Tomorrow sees probably one of the most important policy decisions from the BoE in recent history as futures markets have priced in a 100% chance of a cut in rates; to the lowest level on record. The Brexit effect has seen a deterioration in the UK’s economic fundamentals; business confidence now sits near financial crisis levels, manufacturing shrank at its fastest pace in three years in July and construction has rapidly contracted. No doubt the central bank will forecast much lower growth and higher inflation in the UK for the next couple years. In fact, the IMF slashed its growth forecasts for the UK to 1.7% in 2016 and 1.3% for 2017. Interestingly though, despite these being some of the sharpest downgrades, the IMF still expects the UK to expand at a faster rate than Germany and France for example.
The BoE has maintained interest rates at lows of 0.5% since March 2009, a cut to rates whether by 0.25% or to zero, would see the island nation’s rate lower than that of the US for the first time in a decade. The first and longest time the world witnessed a UK/US rate flip was between November 1980 and September 1984 where the pound fell a massive 49% against the dollar! Having already fallen over 10% (at time of writing) from the pre-referendum highs, we expect that sterling will come under renewed pressure when rates are cut. How far the sterling will fall is anyone guess, but tomorrow’s meeting will give some indication as to how markets will react depending on how aggressively the BoE eases policy (both in terms of rates and QE); the more aggressive its policy stance, the greater the downward pressure on the currency. Our best guess at this time is that sterling has moved to a value which balances the current risks, however, there does appear to be more downside than upside pressure in the near future.
We expect the UK economy will suffer short-term weakness as corporate investment, hiring and consumer expenditure are hit. The main focus is on how the free trade negotiations between the UK and EU unfold. In Switzerland for instance, free trade has been strongly linked with freedom of movement; for the UK populous this is a major factor as immigration was the main reason cited for the Brexit vote.
Stratton Street has exposure to the UK via the likes of pensions and investment company, Scottish Widows. Rated Baa1/A- the 5.5% 2023 issue is trading at a very attractive spread of ~330bps over Gilts. Our proprietary Relative Value Model calculates that the bond should be trading at around 135bps over, which suggests it is currently 4.5 credit notches cheap; thus more than compensating for any downside risks. In a world where 7-year Bunds are trading at negative 0.4% this holding continues to offer an extremely attractive yield around 4%.