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Fears that the credit markets will be adversely affected much further by a Brexit are overblown, or at least have been priced in to a certain extent, as fundamentals are unchanged, says portfolio manager Victor Verberk.
Spreads in corporate bond markets have widened amid concerns that the UK will vote to leave the European Union in a referendum on 23 June. The issue has also caused a run on the pound, which has depreciated by 10% against the euro, and raised volatility in fixed income markets generally.
This volatility rightly or wrongly might fuel contagion risks on the periphery but this seems to us a bridge too far, says Verberk, Robeco’s Head of Investment Grade Credits and manager of the Global Credits fund.
Current opinion polls show that 50% of Britons favor remaining within the EU, while 35% support a Brexit and 15% are undecided. Historically, those undecided in referendums or national elections have tended to vote for the status quo, which would tip the balance comfortably above the 50% needed to remain in the EU.
“This is not the same scenario that we had when Greece almost exited, Spain and Italy were bailed out and the whole Eurozone was at risk: it’s of a totally different magnitude,” says Verberk. “The UK has never been part of the Eurozone, but part of the EU and a trading bloc, The market’s reaction to this theme might have been underestimated beforehand, but let’s not overdo the problem here.”
Verberk’s fund has an overweight position in corporate bonds of UK financial institutions. “Although it’s not fundamentals that drive credit spreads in the short term, we don’t expect that credit fundamentals will change. The debate is what the British pound will do, the effect of a Brexit on Foreign Direct Investment (FDI) flows, and on British GDP growth,” says Verberk.
‘Uncertainty about FDI flows moving out is over-estimating things’
“But we have to remain wary here too, especially about the potential FDI flows out of the UK. FDI flows are incredibly difficult to pinpoint, and if you look at Brazil, the country is in a depression and yet FDIs are still strong. So talking about uncertainty about FDI flows moving out is over-estimating things.”
“On pure credit fundamentals, British corporates would become more competitive as the pound has already weakened by 10%, which is a big move. So the market has already adjusted partly at least. UK exporters would benefit if the GBP remains on the weak side.”
“If the UK exits, a new trade agreement would have to be formed, and that would take a few years. That could cost some GDP performance temporarily – maybe a few years. But it seems excessive to believe that the UK would enter a slower growth era due to an exit. After all the UK has historically been more years out of the EU than it has been in it.”
Verberk says that once the core Brexit volatility has died down – and that might take a few months – the market will go back to looking at the fundamentals that lie behind decisions on whether to invest in UK credits versus their European or US peers, with some potentially favorable comparisons.
“Credit fundamentals won’t change but the market risk premium has changed, and you can see this in UK banks such as Barclays and Lloyds, whose credit spreads have underperformed quite heavily this year,” he says. “Non-banks such as Vodafone have also underperformed dollar and euro credit markets. But we do not see a change in the underlying fundamentals of these companies. For Vodafone, we even see a positive currency translation risk as the money the company makes outside the UK translates into cheaper sterling. Exporters might benefit even more.”
‘UK banks are really cheap now’
“In our credit portfolios we are overweight on UK financials because the UK banks until now were the fastest recovering in cleaning up their balance sheets” he adds. The financials sector has sold off since January, with the UK selling off even more, and the UK banks are really cheap now.”
“The risk-off market has been fueled by a recession fear in the US, consensus positioning in financials (both long credit and equity managers in the financial sector), and a fear that central banks are out of ammunition after QE. Brexit fears came on top of this. Therefore we have to be careful extending risk factor trends.”
“In conclusion, in the medium term these kinds of events tend to revert to a more average position, especially if fundamental trends do not change dramatically.”