Even Brexit That Loosens U.K. Budget Has Bond Investors Upbeat

Updated on
  • RBC sees demand for gilts weathering 30% jump in issuance
  • Swaps price in near 100% probability of rate cut Thursday

For investors in U.K. government bonds, Brexit is turning out to be a blessing.

Splitting from the European Union is generating mounting signs of an economic slump, and Chancellor of the Exchequer Philip Hammond’s readiness to “reset” fiscal policy signals that additional borrowing may be on the way. Yet it’s all being taken in stride by investors in the developed world’s best-performing sovereign bond market of 2016.

That’s because they widely anticipate the Bank of England will announce a new round of monetary stimulus on Thursday, which should support fixed income. Among investors, the debate has been reduced from whether stimulus will come to questions about the amount and scale of the central bank’s response to a Brexit-induced slowdown.

Standard Life Investments Ltd., the second-biggest fund manager in Scotland, advocates “forceful” action by the BOE including rate cuts and asset purchases. It has an overweight position on gilts. RBC Capital Markets says it sees very little prospect of foreign investors fleeing U.K. bonds even as gilt issuance in this fiscal year may rise by about 30 percent from what was previously planned.

Manulife View

Manulife Asset Management says the mere expectation of central bank action has stopped it going underweight on U.K. bonds, which would mean holding a smaller percentage of gilts than is contained in the indexes used to benchmark its performance.

“The U.K. economy is set to slow quite markedly, potentially moving to a shallow recession and given that, there will be clear policy support coming through from the Bank of England,” said James McCann, an economist in the global strategy team at Edinburgh-based Standard Life, which oversees about $335 billion. “Even though we will get a fiscal loosening, that won’t lead to a loss in gilt markets or an increase in yields.”

Britain’s bond market may set a reference point for governments from Canada to Japan and South Korea that are preparing fiscal stimulus to boost growth. With investors hunting for yields in an exceptionally low-rate world, and with central banks keeping monetary policy loose, sovereign borrowers may be mostly protected from higher financing costs.

For a link to how governments are planning fresh spending, as the world slips out of austerity grip, click here

Reports from manufacturing to housing in the U.K. have signaled an immediate drop in economic activity in the period leading to and after the June 23 referendum. That helped keep the pound close to three-decade lows versus the dollar. Even so, gilts were left unscathed, earning 6.6 percent since then. The 13 percent return on the securities this year is the most among sovereign markets in Bloomberg World Bond Indexes.

Osborne Overboard

While former Chancellor George Osborne made taming the deficit a central theme of his time in office, the likely change of direction from Hammond isn’t scaring investors. They’re looking at BOE Governor Mark Carney to cut interest rates and resume asset purchases.

One of the early casualties of Brexit was Osborne’s pledge of a budget surplus by 2020. Yet 10-year gilt yields barely moved on July 1, the day that commitment was abandoned. Then they fell for three days even after Osborne proposed a cut in the corporate tax to 15 percent, which would typically lower government revenue and weaken the outlook for bonds.

Hammond’s Caution

Hammond said he was ready to use his first Autumn statement this year “to reset fiscal policy if we deem it necessary to do so.”

Options include further cutting tax on corporate profits, reducing value-added tax on sales, subjecting less income to tax, allowing companies to make more spending tax-deductible and boosting investment in infrastructure.

To read how U.K. fiscal stimulus is urged by Ex-BOE officials as Carney hits limits, click here

Economic-growth assumptions will prove to be optimistic, and the resultant drop in tax receipts as well as difficulty selling state assets may cause gilt issuance in the current fiscal year to jump to as much 170 billion pounds ($227 billion), according to RBC economist Sam Hill. Even that won’t “put foreign investors off” at a time when the BOE is boosting stimulus, he said. That compares with 131.5 billion pounds of debt sales planned for this year.

History is on Hill’s side. As the U.K. sold a record 227.6 billion pounds of gilts in the fiscal year starting April 2009 amid the global financial crisis, average yields fell to 3.32 percent from 4.12 percent a year earlier as the BOE began buying billions of pounds of bonds in its quantitative-easing program.

The 10-year gilt yield fell to a record-low 0.681 percent last week, a month after the country lost its AAA rating from S&P Global Ratings, the first Group-of-Seven sovereign to get a two-notch reduction by the firm since Italy in 2012.