opinions are vitriolic on the subject of Brexit and whether or not the May government is delivering the "will of the people". At the same time, prominent people are suggesting that the UK could face a very bleak future if there is a "no-deal" exit from the European Union. There is the uncertainty about domestic politics, the legal Gordian knot that is dealing with the ‘Northern Ireland issue', the objectives of the EU is securing the credibility of the single market and the customs union and, not least of all, the medium term economic implications for growth, employment and trade. While most in the markets feel that a deal will be done, at the last minute, I would venture that not many people would say that such a deal would have widespread support. The extreme Brexiteers and the extreme Remainers won't like it. The two main political parties are split internally over the issue and will need to provide some definitive ideas on how to manage the UK post-Brexit before the next planned general election in 2022. Labour wants to win power but its leadership is ambivalent at best over Brexit and ideally wants to be able to subsidise British industries as part of its plan to increase state ownership of the economy over time. The Conservatives look as they will be mortally wounded by the Brexit issue and by the time campaigning for the next election gets underway there could well be different individuals putting together the manifesto and, perhaps, even a new political party that tries to salvage what remains of support for a social market economy with an internationalist face. Political risk is something that needs to be considered in assessing UK financial assets.

Gilts look expensive – The market reaction to Brexit will entirely depend on the details of any deal and the ability of market participants to make any sense of such a deal. In addition there is going to be a transition period of at least two years during which the exact details of the terms of the future relationship with the EU will be decided as will any trade deals with third parties. That together with the political uncertainties ahead of a next general election will be hard for market participants to allocate a risk budget to. So to have a view on UK assets perhaps requires investors to focus on valuations and the fundamental outlook with the obvious attached Brexit-related risk premium. This is not easy though. Take the case of gilts. The 10-year yield is currently 1.58 percent. That compares with a base rate of 0.75 percent, a spread of 83 basis points. In the US the equivalent spread is 95 basis points (bps) and in Germany it is 87 bps. So from a curve point of view, gilts are a little richer than other markets, although this is very marginal. Relative to inflation, the current gilt yield is negative to the tune of 82 bps compared to a positive real yield in the US Treasury market (91 bps) and a negative 43 bps in Germany. So in real terms, gilts are not great value. What about the outlook for rates? Well, the Bank of England appears to be as confused as everyone else about Brexit but inflation. The labour market is tight, inflation is at the top-end of the Bank's target range, producer pipeline inflation is high and wages are picking up. Normally that would suggest further interest rate hikes with the Bank moving towards a neutral monetary stance. So on the basis of all that, gilts look expensive and yields should rise. Moreover, despite a relatively low level of foreign ownership in the gilt market, if the Brexit outcome is looking more negative, then some selling could occur by overseas investors (though I would not put much emphasis on that last point).

But a safe-haven premium may keep them rich –  Having said all that, gilts may very well be benefitting from a safe-haven risk premium. Whatever the implications for the private economy of Brexit, the UK government will still make good on its debt. As long as there is uncertainty about Britain's future relationship with the EU – and that could be for years – that safe-haven premium might remain. But jump forward to a distant day in the future when Britain has finally left the EU and has forged trade deals with other countries. What will be important then? Obviously the performance of the economy and Britain's attractiveness as a destination for investment (will autos companies and rich foreign residential property buyers still view the UK in the same way?) will be important determinants of the value of sterling and the level of interest rates. The UK has, unlike Italy, retained an independent monetary policy and its own currency so there is no risk of redenomination. Investors may, however, need more of an inflation risk premium in the future, particularly if inflation targeting is given less prominence and fiscal policy is used to offset the disruption to growth that is bound to happen. If the country is ruled by a party that engineered Brexit and the economy takes a hit from Brexit, wouldn't the government do something to offset the bad news in order to deliver the promises so sought by the "will of the people"? Given public demands for more spending on the National Health Service and other public services there is a risk of fiscal slippage in years to come. Gilt yields might end up being closer to Treasury yields than Bunds. 

Sentiment – It's difficult to isolate the idiosyncratic element of UK asset performance. Sentiment is weak and uncertainty is high, but recent market performance has been in line with other markets. Even sterling has stabilized. Given the increased tension over Brexit negotiations and the higher risk of a "no-deal" exit, the pound has actually risen against the dollar and the euro since early September. In my opinion, a significant turn for the worse in the outlook for a deal, or for political stability in the UK, would see the pound testing the lows of earlier this year. This in turn might impact on gilt yields through the increase in inflation expectations. On the contrary, given that sterling is relatively weak on valuation measures, the upside might be greater on a deal that allows Prime Minister May to stay in power and get the UK through to a transition period. Maybe then a lot of the sniping would subside and political frictions would start to align around the 2022 election instead. For a period though, there may be some relief.

