Brexit: What Does It Mean for the Bond Market?

By

Kathy A. Jones

- June 24, 2016

Key Points

• Britain's vote to leave the European Union has pushed down U.S. Treasury yields, as risk-averse investors have flocked to the perceived safety of U.S. government bonds.
• The Federal Reserve is now less likely to raise U.S. interest rates this year, and could even move for a rate cut.
• Market turmoil underscores the importance of high-quality bonds as the core of a portfolio.

On Thursday, the British electorate voted to leave the European Union, ending 43 years of participation. It was a surprise. The market had been persuaded by early polls that voters would choose to stay in the EU for economic reasons. But anti-EU sentiment in northern England and elsewhere outside London proved too strong, as voters used the referendum to express their anxiety about the effects of globalization, immigration and regulation on industry. Prime Minister David Cameron has already announced he will step down. Once the prime minister has invoked Article 50 of the Lisbon Treaty, there will be a window of two years to negotiate the exit and Britain’s future relationship with the EU.

So far, here's what we're seeing as markets absorb the news:

• U.S. Treasury yields are down as risk-averse investors have flocked to the perceived safety of U.S. government bonds. The 10-year yield is close to its 2012 low and the 30-year is back to the 1954 low of 2.37%. The market will probably scale back its expectations of a federal funds rate hike this year, and possibly build in expectations for a rate cut later in the year. I think a rate cut remains a very low probability, but the market will probably discount the possibility.
   
• Risk aversion has also driven investors to German bunds and Japanese bonds, which have seen their prices rise. Yields—which move inversely to prices—are well into negative territory stretching out to 10-year maturities. However, peripheral European bond spreads are widening because of concerns that other countries, such as Spain and Portugal, could choose to leave the EU.
   
• Credit spreads in the U.S. will probably widen. Based on credit default swap levels, it looks like energy and financials will be the hardest hit. The sharp rise in the U.S. dollar has sent commodity prices lower, while the financial sector has been hit because it is Britain’s largest industry. Some British-based banks may decide to leave the U.K. and set up headquarters inside an EU country. Some of the weakness in the financial sector will probably spread to U.S. financials. Preferred securities are vulnerable to a selloff due to the weakness in financials.
   
• We don't believe this will lead to financial crisis similar to the one that followed the Lehman Brothers default in 2008. Banks are well capitalized and central banks are providing ample liquidity. However, it is negative for global growth, which is already very soft. Global trade is growing by less than 3% year over year—that is less than half the historical pace. The leave vote raises impediments to the free flow of goods, services and people, and that is bad for trade. Hence, it could slow the global economy further.

What investors should know

All in all, we're likely to see some volatility ahead. Here are a few things to keep in mind:

• Situations like this are why it's important to hold high-quality bonds as the core of a portfolio. Unexpected events can happen, and high-quality bonds provide the ballast for a portfolio that allows you to ride out the ups and downs of the stock market.
   
• Riskier parts of the bond market, such as high-yield and international bonds, are vulnerable because they are highly correlated with equities. That's why we suggest limiting your exposure to those asset classes.
   
• We remain cautious about non-U.S.-dollar denominated bonds. Investors were facing a diminishing risk/reward outlook for their international bond investments even before the Brexit vote, due to factors including negative-interest-rate policies in various countries. This new shock will not improve the situation.

Next Steps

• Follow Kathy Jones on Twitter: @kathyjones

Financial Review

Better Than We Thought

Sinclair Noe — August 27, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

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DOW + 369 = 16,654
SPX + 47 = 1987
NAS + 115 = 4812
10 YR YLD un = 2.17%
OIL + 4.03 = 42.63
GOLD + .10 = 1126.50
SILV + .41 = 14.62

Yesterday Wall Street cracked a six-day losing streak with its best rally in nearly four years. Today, traders piled on; the two-day total, 978 points on the Dow industrials and the best two-day percentage gain since the crisis of 2008; which wipes out Monday’s losses, but still leaves the Dow down from one week ago. On the longer-term charts, Monday and Tuesday dropped below the lows of last October at 15,855, compared to Monday’s low of 15,370, which basically matched the lows from February 2014 at 15,340. On a long-term chart this now provides a range of support. With today’s gains, the S&P has recovered about half of the 11-percent meltdown it suffered over a six-day losing streak.

China’s key stock market index surged 5.3 percent earlier today, for its biggest gain in eight weeks, and the first gain in five sessions. China has been selling down its holdings of US Treasuries; the idea is to put a floor under the devaluation of the yuan; also probably to raise some capital for stimulus. So far, it isn’t an asset dump and there is absolutely no evidence it is the source of economic pain for the US. Even if China wanted to dump Treasuries, there really isn’t a good alternative.

The bigger problem for China, and for the US as a trade partner with China, is the economic slowdown. China accounted for almost 40 percent of global growth last year. China takes in raw materials from emerging market countries and then ships out finished products to the US and Europe. In the age of globalization, any imbalance or excess with a major economy like China inevitably affects other countries. And as excesses in Chinese real estate rolled over to the Chinese stock markets, local investors panicked and that created a nasty case of jitters for global investors. Meanwhile, the Chinese government has been intervening, but they have been more reactive than proactive; trying to staunch the bleeding rather than fending off the wound. But don’t underestimate the power of the People’s Bank of China; it’s a central bank without much restraint.

