Brexit Extension And European Elections: What Do These Mean For The Gilt Market?

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Includes: ADRU, BBEU, BOND, DBEU, DBEZ, DBUK, DEZU, EDOM, FEZ, GBPS, GLTSX, HEDJ, PCI, VGK
by: Bocconi's Valkyrie Trading Society
Summary

The Brexit extension has postponed the risk of a no-deal Brexit and temporarily reduced economic uncertainty in the UK, resulting in higher Gilt yields and lower prices.

The upcoming EU elections, criticism against Theresa May and huge divide between the Conservative, Labour and Brexit Parties can potentially slowdown the UK economy and enhance the level of uncertainty.

This will result in higher Gilt prices (due to higher demand) and lower yields, and benefit fixed income funds actively weighting towards Gilts.

Therefore, the current low Gilt prices which are expected to prevail until the May elections, present an investment opportunity for active investors aiming to benefit from price appreciation.

By Ali Rajani

The European Council has granted the UK Prime minister, Theresa May, a six-month extension to formulate and get a Withdrawal Agreement approved by the UK Parliament. Although this extension is a temporary relief for businesses and investors in the UK, the next few months can prove to enhance the level of uncertainty within the economy and could lead to rising prices in the bond market.

The 10-year UK Government Bonds, also known as 10-year Gilts, are considered a safe investment; therefore, the demand for them typically increases when investors are uncertain about the future of British economy. A number of investment management firms, such as Invesco, have launched ETFs pertaining to the Gilt market. Investors in other fixed income funds should be looking at how their funds are weighting gilts and whether they are actively managing them in their portfolio.

Theresa May from Politics Home What does the extension mean for the UK?

A Brexit extension does not mean that the Parliament will certainly agree on a deal. The UK Parliament is very divided, with the Labour Party rooting for another referendum and a customs union and the Conservative Party striving to pass the divorce agreement. Recently, there has been a new entrant: The Pro-Brexit Party led by Nigel Farage. The Pro-Brexit Party believes that PM May’s deal is the “worst-deal in history” and wants to progress with Brexit in its own way.

Given the division within the Parliament, it will be very difficult to get a Brexit deal finalised by 31st October. This discord also increases the probability of a chaotic, no-deal Brexit. In that scenario, more investors will direct their investments towards safe-haven Gilts because, unlike some other European nations, the UK government’s solvency is not in doubt. This will potentially suppress the yield more than the current levels and increase Gilt prices. The chart below shows how Gilt yields have previously reacted to political tensions and Brexit related chaos:

UK 10-Year Gilt Yields. Source: Investing.com

Although global bond yields have dropped over the past few months, the Gilt has suffered a larger blow due to no-deal Brexit fears. Thus, investors looking for near-term returns in this yield-suppressed market can achieve them through a price appreciation of the 10-year Gilt as uncertainty in the UK rises.

European elections and criticism against Theresa May

If the UK is unable to pass the Withdrawal Agreement by May 2019, which is very likely, it must participate in the European Parliament elections. The opinion polls (as of 23 April 2019) indicate neck-to-neck competition between the Labour, Conservative and Brexit parties.

Source: The Guardian

The Labour Party wants a permanent customs union with the EU; however, the Conservative Party believes that this would hinder UK from setting its own trade policy. Moreover, the Labour Party has been in favour of another Brexit referendum as the UK population has more clarity on the issue. However, such an action can divide the country and result in retaliation by pro-Brexiteers. A nationwide conflict of that level will suppress Gilt yields due to a surge in its demand.

The newly formed Brexit Party, led by Nigel Farage, currently leads the opinion polls. Mr. Farage believes that another referendum will be an insult for the pro-Brexit voters from 2016. The Brexit Party, therefore, aims to leave the EU in a more efficient way than PM Theresa May has suggested.

In the midst of electoral chaos, Conservative MPs are planning to force Theresa May to resign over the next few weeks. Such a change will slow down the Brexit Agreement process, increase the chances of a no-deal Brexit and further suppress Gilt yields.

The Brexit extension until 31st October might have done more harm than good for the UK economy and investors must keep in mind that the risk of a no-deal Brexit has not diminished but merely postponed.

Risks: Why Gilt yields might not decline

However, it is not completely certain that Gilt yields will fall and its demand will rise. The aftermath of a no-deal Brexit can negatively impact the Pound Sterling, resulting in a 5-10% depreciation (Source: Ben Brettell, senior economist at Hargreaves Lansdown), and impose inflationary pressure on the UK economy. An increase in rates by the Bank of England as a response to that scenario can push yields higher, resulting in a decrease in Gilt prices. However, the Bank of England will prefer post-Brexit economic recovery over strengthening the Pound Sterling (Source: Monetary Policy Committee).

On the other hand, a no-deal Brexit will raise costs for UK industries that import from the EU, due to tariffs and other trade barriers. Consequently, the profit margins for many UK firms will decline and unemployment rates will rise in an attempt by companies to cut costs. An increase in unemployment rates will push inflation below Bank of England’s 2% target. This can also be explained by the Phillips curve in the short-run, which portrays an inverse relationship between unemployment rate and rate of inflation (money wages).

Source: A.W. Phillips, The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom

Financial experts such as Mr. Michael Ashton from Enduring Investments LLC believe that the Phillips curve is still alive in the UK. Despite a post-Brexit depreciation of the Pound Sterling, an economic slowdown and high unemployment rates will cause a potential decrease in inflation and lower wages. In such a scenario, the Bank of England would aim at lowering rates to stimulate the economy, which is its core interest. This move will suppress Gilt yields and cause a rally in Gilt prices.

Lastly, it is possible for the 10-year Gilts to be downgraded by rating agencies if political and economic uncertainty within the UK rises drastically after Brexit. Although this is very unlikely, poor economic planning by the post-Brexit government could trigger a downgrading and result in a significant Gilt sell-off. In this scenario Gilt’s demand and price would reduce and yields would rise instead.

Conclusion

Investors should have an active approach, rather than a passive one, for managing their investments in the UK bond market. Gilt yields have risen and prices have dropped due to the relief caused by a Brexit extension; investors should invest in funds that plan on weighting towards 10-year Gilts before Brexit uncertainties and Gilt prices rise again.

Factors such as European elections in the UK, Labour party’s stance on another referendum, a possible resignation by PM May, division within the UK Parliament, increased chances of a no-deal Brexit and a potential economic slowdown, all point towards an increase in demand of the safe-haven Gilts in the forthcoming weeks. However, events such as Sterling-led inflation and downgrading of Gilts by rating agencies can undercut the demand of 10-year Gilts; but this remains unlikely.

Investors should keep in mind that the risk of a no-deal Brexit has not been reduced but merely postponed and Gilt yields have the potential to fall below the 1% mark.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.