Most investment research has been dominated by political analysis in the run-up and aftermath of the UK’s EU referendum. The short-term market moves around this event seem to show the importance of such analysis.
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The short-term market moves around this event seem to show the importance of such analysis. But research shows that most political events are in the category of ‘known unknowns’, with markets adjusting quickly and with the impact on economic growth, inflation and monetary policy – the key fundamental drivers of market returns – being rather limited. Only political events that materially change the economic system or have an effect on systemic risk in the financial sector seem to be relevant for a medium-term investor. The question is whether the UK’s decision to leave the EU is such an event. We don’t think so. Even though it is a seismic political event with important ramifications for the UK and Europe, we don’t see this event, or the associated market moves, materially changing the course of this business cycle. So, in the middle of all the political analysis, we prefer to remain focused on economic fundamentals and market valuation.
In our first article, Will Hobbs, Head of Investment Strategy in UK and Europe, and the Investment Strategy team, put the UK’s decision to leave the EU into context. This edited version of a recently published ‘In Focus’ outlines why we don’t think this event will change the outlook for the global economic cycle or risk assets.
With the theme of our previous Compass being growth and equities, we have decided to focus the rest of this publication on fixed income and credit opportunities. In the second article, Will Hobbs and the Investment Strategy team take us through the inflation and growth backdrop. They highlight the threat posed by many government bond markets pricing in deflation in the context of some signs of inflation coming from the normalisation of energy prices and US wages.
Our third article outlines our tactical asset allocation relative to our long-term strategic allocation and the rationale for our positions. At the time of writing, we are overweight Developed Markets Equities and neutral Emerging Markets Equities. Within fixed income, we are neutral Cash & Short-Maturity Bonds and Developed Government Bonds (underweight duration), overweight in Global High Yield and are underweight in Investment Grade and Emerging Markets Bonds. We are neutral Commodities and Real Estate and underweight Alternative Trading Strategies.
In the following article, Oliver Asselin, Head of Specialist Investment Management, and Daniel Forbes-Ford, Fixed Income Portfolio Manager, analyse credit opportunities in the wake of the recent fall in the oil price and what type of analysis is needed to exploit these opportunities.
The next theme they cover is the impact of the ECB’s Corporate Sector Purchase Programme on the European High Yield bond market – the ‘bazooka’ that has been taken out of the pocket.
We also explore the opportunities for Credit Long/Short managers, with Suraj Valand, Head of Alternative Trading Strategies, going through the different strategies and what the managers are up to.
Finally, Peter Brooks, Head of Behavioural Finance, outlines how behavioural aspects can influence the bond market, with implications for the effectiveness of negative rates and the pricing of default risk.
In conclusion, we see several opportunities within the fixed income and credit area. Even though government bond markets look so expensive that even a slight pick-up in inflation could lead to a meaningful correction, the credit side still provides selective opportunities. The key to exploit these opportunities will be detailed credit analysis, either by the fixed income portfolio managers within our Specialist Investment Management team or by our third-party managers, including a range of specialised alternative credit managers.
Part of the reason we don’t think that the politics around the UK exit from the EU will have a meaningful impact on systemic risk or the business cycle is that central banks and market participants have had a chance to prepare for this event. However, we expect bouts of market volatility, as the central bank response unfolds and politically focused market participants express different views on the effectiveness of these measures. This environment will create opportunities for short-term investors. But for us, as medium to long-term investors, we still think it makes sense to stay invested in our diversified strategic asset allocation combined with tactical exposures based on fundamentals and market valuations.