On the surface, Britain's exit from the EU appears to be supported by the positive economic performance over the summer, also thanks to a more competitive pound and lower interest rates. However, there is a risk that the UK will decide that controlling immigration is more important than maintaining access to the single market, resulting in a deterioration of trade and the potential flight of non-UK companies from the country.
We all know the risks: The UK has a large deficit, the direction of its post-Brexit policy is unclear and capital outflows could drive up bond yields sharply and further weaken the exchange rate. The equity market has so far welcomed the decline in the pound, but the increase in volatility in currency markets and interest rates could hurt the economy even before we see the real consequences for trade and investment.
It is therefore difficult to be optimistic about the country and its financial resources, unless bonds fall further, a clear Treasury spending plan is proposed and Brexit negotiations take a more positive turn. For the moment, therefore, I don't think there are many reasons to be particularly optimistic.
Politics was a major driver for markets in 2016 and that bias will not change. When I think of all the political risks we are facing, there is reason to be quite pessimistic. If global growth were around 4-5%, the situation would be different, but this is not the case. The difficult relationship between financial market valuations and economic fundamentals is rather fragile.
So how to protect the bond portfolio?
I think bond investors need to be very cautious. This means limiting duration risk, given the possible increase in yields resulting from expected political changes or inflationary risks. It also means limiting credit risk due to the sensitivity of tight credit spreads to volatility in interest rate markets.
Interestingly, while the Bank of England has bought over £500m in corporate bonds in recent weeks, spreads are wider and the corporate bond index has underperformed Gilts since mid-September. We prefer breakeven inflation exposure and the diversification offered by emerging market debt. Overall, however, the bond rally is over for now and the last thing investors need is market beta exposure in fixed income.
