Why global investors should not be scared of UK exposure
30 March 2017 by Chris Bowie
With the UK formally triggering article 50 yesterday, and as Q1 draws to a close, I thought it would be useful to reflect on the most frequent question I have had from non-UK investors this year: given Brexit, why do we see so much value in the UK credit curve? In the eight trips I have made to continental Europe so far this year, I have answered that question in the following way, which we think is relevant to global investors, European investors, and UK investors alike.
Firstly, Brexit is already in the rates price. My evidence? Inflation forwards.
Source: Bloomberg as at 30th March 2017
The UK currently has headline CPI of 2.3%, some 30bps higher than the target rate of 2%. Looking at the US – headline CPI is now 2.7%, also against a 2% target. But when you look at inflation expectations (as measured by 5y5y forwards), you see a completely different picture. Here the weakness of the pound post Brexit has clearly driven expectations higher, so much so that they are more than 100bps higher than the US equivalent measure – despite the US having higher current CPI. There are clear risks that the weakness in the pound imports inflation, but our view is that the risk of UK CPI breaking 4% are reasonably low. Instead we think the inflation forwards market has priced it correctly, at 3.44%. If we are wrong, then the MPC could be forced to raise rates this year – but we think it more likely that UK rates remain on hold this year as the Fed continues to raise. Also interesting to note is that both the US and Europe have expectations lower than current CPI, whereas in the UK expectations are higher than current CPI. I think this is clear evidence that Brexit is already priced into rates markets.
Secondly, Brexit is already in the credit price. My evidence for this is that if you look across the currencies and ratings bands that we mostly invest in, AA through to single-B in EUR, USD and GBP, the sterling market is the cheapest credit globally.
Source: TwentyFour, underlying data Barclays as at 29th March 2017
Prior to Brexit, this was not the case. The US market was the cheapest because it was a market later in its credit cycle, where leverage was higher, ratings were lower and the upgrade to downgrade ratio was significantly worse. Brexit changed that picture – and UK credit is now the cheapest globally, and presents clear value to investors in our view. Remember many of these companies are European and US companies who have borrowed in sterling – a lot of the time you are buying the same credit risk as in euros or dollars, but you get paid more spread for those same companies.
Thirdly, Brexit is an earnings event, not a solvency event. Despite the myriad of economists, pundits, politicians and publications telling us how awful Brexit would be from June 24th onwards, so far the economy has held up remarkably well. As the weakness in the pound post Brexit has neatly illustrated, the exchange rate is the escape valve that can help restore competitiveness. This is not to understate the risks however – yesterday highlights the fact that the risks have still yet to be quantified and addressed over the next few years. However, we remain convinced that the UK will remain a strong global economy, an attractive place in which to do business, and which has attractive returns on capital for its investors. As such, we think medium term the risks are more likely to be earnings based rather than solvency based, and thus corporate bonds may well be more attractive than equities. Furthermore, as Eoin wrote in The 2017 Bank Stress Test – Introducing the BES recently, the forthcoming bank stress tests will likely be manageable for UK banks, despite having quite penal stresses applied. The UK banking sector is significantly better capitalised than during the crisis, reiterating that the risks are earnings/profitability based and not solvency/default based.
Lastly, for those of you that are stock pickers like us, you buy companies you like wherever they are located in the world, provided the valuations are attractive and the volatility is commensurate with the likely returns. This should not exclude you from investing in areas that are more challenging to analyse – far from it in fact as it presents many opportunities.
So from a global perspective, we think our home market of the UK is currently the most interesting. Of course there are risks, just as there are with political risks in Europe or rates risk in the US for example. You do not have to be a cheerleader for the leave camp to construct a positive case for the UK – far from it. In our view many of the Brexit risks have been priced in already, thereby providing some of the best return opportunities for investors over the medium term as we see them.
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