The Problem With Gilts
Since the result of the UK referendum in June 2016 there has been a noticeable ‘Brexit-premium’ associated with most sterling denominated assets. This is understandable given the high degree of uncertainty about the final agreement (or not, as the case may be) with the EU, and when this may be resolved. While this additional premium is justified for risky assets, investors still require a risk-off, negatively correlated asset to manage their portfolios.
For those investors that can only invest in sterling assets they have no alternative but to use gilts as their natural risk-off asset. Thankfully, these have shown exactly the characteristics expected from risk-off products and have shown predictable negative correlation to risky assets throughout the period since the referendum result.
However, if the Brexit negotiations do not find a suitable solution it could result in gilts adopting a degree of credit risk, like we have seen in other sovereign states that have endured a period of economic uncertainty and stress. This is not our base case but one that could be envisaged in a worst case scenario.
On the other hand, if a workable agreement with the EU is found, one can imagine that considerable capital, currently side-lined, would flow back into UK to satisfy the entrepreneurial spirit that clearly exists in the UK economy. However, this return of animal spirits to UK investors would have a knock-on effect for base rates which traditionally are more closely mirrored with our friends across the pond.
We would further note the latest comments by Michael Saunders, MPC voting member, about the ‘big drag’ that Brexit has had on the UK economy and that the weaker currency has induced inflation. Over time even currency induced inflation can become ingrained and is no longer transitory, and needs to be addressed through monetary policy.
So a combination of a catch up in investment spending, a rejuvenated consumer, on top of some already ingrained inflation could indeed create the backdrop for a gradual return to neutral rates in the UK. Now, while we appreciate that Mr Saunders is one of the more hawkish members of the MPC, but if the UK was to have a “soft Brexit”, we think he might not be far off the mark with his estimate that the neutral rate for UK base rates is about 2% – still some 5 hikes from where we currently are. Hence our nervousness on holding UK gilts.
However, for those investors who do have the ability to use foreign exchange hedging, there are less risky ‘risk-off’ products to consider. In our view US Treasuries stand out in this regard. In terms of yield, once adjusted for currency hedging, there is very little to choose between risk-off assets, and investors do not really hold them for yield these days, they are held for capital protection on the downside and their negative correlation. Consequently, after 9 rate hikes, we believe the US offers more scope for future cuts, and additionally has little chance of a credit premium being attached to its Treasury bonds.
Having been asked many times recently why the risk-off portion of our funds are not in gilts, it is quite simply that gilts potentially present a problem in a downside scenario and more likely, could pose a problem in a more positive scenario. Fortunately we believe there are better choices available to investors who can currency hedge.