PHIL MILBURN
As a fixed income investor based in Brexit-facing Britain, I’m often asked to opine on gilts – the bonds issued by the UK government to fund its borrowing. Historically, gilts have been considered a super safe investment given they are issued by her majesty’s government, which has yet to renege on a debt.
In recent weeks I’ve made some comments which suggest I see the UK gilt market as a toxic investment. Befuddled looking friends have asked whether I remember the country is about to leave the European Union, and why, under that circumstance, I don’t buy the UK’s “risk free” asset? Funnily enough I have not forgotten Brexit. Rather, I’m of the opinion that those seeking such support for a position in UK bonds are clutching at wispy straws indeed. To honestly believe gilts in a post-Brexit world are risk free ignores the lessons of several hundred years of market history.
Let’s break down the three Brexit scenarios I believe worth considering.
First up: the “no clean trade” agreement.
Doom mongers forecast that in this vision of the future, the UK economy enters a death spiral. That is wrong. In our projections, sterling simply falls around 10 per cent, as it did in 2016 following the result of the referendum. Corporate earnings and associated tax take (in sterling terms) rise significantly – overseas earnings are, of course, way over 50 per cent of the FTSE 100’s income. Inflation increases, and growth remains positive – the Brexit brigade say “I told you so” and forget about the billions more in sterling that the NHS pays for dollar-priced drugs. The Bank of England flirts with more Quantitative Easing (QE), but opts to wait and see, as they allow sterling to fall to $1.15 and €1. By 2020, inflation is around 3.5 per cent, and rates have risen 1 per cent. Yields (the juicy income you get in exchange for lending the government money via the gilt) move to 2.5 per cent, and thanks to a quirk of bonds’ behaviour which sees their price go down when their yields go up and vice versa, gilt investors make a capital loss.
Scenario number two: a good, orderly Brexit.
Little to see here, and the UK somehow convinces Europe we are still worthy guests at their party. Growth and inflation continue around current levels, of course the stock market falls a bit as the pound rises to $1.4 and €1.25. The Bank of England’s Monetary Policy Committee (MPC) raises rates as inflation remains above target into a third and fourth year. Yields rise to 2.5 per cent by 2020 and gilt investors... make a capital loss.
And finally, our third forecast: Brexit. Is. Awful.
The Bank of England reintroduces QE. The pound plunges and gilt yields fall to 0.5 per cent. Domestic investors make capital gains on gilts (thanks to that quirk of prices having an inverse relationship to yields) – and then realise they would have made more in sterling just buying US treasuries and not hedging the currency.
In this scenario, we also see weak sterling, easy money and full employment create an inflationary bubble reminiscent of the 1970s. We pray debt-to-GDP (a ratio which shows whether an economy is making/selling enough goods and services to pay back its debts) remains below 120 per cent, or else once people see through the QE fudge, the UK will need to call in the IMF.
My firm view is that either scenario one or two plays out, and gilt yields move much higher. If you think I’m wrong then you are betting against a G7 economy with a fully floating exchange rate.
Phil Milburn is co-manager on the Liontrust Global Fixed Income team.
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