The other EU headache – Italy does not want to leave the European Union but it is causing Brussels just as many, if not more, headaches as the UK. The Italian budget has, apparently, not been enthusiastically received while the coalition in Rome has started to reveal its own internal divisions over what parts of the economic programme should be emphasized over others. The EU leadership has told Italy that the proposed deviations in the budget plans from the previous fiscal proposals were unprecedented. Clearly, the EU is concerned about long-term debt stability in Italy and the moral hazard attached to allowing a more expansionary fiscal stance. This is not likely to be resolved anytime soon, so the risk is that Italian bond yields move higher (10-year currently at 3.75 percent, the highest yield since early 2014). While the UK exit is a mess, Italy has much more to lose should from putting itself in a position where its own membership of the EU might be questioned. While this risk is very remote, markets have a tendency to go through periods of pricing in remote risks. Who is to say that the BTP-Bund spread won't re-test the highs seen during the 2012 European sovereign crisis? Indeed, the peak of the spread in December 2011, at 528 bps is closer to where we are today than the tightest post-crisis level of just below 100bps seen in 2015. Either the EU has to soften its opposition to the proposed increase in the Italian deficit or the populist coalition in Rome has to row back on promises it made in the election earlier this year, which at the moment does not seem likely. 

One-off or all-off – A number of countries have been punished by credit markets in 2018. Argentina and Turkey in emerging markets and Italy. In that context it is interesting that the UK has managed to avoid a serious hit to its financial markets. What is interesting is that these individual country events have only had limited contagion on other markets. Yes, the Spanish government bond spread against Germany is higher but by significantly less than the Italian move. Yes, other emerging market spreads have widened but nothing like the case in Turkey and Argentina during the summer.  Investment grade and high yield credit spreads are wider but volatility has stayed relatively low. My concern is that, at some point, these idiosyncratic moves will all add up to a more significant systemic risk-off regime. The recent increase in equity market volatility is a sign of this coming.

The tortoise and the hare –  So the Brexit saga goes on but it is not the most worrying thing in global markets. The underlying regime of risk assets re-pricing in a world of reduced global liquidity is what investors should really be focusing on. In that world one has to focus on valuation and quality. Not much is cheap and credit quality is deteriorating. I can't help coming back to US treasuries yielding more than 3 percent with the Fed presumably being closer to the end of the hiking cycle than the beginning. Despite modestly negative returns, euro fixed income has outperformed equities.  It has been the same in the UK, with gilts down 1.5 percent and the All-Share index down 8.6 percent year-to-date. Only in the US have equities outperformed bonds, but the way things are going that might not be the case by the time we get to the end of the year. Who would have thought that in a rising rate environment with global synchronised growth, good-old fixed income would be the tortoise that beat the hare?

Have a great weekend, and enjoy the return of the Premier League. United versus Chelsea – the only thing predictable about that is the "fruity" reception that José will get at the Bridge. I hope that Rashford can bag a couple like he did for England in Spain but, as they say in the part of Derbyshire where I grew up, you can live in Hope, but you'll die in Castleton.

Have a great weekend,

Chris

 





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Chris Iggo, CIO Fixed Income, AXA Investment Managers, serves up his always hugely informative and entertaining end of the week essay.

Summary  -  Brexit is an intriguing political drama, taking up more radio and television airtime, and more online and newspaper space than any other subject (at least in the UK). Yet the markets don't know what to do with it. The outlook is so uncertain that investors are finding it difficult to price in any particular outcome. Contrast that with Italy. Even though an Ital-exit is extremely unlikely, markets have priced in a credit risk premium in Italian bonds that reflects some combination of fiscal slippage and a longer-term credit risk that is higher than the rest of the major euro member countries. With equities having a typical October, risk-off concerns have ratcheted higher in recent weeks. For all the global growth euphoria at the beginning of the year, bonds have outperformed equities in Europe and could easily do so in the US by close of play. Bonds, you "gotta love'em"!

What is the Brexit effect? –  In the year to the end of September, a period during which the political atmosphere around Brexit negotiations became increasingly tense, the local performance of the UK government bond market (gilts) was better than that of US treasuries and European government bonds. It was the same for inflation-linked and corporate bond. US dollar based investors who invested in UK fixed income during that period and hedged their exposure into US dollars would have enjoyed returns that were much stronger than those provided by US government, investment grade or high yield bonds. Over the same period, the Bank of England's trade-weighted measure of the sterling exchange rate was flat – sterling went up in early 2018 and down in the second half of the year. Again, in local currency terms, the UK stock market didn't do too bad on a relative basis, especially compared to other European bourses. So looking at market performance it is difficult to see, from a top-down perspective, what the impact of Brexit has been for investors.