The countries most at risk to a China slowdown are regional trading partners like South Korea, Vietnam, Thailand, and Indonesia; also emerging market countries like South Africa, Turkey, and Brazil; Europe has some vulnerability because its economy has been weak for some time. The US is largely insulated from China’s downturn. Exports to China amount to only 1 percent of US gross domestic product; and the US economy has been much stronger than almost all other global economies.

If this is beginning to sound a lot like the Asian Contagion of 1997, well, there are certainly similarities. And it might be a mistake to think that China’s economy could fall and drag down the emerging markets and we would walk away unscathed. One challenge is money moving to the safe haven of the US dollar; a stronger dollar makes US goods and services less competitive overseas. And an interest rate hike from the Fed would make the dollar even stronger.

And so today Fed policymakers meet with other central bankers and economists from around the world at an informal summit in Jackson Hole Wyoming. Janet Yellen will not attend. NY Fed President William Dudley said a September hike seemed “less compelling” given recent global economic uncertainty. Kansas City Fed President Esther George says the market turmoil “complicates” any decision to raise rates, but she repeated her long-held call for normalization. Typically, but not always, when the market drops 10%, the Fed follows by cutting interest rates. That isn’t an option, but it will make it much harder to hike rates.

The economy is in better shape than we thought. The Commerce Department has revised second quarter gross domestic product from an initial estimate of 2.3% growth to 3.7%. Businesses increased investment by 3.2% versus an initial drop of 0.6%, with spending on structures such as office buildings rising by 3.1% instead of a drop of 1.6%. One reason businesses might have invested more: Corporate profits jumped an estimated 2.4% in the second quarter after declining by 5.8% in the first quarter. And they boosted spending on equipment by 10.7%, rather than 7%. State and local government spending was boosted to 4.3% from 2.0%.

Then again, the economy might be in worse shape than we thought. The headline GDP number was strong, but we also saw a report showing gross domestic income increased at an annual rate of just 0.6 percent. GDP tracks all expenditures on final goods and services produced in the United States, whereas GDI tracks all income received by those who produced that output. And for the first time the Bureau of Economic Analysis released an average for the GDP and the Gross Domestic Income growth rates. That average came in at 2.1 percent after rounding, and that’s probably closer to the truth than either number alone. The scary part is that there is a big spread between GDP and GDI.

Oil prices spiked on the GDP report, up 10.4% on the day. Oil dropped below $40 this week as problems in China raised concerns about slowing economies and weak global demand. Prices are down about 32 percent from this year’s closing peak in June on speculation that a world supply glut will be prolonged. OPEC members are sustaining output while U.S. stockpiles remain more than 90 million barrels above the five-year seasonal average. So, why the big spike in oil today? Did the supply demand picture change radically from this time yesterday? Of course not. What we are seeing is casino-style speculation in oil markets. Good news, in the form of the GDP report, likely resulted in a short squeeze.

The National Association of Realtors reports contracts to buy previously owned homes rose less than expected in July, but continued to suggest upward momentum in the housing market recovery. Pending Home Sales Index, based on contracts signed last month, increased 0.5 percent to 110.9. Pending home contracts become sales after a month or two, and last month’s increase suggested further gains in home resales, which reached an 8-1/2-year high in July.

Filings for U.S. jobless benefits dropped to a three-week low. Unemployment applications dropped by 6,000 to 271,000 in the week ended Aug. 22. As the unemployment rate has dropped, demand for skilled workers is convincing hiring managers to keep staffing levels consistent with sales.

Arizona has the third-worst job market in the U.S., according to one measure used by the U.S. Bureau of Labor Statistics. Not only did the federal agency look at the official unemployment rates for U.S. states, but also the number of discouraged jobless workers who have stopped looking for positions and the number of part-time workers who would prefer full-time hours. Arizona and its two neighbors, California and Nevada, have the highest unemployed and underemployed rates in the country. Arizona’s jobless and underemployed rate is 13.8 percent. Arizona’s official and traditional unemployment rate is 6.1 percent for July, that’s up 0.2% from June. That ranks 41st. Arizona’s economy lost 7,200 non-farm jobs last month.

CVS Health is jumping further into tele-health with a partnership that will expand patients’ remote access to doctors. Three leading tele-health companies – American Well, Teladoc and Doctor On Demand – will begin receiving referred CVS customers, as well as referring their own customers to 150 CVS walk-in clinics, in six states by the fourth quarter. The new move also underscores CVS’s push to position itself as a broader healthcare services company, and not just medications.

Boeing has agreed to a preliminary deal to settle a long-running lawsuit accusing the company of mishandling its 401(k) plans it offered to its employees. The class-action accused Boeing of failing to uphold its fiduciary duties by allowing excessive fees to go unchecked, choosing higher-cost retail mutual funds over cheaper options, and improperly making 401(k) plan decisions to benefit vendors.

A bankruptcy judge has approved Corinthian Colleges’ liquidation plan, which sets aside millions of dollars in debt relief for former students. Late last year, Corinthian sold off more than half its campuses following multiple probes into whether it misled investors and students about its finances and job placement rates. Corinthian abruptly closed its remaining 28 schools in April, becoming the largest failure in for-profit higher education.

If you’re looking for a new car, you might want to check the rating on that car. The new Tesla P85D just earned a ranking of 103 out of a possible 100 from Consumer Reports. One reason for the high ranking is that the car is very fast, zero to 60 in 3.5 seconds. Despite the record score, the magazine criticized the $127,820 test vehicle for the quality of its interior materials compared with other luxury models, as well as a ride that is firmer and louder than the base Model S.