Brexit: What to watch out for as talks heat up

With Brexit talks breaking down late on Sunday night in Brussels over the Irish border, investors may be wondering how to best navigate the next few weeks and months. At PIMCO, our assessment is that a number of UK assets have already priced in a significant chance of a disruptive Brexit, but there is scope for further moves in either direction, depending on the path the negotiations take.

Base case: Cooperative outcome to Brexit talks

Our base assumption is for a cooperative outcome to the current negotiations, such that both the UK and European Union (EU) can sign the transition deal extending the negotiations out to December 2020. We see incentives for both sides to agree to the transition: For the EU, it would ensure that the UK contributes to the EU budget until the end of the current fiscal period in December 2020; for the UK, it would assuage the risk of a disruptive separation in just five months' time, an event for which the economy would unlikely be fully prepared. Indeed, we see a greater risk for a disruptive Brexit at the December 2020 deadline than the current March 2019 deadline. That said, we consider it prudent risk management to think through all eventualities.

Near-term Brexit risks

We see a number of UK assets pricing in a relatively high chance of a disruptive Brexit, given current levels.

When we look at the bond market, UK yields have tracked euro yields very closely, despite the UK having already started its interest rate hiking cycle. We believe this is because some market participants expect the UK monetary cycle to pause (or even reverse) in the event of a disruptive Brexit. So rather than tracking moves across both the US and European markets, UK yields have tracked those in areas where the tightening cycle has yet to begin.

Meanwhile, we view the British pound as between 5% and 10% below its long-term fair value, which we attribute predominantly to Brexit risk. And when we look at the sterling corporate bond market, while most UK industrials trade in line with their peers, UK banks still trade at a yield premium, which again we would assign to Brexit risk. UK banks operate in one of the world's most regulated financial systems and have some of the highest capital ratios in the industry.

For this reason, we think there is good reason to appropriately scale exposures to assets that could benefit from a cooperative Brexit. In a cooperative Brexit, we would expect UK government yields to underperform German bunds and US Treasuries, and see scope for a steady appreciation of the British pound and for UK bank debt to outperform broad financial debt. For global portfolios, we reflect this view through a modest underweight to UK duration and a modest overweight to UK commercial bank debt. However, given the binary nature of the potential outcomes, we continue to emphasise appropriate sizing of these exposures.

Hedging Brexit risk

Irrespective of one's view on Brexit, we think it is prudent to consider appropriate portfolio hedges against a disruptive Brexit. In such an outcome, we think UK bond yields could fall by 25-40 basis points, the British pound would likely fall a further 5%-10% and UK commercial bank debt would come under further pressure. Asset classes such as commercial real estate would also likely see a drop in liquidity due to the economic uncertainty. For portfolios with less-liquid UK assets, we still see the British pound as a strong tool to hedge overall portfolio risk; not only is it sensitive to Brexit risk, but it is also highly liquid. In this way, portfolio managers can seek to mitigate short-term portfolio volatility without being forced to transact in less-liquid securities in the portfolio.

The good news? We believe markets still provide participants with both the scope to benefit if their view on Brexit proves correct and sufficient opportunity to hedge unwanted risks if their assessment of the outlook changes.

Learn about PIMCO's outlook for the UK and global economy in 2019.

Mike Amey is head of Sterling Portfolio Management and ESG Strategies, PIMCO

 

DISCLOSURES

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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