Growth has been in the middle of the pack  –  At the macro-level, UK growth has not been that big a disappointment on a relative scale either. Since beginning of the recovery after the financial crisis – and remember the UK was pretty badly hit given what happened to the banking sector and given the fiscal tightening that followed – UK GDP has recovered at a pace behind that of the US, Canada and Germany but ahead of other G10 countries. Since the 2016 referendum, GDP growth has averaged 0.4 percent per quarter. That compares to 0.5 percent  for France and 0.53 percent for Germany and 0.35 percent in Italy. Conceptually it is possible to believe that investment decisions have been impacted by the uncertainties over Brexit but the evidence is not fully supportive of that view – growth has not hit some kind of Brexit brick wall. At least not yet. Moreover, as this week's labour market report confirmed, there are some positive aspects to the UK's economic performance. The unemployment rate remained at 4.0 percent (2.6 percent on the claimant count measure) and, suggesting further that the labour market is quite tight, jobs growth appears to have flattened out but average earnings growth has picked up. August saw the pace of regular pay grow to 3.1 percent on a year on year basis, up from 2.9 percent previously. Real average earnings growth is back in positive territory and, although retail sales growth fell back a little in September, the y/y growth rate has been significantly higher in 2018 than it was in 2017. Consumer spending is not booming, and there have been plenty of examples of bad news from the UK High Street this year, but neither are consumers hiding away.

No clear investment views – I've attended a number of sell-side events in recent weeks, at which investment bank traders and strategists share their views with clients. Brexit has been amongst the most common topics for discussion but unlike trade or the Federal Reserve's interest rate policy, it is a topic where no-one really has a view on the market implications of Brexit or is able to suggest trade ideas or investment recommendations. That's of course because no-one, not even in the "temples of knowledge" that exist in the City or on Wall Street, has a clue on just how things are going to unfold. As I write, Prime Minister May is putting on a brave face, suggesting that a deal is close at hand, while back home it seems a growing number of members of her own Party are sharpening their knives. Radio talk shows and twitter opinions are vitriolic on the subject of Brexit and whether or not the May government is delivering the "will of the people". At the same time, prominent people are suggesting that the UK could face a very bleak future if there is a "no-deal" exit from the European Union. There is the uncertainty about domestic politics, the legal Gordian knot that is dealing with the ‘Northern Ireland issue', the objectives of the EU is securing the credibility of the single market and the customs union and, not least of all, the medium term economic implications for growth, employment and trade. While most in the markets feel that a deal will be done, at the last minute, I would venture that not many people would say that such a deal would have widespread support. The extreme Brexiteers and the extreme Remainers won't like it. The two main political parties are split internally over the issue and will need to provide some definitive ideas on how to manage the UK post-Brexit before the next planned general election in 2022. Labour wants to win power but its leadership is ambivalent at best over Brexit and ideally wants to be able to subsidise British industries as part of its plan to increase state ownership of the economy over time. The Conservatives look as they will be mortally wounded by the Brexit issue and by the time campaigning for the next election gets underway there could well be different individuals putting together the manifesto and, perhaps, even a new political party that tries to salvage what remains of support for a social market economy with an internationalist face. Political risk is something that needs to be considered in assessing UK financial assets.

Gilts look expensive – The market reaction to Brexit will entirely depend on the details of any deal and the ability of market participants to make any sense of such a deal. In addition there is going to be a transition period of at least two years during which the exact details of the terms of the future relationship with the EU will be decided as will any trade deals with third parties. That together with the political uncertainties ahead of a next general election will be hard for market participants to allocate a risk budget to. So to have a view on UK assets perhaps requires investors to focus on valuations and the fundamental outlook with the obvious attached Brexit-related risk premium. This is not easy though. Take the case of gilts. The 10-year yield is currently 1.58 percent. That compares with a base rate of 0.75 percent, a spread of 83 basis points. In the US the equivalent spread is 95 basis points (bps) and in Germany it is 87 bps. So from a curve point of view, gilts are a little richer than other markets, although this is very marginal. Relative to inflation, the current gilt yield is negative to the tune of 82 bps compared to a positive real yield in the US Treasury market (91 bps) and a negative 43 bps in Germany. So in real terms, gilts are not great value. What about the outlook for rates? Well, the Bank of England appears to be as confused as everyone else about Brexit but inflation. The labour market is tight, inflation is at the top-end of the Bank's target range, producer pipeline inflation is high and wages are picking up. Normally that would suggest further interest rate hikes with the Bank moving towards a neutral monetary stance. So on the basis of all that, gilts look expensive and yields should rise. Moreover, despite a relatively low level of foreign ownership in the gilt market, if the Brexit outcome is looking more negative, then some selling could occur by overseas investors (though I would not put much emphasis on that last point).

