Global Weekly: To Brexit or not to Brexit, that is the question

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UK prime minister Theresa May’s inevitable Brexit deal defeat on Tuesday marked the end of the beginning rather than the beginning of the end, as the Brexit process is now entering a new phase.

The British parliament voted massively against the proposed deal negotiated between prime minister May and the European Union, by 432 votes to 202. However, prime minister May survived Wednesday’s vote of no-confidence against her government. So what’s next ? There are several possibilities, including a hard Brexit, a delay of the departure deadline (currently, the UK is due to leave the EU on 29 March), a new referendum (difficult within the current time frame) and a unilateral revocation of article 50 (in which exit proceedings for EU member countries are described). A revocation of article 50 would probably cause an unprecedented political crisis in the UK. Market reactions on Tuesday’s vote were muted, as the result had been largely anticipated.

In the US, the earnings season is about to get into full swing. So far, 39 companies included in the S&P 500 Index have reported their results. So far, earning and sales came in slightly ahead of expectations. Positive surprises were seen in the consumer and industrial sectors. In the financial sector, both sales and earnings came in slightly below expectations (although it should be noted that only 13 out of 103 financial companies have reported so far). Stock price reactions were nonetheless positive, as financials outperformed the broader market this week. S&P 500 earnings and sales are currently showing 18.7% and 7.4% growth rates.

It will be interesting to see how this earnings season unfolds in the coming weeks. Recently, we have slightly scaled back our allocation to equities from a modest overweight to a neutral stance. In terms of regions, we have a strong overweight in emerging markets, we are modestly overweight US and strongly underweight Europe. In our sector allocation, we maintain our current positioning for the time being: we have an overweight allocation to the energy sector, we are more modestly overweight industrials, underweight financials and utilities, and slightly underweight communication services. We take a neutral stance on all other sectors.

Investment-grade more vulnerable than high-yield?

Sentiment in financial markets remains brittle. Fear of a recession and uncertainty around the ongoing Brexit process, trade war talks, oil prices and monetary tightening continue to make investors wary of risk.

Risk premiums on investment-grade euro corporate bonds compared to German Bund yields saw a low of 0.8% in February last year and are currently hovering around 1.6%. A doubling in premium. High-yield premiums, however, were much higher the last time we saw investment-grade corporate bond spreads reach this level. The risk-off effect of late therefore seems to have hit investment-grade bonds harder than high yield. Why are investment-grade bonds considered to be more vulnerable than high yield by investors?

Firstly, the corporate bond market has grown rapidly the last few years, as companies have been issuing a lot of bonds (corporate debt levels, however, have not grown, as companies nowadays are borrowing less from banks, but turn to the market for funding instead). This trend is expected to continue – and if banks become more reluctant to lend (tightening of financial conditions) against a backdrop of rising recession fears, even more capital will be raised through bond issuing.

Secondly, the functioning of this process has been helped by the corporate bond buying by the European Central Bank (ECB). The ECB has been buying approximately one third to half of the newly issued bonds. Now that the central bank has ended its asset purchase programme, a new investor has to step in this year. Bonds issued this year have been placed with high premiums compared to the outstanding bonds of the issuing company, signalling that it has become more difficult to borrow capital. Now that the company earnings season is kicking off, bond investors will surely be keen to find out how companies have actually fared over the recent quarter, against the background of a slowing economy. In particular, investors want to know if recessionary fears are justified. If not, which is the opinion of our economists, this market could very well be attractive.

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