How Brexit Will Impact Bonds in 2018

Euan McNeil, co-manager of the Kames Investment Grade Bond fund says Brexit progress to dominate outlook for fixed income investors

External Writer 2 January, 2018 | 1:49PM
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As the experience of the past 18 months has proved only too well, predicting the outcome of political events, and more importantly their influence on markets, has generally been a fruitless task. The conventional wisdom around the likely outcomes of the Brexit vote and the US presidential election proved spectacularly wrong. The initial forecasts of domestic economic doom in the immediate aftermath of Brexit also proved to be wide of the mark, at least in part due to the prompt action of the Bank of England.

The biggest influence on the economy is likely to be Brexit

However, there has been clear evidence of a slowdown in UK growth in recent months, which was confirmed in the Budget in late November by the OBR’s downgrade to UK growth. It is difficult to disagree with this assessment given the ongoing uncertainty around Brexit negotiations. Our expectation is that this caution will also permeate decision-making at the Bank of England next year. It would be foolhardy on the part of the Bank to engage in a series of rate hikes against this backdrop.

The single biggest identifiable influence on domestic economic policy is likely to continue to be progress around Brexit. If negotiations continue to be problematic – and trade talks are not concluded in a sensible timeline – then arguably the Bank of England would be forced into pursuing a more accommodative monetary policy, which would in all likelihood see government bond yields move lower.

Whilst the actions of, and rhetoric from, the US Federal Reserve and European Central Bank do not directly influence the returns of sterling-denominated credit, clearly the market’s perception of their approach will influence the direction of credit spreads. It is our expectation that the continued absence of any material wage inflation in either Europe or the US should ensure that both the ECB and Fed err on the side of caution with regard to their monetary policy, and thus their communication to the market.

Should our faith around the caution of central banks prove to be misplaced – or should a discernible uptick in pricing pressure come through – then we would be forced to reappraise our generally benign outlook for spread product. However, if the central case proves to be correct, then our ability to generate excess returns for our client base will again be heavily influenced by stock selection, active duration management, and a willingness to rotate individual credit exposures and exploit relative value opportunities.

Predicting volatility is generally as unrewarding as predicting politics, but if we continue to operate in a market that exhibits similar characteristics as those witnessed in 2017, then these same factors are likely to be similarly integral to generating outperformance in 2018.

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