1. Brexit – It’s Starting to Get Real
Late last week news broke that UK Prime Minister Theresa May will outline her Brexit strategy in a speech at Lancaster House in London on Tuesday January 17th. As generally happens in situations like this, government ministers and political spin-doctors begin to leak details of the strategy in the days beforehand, and this occasion has been no different. During the weekend, various Ministers and Advisors have been appearing on television and radio chat shows, giving hints as to what might be expected from the speech. It appears that PM May will signal she intends to pursue a “hard Brexit” strategy, intending to quit the EU’s single market for goods and services in return for two of her key demands – being able to control immigration and removing Britain from the jurisdiction of the European Court of Justice. Government sources have admitted that this news is likely to cause a “market reaction” – meaning they expected the UK currency to come under further downward pressure. Whilst publicly still maintaining that it will be possible to agree a trade deal with the EU within two years of triggering Article 50, privately many UK government ministers are admitting that there may be a need for a transitional deal to avoid tariffs being imposed when Brexit actually occurs. Over the weekend, a cross-party group of politicians who were tasked with advising on a Brexit strategy told the UK government in no uncertain terms that a formal white paper setting out the government’s priorities and plans should be published by the middle of February. Meanwhile the government is still awaiting the result of an appeal to the UK Supreme Court on whether the government needs to consult parliament before triggering Article 50. That verdict is expected sometime within the next two weeks. In an interview with a German newspaper, UK Minister for Finance Philip Hammond appeared to suggest that the UK was prepared to do whatever was necessary to regain competitiveness, even to the extent of slashing UK corporate tax rates in order to attract (or even maintain) investment in the economy. We have always maintained that the real effect of Brexit on the UK economy would only be apparent when the actual process of Brexit started, and it looks like that should start this week. We continue to believe that an underweight stance in UK government bonds is warranted against this backdrop.
2. Italy remains in the headlines
Two further bits of news concerning Italy emerged last week, but neither is likely to cause any significant re-pricing of Italian government bond prices in the near future. Early last week, the Italian Constitutional Court reviewed a request filed by Italy’s largest trade union, CGIL, to hold a referendum on some elements of labour market reform, which were enacted by ex-Prime Minister Matteo Renzi. The Court turned down the request, and this would appear to make snap elections less likely in the short-term. If the referendum request were approved, the current government would have been tempted to hold elections as soon as possible, since under Italian law if Parliament is dissolved before the end of the legislature, any approved referendum would have been suspended and postponed by one year. The next big political date for Italy is January 24th, when the Constitutional Court will rule on the Italicum voting system. Given the result of the referendum on constitutional reforms in early December 2016, we doubt this upcoming ruling is particularly critical. Secondly, late last Friday evening the Canadian rating agency DBRS downgraded Italy’s sovereign rating from “A” to “BBB”. DBRS was the last of the major rating agencies to rate Italy as “A”, but the rating was put on review quite a while ago; however, the decision was delayed until DBRS had seen the result of the referendum in December 2016. But this result was not the only reason for the downgrade – other factors that contributed to the downgrade included uncertainty over the political ability to sustain the structural reform effort, the continuing weakness in the banking system and the lack of progress in recapitalizing Banks, and an on-going period of fragile growth. In reality, the downgrade will have little significant impact – Italy still will be eligible for the ECB’s Quantitative Easing programme. Nevertheless, it is another negative factor for the Italian banking sector. When Italian banks borrow funds from the ECB, they pledge Italian sovereign bonds as collateral to back these borrowings. However, the ECB apply a haircut to this collateral depending on the rating of the sovereign. As a result of the downgrade to BBB, it is estimated that, on average, the haircut on the Italian sovereign debt pledged as collateral will rise by just over 7% or about €5bn – an annoyance but not a game-changer. We would view any weakness in Italian sovereign bond yields as a buying opportunity.
3. Our Outlook for Euro Investment-Grade Credit
Heading into the first quarter of 2017, we remain constructive on European Investment Grade Credit overall, continuing to view value in segments of the market, most particularly selected Corporate Hybrids and Subordinated Financials. In terms of sector preferences, we see particular value in Real Estate, Insurance, Transport and also the Energy sector. However, despite some widening over the last quarter on investor profit taking, the senior unsecured Corporate Sector Purchase Programme (CSPP)-eligible debt universe still offers little scope for further outperformance over 2017 in our view. While ongoing ECB buying may dampen spread volatility during periods of market weakness, we view Investment Grade senior unsecured spreads at the long-end in particular as vulnerable to further yield curve normalisation. There are also reasons for a more cautious stance from rising political and macro risks in our view, whether it be from the large calendar of elections in Europe in the coming months (leading to fears of more populist outcomes), Brexit or rising protectionist fears from the U.S. which may weigh on Emerging Markets-exposed names in particular. This more cautious view is reflected in our ongoing underweight credit spread duration positioning, although we remain long credit risk overall through our preference for higher beta, more attractively priced segments of the credit market. The ongoing need for some caution is also reflected in higher cash balances and an increased focus on more liquid, benchmark issues.