Doing the Deal: Post-Brexit Investment Implications
With the no-deal risk factor now removed, investors can now weigh the investment implications for various UK exposures.
We believe the current conditions may support investment grade credit, although financials will be under pressure given the lack of equivalence with the EU. Broader UK equities may now represent a value opportunity.
The UK and EU finally managed to agree on a trade deal. As had become habitual in this game of brinkmanship, the agreement came close to the deadline, meaning there was a mad rush to ratify it before the end of the year.
The ability to negotiate a deal was one of the key risk factors for the final quarter of 2020, so the fact that it has been resolved should be viewed as a positive for risk assets. That said, the fairly muted reaction from the GBP – the broad trade-weighted index initially bounced but has failed to break to new highs – suggests that the market was broadly positioned for a deal.
UK equity markets are higher but, globally, equity performance has also been driven by the signing into law of the US stimulus package, making it hard to determine a specific Brexit effect. This muted market reaction may be in part due to the time of the year, with trading possibly limited to market participants neutralising existing positions rather than initiating fresh ones, but it may also be that its financial impact is unclear.
An opportunity in investment grade credit
A deal is better than no deal, but there are some material costs that exporting businesses will now be forced to bear in the form of proving compliance with EU regulations. Perhaps the biggest issue with the deal is the lack of any clarity around access for financial services providers to the EU single market. Equivalence has not been granted – which is odd from a practical standpoint given the UK is currently fully aligned – but will be looked at by March 2021. Most of the large banks and asset managers should have made provisions to run operations out of the EU, limiting the disruption, but it is still likely to add to costs and this may ultimately prove prohibitive for smaller financial companies.
From that perspective, while the deal and the rising tide of equities should support investment grade credit, limiting exposure to financials may be wise. In this context, an all maturity index such as the Bloomberg Barclays Sterling Corporate Bond Index, where financials constitute around a third of the index, is better positioned than shorter options such as the Bloomberg Barclays 0-5 Year Sterling Corporate Bond Index, which is closer to 50%. There will be some risks around this, given its longer duration (8.7 years versus 2.5 years) although the longer index provides compensation in the form of a higher running yield (an additional 55bp) and a more attractive spread to gilts (+25bp).
Gilts carry on regardless
In the government bond space, gilts have not moved very far. Again, this could be indicative of positioning at this time of year or the fact that a deal was already largely in the price. Overall, it is hard to view recent developments as positive for gilts for a few reasons:
A no-trade-deal scenario has been averted, greatly reducing the need for safe haven assets. A no-deal scenario would also probably have forced the Bank of England (BoE) to cut rates and speed up gilt purchases.
The Oxford University/AstraZeneca vaccine has been authorised. This news should allow an accelerated immunisation programme in the UK.
Even though a post-Christmas/New Year surge in infections looks likely, markets have so far shown their ability to look through near-term issues and focus on the better economic backdrop that may persist for most of 2021. The State Street Global Advisors forecast for UK growth is an impressive 7.9% for 2021. While this may prove a little over-optimistic given the lockdown now in place, it appears unlikely that the BoE will cut rates into negative territory with growth running at its fastest pace since the 1980s. Yet the money markets continue to price an eventual cut (the SONIA forwards price around a 50% probability of a 25bp cut by end Q1 2022). The market is likely to gradually price out the probability of a cut, which creates a bearish backdrop for gilts.
Bank of England Rate Cuts Still Priced by the SONIA Forwards