Worst of Brexit Pain Yet to Be Felt in U.S. Credit, Banks Warn

Brexit Rattles Markets: How Will Central Banks React?
  • Morgan Stanley, UBS tell clients to keep money in cash
  • U.S. junk, investment-grade bonds seen extending declines

Morgan Stanley and UBS Group AG are telling their clients to brace for deeper losses in U.S. credit as a result of the U.K. vote to leave the European Union.

While the "leave" camp’s win in the U.K. referendum has already rattled markets and caused U.S. corporate bond spreads to surge the most since the European sovereign debt crisis, credit strategists at the two banks say the worst is yet to come. Bonds aren’t cheap enough to warrant taking the risk that the market volatility isn’t temporary.

"Despite the urge to step in and buy U.S. credit at modestly wider levels than a few days ago, we recommend patience," Morgan Stanley strategists led by Adam Richmond wrote in a note to clients Monday. "While the full impact of the U.K. leave may not be known for some time, the U.S. economy is not in a position to withstand a large shock."

After the vote, frazzled investors dumped U.S. corporate bonds with global assets, with spreads on investment-grade and high-yield debt widening 14 basis points to yield 2.48 percentage points more than U.S. Treasuries, according to Bank of America Merrill Lynch index data. Corporate bond spreads haven’t spiked that much in one day since October 2011 -- when investors were concerned that sovereign debt turmoil in Europe would worsen and infect the banking system.

Recession Concerns

UBS’s Stephen Caprio is advising investors to resist deploying new cash to buy bonds on the cheap for now as Brexit increased the likelihood of a U.S. recession to 34 percent. That along with a stronger U.S. dollar, low oil prices and banking sector stress could upend vulnerable credit markets. In that case some high-yield and investment-grade companies may struggle to access debt markets, according to UBS.

"We do not believe investors should be buying Friday’s dip in credit yet," Caprio wrote in a note to clients. "It is not often that an exogenous shock has hit so late in the credit cycle with central banks already at the zero bound."

The U.S. economy and company creditworthiness are already weak enough that it may not take much to spark a deeper sell-off in corporate bonds, according to Morgan Stanley’s Richmond.

There were signs economic risks were rising even before the Brexit vote: U.S. corporate profits are down 15.5 percent from a peak in the fall of 2014 and business investment has deteriorated, Richmond wrote.

What’s more, companies -- even large blue-chips -- are about the least creditworthy they’ve ever been as they’ve borrowed rampantly in the face of weak earnings, according to Morgan Stanley.

"A catalyst is here," Richmond wrote. "The worry that global growth is weakening and central banks can’t do much about it, which was prevalent earlier this year, won’t be far behind."

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