But a safe-haven premium may keep them rich –  Having said all that, gilts may very well be benefitting from a safe-haven risk premium. Whatever the implications for the private economy of Brexit, the UK government will still make good on its debt. As long as there is uncertainty about Britain's future relationship with the EU – and that could be for years – that safe-haven premium might remain. But jump forward to a distant day in the future when Britain has finally left the EU and has forged trade deals with other countries. What will be important then? Obviously the performance of the economy and Britain's attractiveness as a destination for investment (will autos companies and rich foreign residential property buyers still view the UK in the same way?) will be important determinants of the value of sterling and the level of interest rates. The UK has, unlike Italy, retained an independent monetary policy and its own currency so there is no risk of redenomination. Investors may, however, need more of an inflation risk premium in the future, particularly if inflation targeting is given less prominence and fiscal policy is used to offset the disruption to growth that is bound to happen. If the country is ruled by a party that engineered Brexit and the economy takes a hit from Brexit, wouldn't the government do something to offset the bad news in order to deliver the promises so sought by the "will of the people"? Given public demands for more spending on the National Health Service and other public services there is a risk of fiscal slippage in years to come. Gilt yields might end up being closer to Treasury yields than Bunds. 

Sentiment – It's difficult to isolate the idiosyncratic element of UK asset performance. Sentiment is weak and uncertainty is high, but recent market performance has been in line with other markets. Even sterling has stabilized. Given the increased tension over Brexit negotiations and the higher risk of a "no-deal" exit, the pound has actually risen against the dollar and the euro since early September. In my opinion, a significant turn for the worse in the outlook for a deal, or for political stability in the UK, would see the pound testing the lows of earlier this year. This in turn might impact on gilt yields through the increase in inflation expectations. On the contrary, given that sterling is relatively weak on valuation measures, the upside might be greater on a deal that allows Prime Minister May to stay in power and get the UK through to a transition period. Maybe then a lot of the sniping would subside and political frictions would start to align around the 2022 election instead. For a period though, there may be some relief.

The other EU headache – Italy does not want to leave the European Union but it is causing Brussels just as many, if not more, headaches as the UK. The Italian budget has, apparently, not been enthusiastically received while the coalition in Rome has started to reveal its own internal divisions over what parts of the economic programme should be emphasized over others. The EU leadership has told Italy that the proposed deviations in the budget plans from the previous fiscal proposals were unprecedented. Clearly, the EU is concerned about long-term debt stability in Italy and the moral hazard attached to allowing a more expansionary fiscal stance. This is not likely to be resolved anytime soon, so the risk is that Italian bond yields move higher (10-year currently at 3.75 percent, the highest yield since early 2014). While the UK exit is a mess, Italy has much more to lose should from putting itself in a position where its own membership of the EU might be questioned. While this risk is very remote, markets have a tendency to go through periods of pricing in remote risks. Who is to say that the BTP-Bund spread won't re-test the highs seen during the 2012 European sovereign crisis? Indeed, the peak of the spread in December 2011, at 528 bps is closer to where we are today than the tightest post-crisis level of just below 100bps seen in 2015. Either the EU has to soften its opposition to the proposed increase in the Italian deficit or the populist coalition in Rome has to row back on promises it made in the election earlier this year, which at the moment does not seem likely. 

One-off or all-off – A number of countries have been punished by credit markets in 2018. Argentina and Turkey in emerging markets and Italy. In that context it is interesting that the UK has managed to avoid a serious hit to its financial markets. What is interesting is that these individual country events have only had limited contagion on other markets. Yes, the Spanish government bond spread against Germany is higher but by significantly less than the Italian move. Yes, other emerging market spreads have widened but nothing like the case in Turkey and Argentina during the summer.  Investment grade and high yield credit spreads are wider but volatility has stayed relatively low. My concern is that, at some point, these idiosyncratic moves will all add up to a more significant systemic risk-off regime. The recent increase in equity market volatility is a sign of this coming.

The tortoise and the hare –  So the Brexit saga goes on but it is not the most worrying thing in global markets. The underlying regime of risk assets re-pricing in a world of reduced global liquidity is what investors should really be focusing on. In that world one has to focus on valuation and quality. Not much is cheap and credit quality is deteriorating. I can't help coming back to US treasuries yielding more than 3 percent with the Fed presumably being closer to the end of the hiking cycle than the beginning. Despite modestly negative returns, euro fixed income has outperformed equities.  It has been the same in the UK, with gilts down 1.5 percent and the All-Share index down 8.6 percent year-to-date. Only in the US have equities outperformed bonds, but the way things are going that might not be the case by the time we get to the end of the year. Who would have thought that in a rising rate environment with global synchronised growth, good-old fixed income would be the tortoise that beat the hare?

Have a great weekend, and enjoy the return of the Premier League. United versus Chelsea – the only thing predictable about that is the "fruity" reception that José will get at the Bridge. I hope that Rashford can bag a couple like he did for England in Spain but, as they say in the part of Derbyshire where I grew up, you can live in Hope, but you'll die in Castleton.

Have a great weekend,

Chris

 



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