Wealthy Nations Daily Update - Brexit: Do Gilts Offer Relative Value?

So far this year using “sterling” as a compliment is rather unbefitting; the Great British Pound is among the worst performers year-to-date of any currency. Today it dropped below 1.40 to the US dollar and is currently down over 5.5% year to date - more than the Korean won (5.0%), Russian rouble (4.5%) and the Indian rupee to name but a few others ranking near the bottom. Since London Mayor Boris Johnson’s announcement to back the “Out” campaign on Monday the pound accelerated its decline. Sterling now only has to drop a little further, to below 1.3770, to surpass GFC lows - allowing the headlines to turn from “7 year lows” into “30 year lows”. Moreover the press are peddling analysts’ “forecasts” that a Brexit could push the currency below 1984/5 levels. That would mean a further 24% decline to below 1.0520 to the dollar, at which it would become a “new all-time low”. Incidentally during this Sceptered Isle’s zenith one could apparently get 10 dollars for each pound note (20 shillings). However this was around 1864 - a time when the US introduced Greenback notes as a fractional currency during the American Civil War.

For some time now front pages, financial blogs and news-streams have been littered with Brexit headlines and speculations. It’s easy to lose interest in such political charades that drags on yet continues to waver and prove difficult to forecast. So have markets fully factored in the recent swing in public sentiment towards the “Out” campaign? The jury is still very much out on what the outcome will be (and which outcome would ultimately be most beneficial economically) but FX markets have at least been trying to respond to shifting sentiment. Elsewhere investors seem somewhat subdued in hedging against a Brexit and related risks. The FTSE100 barely moved on the day of Boris’ latest dissension and the dent on Gilts has already been reversed. 10 year UK Gilt yields have again pushed lower to 1.37%, down from 1.96% at the start of the year.

With UK’s government debt around 100% of GDP, alongside the debt uncertainties surrounding a follow-on Scottish referendum, it seems possible that the risks have not yet been fully accounted for in market prices. The £1.43tn gilt market should not simply be considered a “safe-haven” because of its current low yields and historical stature. Even if the likelihood of default remains low the potential for spreads to widen from such levels seems relatively unattractive. The lack of cushion in spread protection and vulnerable Net Foreign Asset position accentuate the fallout from a potential British exit from the EU. We are by no means bearish on the future of the British economy but tend to observe that risks in “familiar” but indebted economies can often be understated whereas concerns over “emerging” but also creditor nations/corporations can often be a little neurotic. For example, hold the likes of Microsoft (Aaa/AAA) or Apple (Aa1/AA+) instead of similar duration Gilts (Aa1/AAA) and you receive around double the yield (and without exposure to sterling). In addition to their similar credit rating, and arguably at least equal ability to pay creditors, such bonds offer an important cushion in their spread which should help protect against potential downside volatility. Our investment approach attempts to identify value on the basis of fundamentals and not shifting market biases. Where uncertainties prevail without being adequately compensated for we will look for alternative opportunities that do offer attractive risk adjusted returns.