27th June 2016

Calm down dear, calm down

FTSE 100
6,139, -199
9,557, -700
S&P 500
2,037, -76
iTraxx Main
95bp, +20bp
iTraxx X-Over Index
400bp, +78bp
10 Yr Bund
-0.03%, -14bp
iBoxx Corp IG
B+157bp, +14bp 
iBoxx Corp HY Index
B+523bp, +45bp
10 Yr US T-Bond
1.56%, -18bp

Britannia riles the waves… The British people have decided to leave the EU. Now comes two years of negotiation and some uncertainty, but also fantastic opportunity. Yes, the markets have fallen hard, sterling is down in the dumps (no bad thing), Gilt yields have collapsed (no bad thing either in the near term) and stocks have had their usual severe kicking. But soon(er) this week, we expect stability then some recovery and correction from this predictable and horrible overreaction – and then excitement and anticipation as we all get back to embracing our new future and making this whole “Brexit thing” work.

britanniaThe reaction to events has been fantastic, but we would also say predictable. The market has always reacted to uncertainty through severe risk-off positioning, and the trading we’re seeing right now highlights that. It’s taken in the periphery, where stocks had their biggest one-day falls ever: the euro plummeted against the US dollar and stocks in Europe fell by up to 13%, while corporate bonds saw a sharp reassessment in value and sterling fell, as one might have anticipated on such an outcome. Safe havens saw the 10-year Bund yield down at an incredible -0.17% at one stage, while the curves flattened like we could never imagine as the 30-year Bund rallied by 15 points, only to close around 9 points higher!

Where to from here?

To start with, it is not the end of the world, nor ought it develop into a global financial crisis of the systemic sort. The central banks were immediately in damage limitation mode while the politicians – having been wrong-footed immediately into the referendum – will hopefully profess calm, and finally act on the message sent to them by the British public. We’re not sure about that, although the Spanish election result (not known at the time of writing) might help nudge them in the right direction.

While the panic everywhere is blamed on Brexit, let’s not forget that the global economy has been in an 8-year rut, and as we wrote last week, that will possibly turn to 16 years because of the political establishment’s inability and unwillingness to enact the far-reaching, difficult but necessary structural reforms needed to turn the macro juggernaut round. A few months down the line, some might blame the referendum vote for the ills of the macro economy and even hide behind it. Don’t be fooled by that. What it is does mean is that policy will now remain accommodative for several years, that corporate profitability will stay under pressure and investment and capex levels are not going to return to normal levels any time soon.

For now, expect smaller stock moves, expect government bond prices to bounce back a little – but just a little, because further central bank easing will make sure yields stay low(er). Oil prices might fall too as macro slows further.

Bullish sell-off, if ever there was one for corporate bonds

For corporate bonds, we will have our own ructions, but there is little currency risk for the foreseeable future as the eurozone is unlikely to fall apart (for a few years, anyway). Euro-currency risk will come into view for some. However, we have had the usual jockeying by dealers and investors around positions in those companies exposed to the UK, international trade, the periphery and so forth. Broadly, we think there is more opportunity than there are risks here.

That is how it played out, and we endured one of the most bullish sell-offs ever seen! There were more buyers than sellers, but the Street has no inventory and refused to short the market. They’re simply brokering it. Investors have been relatively calm and all the volatility has been around equities, rates and EM. The corporate bond market is this crisis’s sweet spot.

The ECB will be hoovering up risk as some sell into the volatility and move to more defensive positioning. We could find that the ECB’s balance sheet of corporate bonds rapidly balloons to levels that only a crisis could make happen. They’re a useful backstop bid at the moment – but remember, these bonds will never come back. So think twice and be careful about reducing risk into that bid – or any bid, for that matter. And from a total return perspective, the corporate bond market is going to be top of the pile as spread weakness (which will not be justified by the very low flows) is offset by the massive rally in government bonds.

Where “credit” was correlated to the rest of the market, it was in indexes. Here, the synthetic iTraxx indices gyrated to the volatility in stocks. Main and X-Over shot higher as investors and fast money sought to hedge risks and/or take a directional punt as events unfolded. Main finally closed 20bp higher at 95bp and X-Over a stunning 78bp higher at 400bp.

Total returns hold firm – for corporate bond investors

Spread weakness can, and likely will, recover into these illiquid corporate bond markets. The Markit iBoxx IG corporate bond index was up at B+157bp, some 14bp wider in the session but just 4bp wider YTD. The massive rally in the Bund though helped sustain returns at +3.4% YTD and the index yield only moved 2bp higher to 1.24%. In HY, the closer correlation with equities and the higher beta nature nature of the asset class saw greater weakness as the index went up 45bp to B+523bp. Returns though stay easily in the black at +2.5% YTD.

In sterling, it is an even more remarkable story. There was weakness, as spreads on the iBoxx index jumped 22bp to G+202bp, but the index yield was lower at 3.43% (-3bp) and returns higher at 5.2% YTD. It’s a longer duration market, and that 10-year Gilt yield did after all fall by 29bp to a record low close of 1.08%.

The volumes and trading flows suggest that there was little panic in the corporate bond market, more perhaps a bit of bewilderment. There was little by corporate bond fund outflows too. Spreads were understandably marked wider, there was admittedly much apprehension, but the rally in the underlying saw total returns hold up. It’s a different story for benchmark players, as higher beta portfolio positioning will have eaten into performance versus benchmark.

Nevertheless, we closed off the worst levels for the session into the end of last week in most markets, although additional weakness into the US close might impact how the market trades at the open today. The DAX is now down 11% YTD, the CAC index some 13% and the S&P just 0.03% lower. The FTSE is UP 0.75%.

And the rest…

And finally into the close on Friday, Moody’s saw fit to downgrade the outlook for the UK’s sovereign rating to negative from stable. No surprises here as they had already forewarned. keep calmThey’re seemingly knowing that the UK is on a severe downer and have the inside edge versus the markets. We would say they are in the dark as to how events play out, just like we all are. How the EU’s establishment react over the coming months will decide the rating agency’s next move. We can understand Moody’s move but let’s all hope they repent at leisure.

It is too early to be thinking about producing an emergency (UK) budget – there might not even be a need for one. The markets reacted as we could have expected and already in an amazing session, many were looking to pick up cheap assets, viewing the sell-off as an opportunity. There will be more volatile sessions as the political ructions and economic ramifications play out. Overall though, we remain optimistic and believe that the negative reaction we saw on Friday will dissipate soon enough, leaving most markets to recover many of their Brexit-related losses.

The fact is, the majority of the UK population which voted did so to leave the EU, while the subsequent hysterical reaction of impending Armageddon has been from the “Remainers” and the establishment portion of it (in the UK/EU). Now is the time for calm reflection and duty to act out the will of the people in a responsible and spirited manner. There is much to look forward to.

Have a good week, I’m going back to my holiday. Back Friday.

Suki Mann

A 30+ year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on CreditMarketDaily.com.