Gilts return more than 3x global equities

Howard Cunningham, Fixed Income Portfolio Manager at Newton Investment Management comments on sterling and gilt yields as Brexit negotiations continue:

“Gilt investors have so far benefitted from the never-ending story of Brexit with over-15-year gilts returning more than 22% in the year to 30 September 2019. Although recent optimism that a deal between the UK and the EU could be agreed generated a dip in gilt prices at the end of last week while the pound jumped at the news.

“Agreeing a deal acceptable to the EU is possible. Agreeing a deal acceptable to Parliament is also feasible. The difficulty lies in making it the same deal. The more concessions the UK makes, the higher the chances of agreeing a deal with the EU, but conversely the lower the chances of parliamentary approval. Even if an outline of a deal is reached, it seems odds against ratification by 31st October, and so another extension will be required, either to allow time for ratification, or go back to the drawing board in the event of no agreement (an election or referendum).

“Unsurprisingly there remains some concern in the market that an extension may still be needed. A delay could avoid the worst effects of an immediate ‘cliff-edge Brexit’, although more months of uncertainty would likely inflict further damage on investment activity and consumer confidence, weigh on economic growth as well as on the pound, and support gilts.

“The UK remains reliant on inward investment, with overseas investors owning approximately 28% of the UK gilt market. A disorderly Brexit could cause them to reconsider their exposure to gilts. The central bank could increase asset purchases and domestic investors may increase their gilt weightings as a ‘flight-to-quality’ move (versus other domestic UK assets), which would take up some of the slack, but a large buyer turned seller could well push gilt yields up. “According to the IFS even with a Brexit deal in place the UK’s deficit could nearly double to £50bn, and the debt/GDP ratio is headed towards 90% (a level not seen since the mid-1960s). It predicts that the deficit will double again (to over £100bn) in the event of ‘no deal’, even if disruption is kept to a minimum. Furthermore, rating agencies have already downgraded the UK since the 2016 EU referendum, and have indicated they will cut the rating further in the event of a disorderly Brexit.

“Small sovereign downgrades from very high levels do not necessary lead to higher government borrowing costs (indeed, the reverse was true in the US and Europe over recent years). However, the relationship between ratings and spreads for risk is not linear, and subsequent downgrades may have increasingly negative effects.

“The best near term outcome for sterling would be if a deal was reached by the end of the week, however, if a deal is not agreed there is likely to be a further extension that could bring continued low growth, low appetite for risk, and ultra-low gilt yields. Investors will be watching the negotiations closely this week and we expect to see further shifts in gilt yields and the pound.”