Tanguy Le Saout is Head of Fixed income Europe, Pioneer Investments
BREXIT – Some Further Thoughts
The vote last week by the population of the United Kingdom to leave the European Union was a genuine shock. Although the opinion polls predicted a close outcome, the bookmakers and the market had discounted a “REMAIN” win and priced accordingly. Much has already been written about the effects of this result, but we suspect that many of the consequences (both political and economic) are, as yet, unforecastable. Therefore, we will limit ourselves to a few comments this weekend, as the shock of the event continues to reverberate globally.
- The result was more of a “Bear Stearns” moment than a “Lehmans” moment. By this, we mean that markets knew a “LEAVE” vote was a possibility – it was a “known unknown”. Central banks had already been making plans for the fall-out from a “LEAVE” vote through the provision of abundant liquidity to the banking system. That was why markets functioned so well on the day of the result – volatility was high but liquidity was available.
- The most immediate effect will be on growth. Forecasts suggest that the referendum campaign, the result and the uncertainty that will be a fact of life over the next couple of years could knock between 1.5%-2% off U.K. growth in 2016/2017. Estimates for the E.U. are for a loss of output of about 0.5%. Worse case scenarios could even be looking at a recession in the U.K. in early 2017.
- Based on that outlook for growth, the second significant effect is on central banks’ monetary policy stances. The Bank of England and then ECB are likely to become even more accommodative. We think the Bank of England will prefer to increase its asset purchase programme first and then potentially cut rates. The ECB is likely to further increase its Quantitative Easing programme and extend its lifespan. It is also unlikely that we will see any further rate hike from the U.S. Federal Reserve in the near-term.
- With the economic growth outlook deteriorating and monetary policy remaining accommodative, pressure on bond yields is likely to remain to the downside in the near-term. Although we may have fundamental concerns about the long-term valuations of fixed income markets, the near-term picture suggests that bond yields will remain lower for longer.
- In the past, economic fundamentals usually dictated the level of bond yields. Since the global financial crisis of 2008, central banks have been driving bond yields, with their (sometimes extraordinary) monetary policy actions. Now, we may face a period where politics will be the major market force. The political uncertainty is not just in the U.K., but also in places like Spain, Italy, France, Netherlands and Germany, all of whom will go to the polls in either national elections or referenda in the next 18 months. The U.K. result could possibly encourage anti-E.U. sentiment and the rise of far-right parties.
- How the E.U. now reacts will shape its future. It may well be that the “BREXIT” result is a wake-up call to E.U. politicians and push them towards making the decisions that they should have made over the last decade, such as a fiscal union, deposit insurance and a proper banking union. On the other hand, the E.U. may decide to do what it has always done in times of crisis and agree to closer co-operation but not make any significant changes. The former would be the silver lining on a dark cloud, the latter would surely lead to further political and market uncertainty.
- Finally, we think the immediate outlook for Euro investment grade fixed income markets warrants caution, and defensive positioning. Market participants are unlikely to be in a “risk-taking” mode over the coming months and we could experience bouts of “risk-off” sentiment. With pressure on growth, monetary policy remaining accommodative, and increased political risk, bond yields are likely to remain low.
Banks Purchases of Sovereign Bonds – Why the ECB is Worried
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A recent report from Standard & Poor’s noted that far from reducing their holdings of sovereign bonds, banks across Europe have actually been investing more heavily in government bonds, exacerbating the loop between the health of a country’s banking system and the health of the government itself. Despite plans to try and reduce banks’ exposure to domestic sovereign debt in the aftermath of the global financial crisis of 2008, banks’ holdings of their own state’s debt doubled in that period. Western European banks holdings of their own government’s debt has risen from a low of €355bn in September 2008 to €791bn today, whilst Southern European banks holdings have increased from €272bn to €722bn. Much of this can be attributed to regulatory reasons – banks are encouraged to hold liquid assets like sovereign bonds and sovereign debt is classified as “risk-free”, meaning no capital has to be held against it. The ECB’s offer of cheap funding to banks through its Long-Term Refinancing Operations (LTRO’s) also saw banks borrow funds from the central bank and invest in sovereign bonds – the so-called “carry trade”. Recently, Germany floated proposals to introduce rules capping the amount of sovereign bonds that could be held by banks, but unsurprisingly it was shot down by southern European states. Given the figures above, it isn’t hard to see why.
Spanish Election Results – NingunCambio!!
Spain went to the polls again on Sunday June 26th for the second time in 6 months to try and elect a government. The last national elections in December 2015 saw no party (or combination of parties) able to form a government, so after 6 months of negotiations and talks, it was time to do it all over again. And just like in the U.K. referendum on E.U. membership, the opinion polls got it wrong again. Caretaker Prime Minister Mariano Rajoy’s People’s Party actually increased their numbers of seats from 123 to 137, but still not enough to form a majority government. The PSOE socialists lost 5 seats and fell to 85 seats. The big loser was the anti-establishment Podemos party, which had been predicted to overtake the Socialists and win 93 seats, but actually only ended up with 71 seats, the same as last December. That puts Rajoy and the People’s Party in the driving seat to form a government, but their natural partner, the pro-market Ciudadanos party lost 8 seats and is left with 32 seats, leaving both parties 7 seats short of a majority. In one sense, the good news is that, unlike the U.K., the Spanish electorate have not voted for any radical solution – the bad news is that we could be in for another period of protracted political negotiations. The result is not as bad as markets feared – there had been talk of the formation of a coalition between the two far-left parties Podemos and IU (called UnidosPodemos) who could have joined with the PSOE socialists to form a left-wing government. Whilst not a result the markets would have chosen, at least it is not the result that markets feared. Spanish bonds can probably tighten in spread terms against Germany, but that tightening may be limited by the lack of political clarity.