In the following Q&A, portfolio managers Andrew Balls, Mike Amey, and Philippe Bodereau discuss PIMCO’s outlook for the UK and the European Union amid Brexit, and assess global ramifications.
Q: What is the impact of Brexit on our outlook for the UK and global economies?
Andrew Balls: At PIMCO we like to start with the long-term view, or what we call our secular outlook, which is our framework for the global economy over the next three to five years. We recently met to discuss this and concluded that the world looks “Stable But Not Secure” – a baseline of continued muddling through for the global economy but with rising risks. One such risk is the threat of growing populism and its political and economic consequences. This trend makes us cautious on Europe over the secular horizon, and the results of the referendum are consistent with this view.
That said, for now at least, we think Brexit is principally a UK event, with global knock-on effects contained. In the UK we expect a reduction in growth in the range of 1 to 1.5 percentage points over the next four quarters, dropping the growth rate to close to 0%. We think it is likely that the Bank of England (BOE) will react by cutting its policy rate from the current 0.5%.
Globally, the Eurozone will be most impacted, and we expect further easing measures from the European Central Bank. However, we think the impact of the increased uncertainty on Eurozone GDP will only be 0.2 or 0.3 percentage points. We do not foresee a large spillover effect into the U.S. economy, but we do think the Federal Reserve could delay additional rate hikes. From a previous expectation of one or two rate increases in 2016, we think it now looks likely that the Fed will hike rates once this year. But it’s very fluid and it will ultimately depend on market movements and the economic data. What is clearer is that markets are pricing in very little Fed tightening over time – the next full 25bps rate increase is not priced in until the end of 2018. That to us seems implausible and we think it worth positioning for a faster pace of tightening.
Q: What are the risks to our baseline view?
Balls: One danger is that markets fail to stabilise, and we see a self-perpetuating cycle in which volatility begets more uncertainty, and this subdues economic activity over time. Reactions to date, however, do not support this. Markets seem to have broadly priced in the new reality and moved in line with our view – UK assets have been most impacted, particularly equities and currencies, and U.S. treasuries have rallied on a flight to quality. Eurozone banks have also seen selling pressure. But outside of this, moves have been more muted, and current levels do not appear too extreme given that many assets have hit comparable levels at other points earlier in June. We are only a few days in and this could change but so far the market indications are in line with our view that this is largely a UK event and certainly not a global systemic event.
One key barometer to look at is the U.S. dollar. Since the G20 meeting in Shanghai we’ve had no surprises out of China, but a stronger dollar increases the risks of another devaluation of the yuan, which could trigger considerable volatility, much as it did at the beginning of the year and in August 2015.
Q: Does Brexit threaten the long-term stability of the European Union (EU)?
Balls: As mentioned we see rising populism as a key risk over the secular horizon and we are cautious on European assets for this reason. Perhaps on the margin Brexit encourages other populist movements, but we do not see it as a significant change – the risks were already there. Indeed, the results of the Spanish election over the weekend were better than expected for the centre right party and worse for Podemos, the populist party, possibly influenced by demonstration effects from the UK.
It is also important to realise that the UK has voted to leave the EU, not the Eurozone (the single currency area), of which it has never been a member. To us a country leaving the Eurozone clearly poses far greater risks for stability of the Eurozone than a country potentially leaving the EU. For example, we feel that if Greece had exited the Eurozone in 2011/12 that would have been far more damaging than the UK exiting the EU today. We also have a far clearer view of the ECB’s reaction function now than we did then, given its quantitative easing programme. This will help to limit volatility for European sovereigns. Nevertheless, the risk of a populist party taking power in the Eurozone in coming years, particularly in a big country, remains a clear concern.
Q: What are the next steps for the UK?
Mike Amey: With 52% of people voting to leave, on a 72% turnout, the UK government has been given a clear mandate to initiate and complete the UK’s exit from the EU. The current uncertainty is around who will lead this, following Prime Minister David Cameron’s announcement that he will resign. The selection of a new conservative party leader, who will in turn be prime minister, will be completed by early September. Now that Boris Johnson, the most prominent member of the leave campaign, has withdrawn from the race, the front runners are Theresa May, the current Home Secretary, and Michael Gove, the Justice Secretary. Until that contest is completed, the UK government is effectively in limbo.
There has been some talk among European leaders of forcing the UK to start negotiations before then, but the reality is that only the UK can invoke Article 50 of the Lisbon Treaty, which formally initiates the withdrawal process. We can’t see this happening until September at the earliest, and only once this occurs will the two-year window on negotiations start. So all in all we are looking at a minimum of two years before the UK gets even close to formally leaving the EU.
Q: Could you elaborate on how markets are functioning?
Amey: So far markets have been volatile but orderly and functional. Liquidity has been sufficient, heavy volumes are being traded, and markets are clearing. UK equities and sterling have been hit hard but levels are not alarming, and, as Andrew mentioned, many asset levels are comparable to lows reached earlier in the year. After initial volatility, markets also appear to be stabilising. We think this reflects the event being principally a UK one with global contagion contained. In part, this is due to the timeline mapped out above. This is going to take a long time to play out, with the biggest surprise having already occurred. It’s difficult to see how such a long time frame manifests itself in a broader systemic event. But again, we are in early days, and things could change.
Q: What are the consequences for the UK banking sector? Are the dislocations in UK bank equity and capital securities valuations justified?
Philippe Bodereau: We need to distinguish here between multi-national banks based in the UK, which are principally engaged in investment banking, and domestic UK banks, which are principally retail and commercial domestic lenders. For the former there will be potential disruption in terms of moving certain staff. They may also lose passport rights to do business across the EU, which could have an impact, but overall these are operational disruptions with limited macroeconomic significance. For the latter, however, the situation is very different, and we think the fall in share prices is justifiable. Lower interest rates, slower loan growth and rising credit losses all feed into lower forecasts for future earnings.
From a credit perspective, the outlook is much more sanguine. UK banks have high capital ratios of 12%-16%, and large and liquid balance sheets. They have performed well in recent stress tests, and we currently see no signs of what may be a political crisis turning into a banking crisis. We think the dislocations in valuations in this sector, particularly in UK bank capital and subordinated debt, could offer opportunities.
Q: Is the same true for Eurozone banks?
Bodereau: Eurozone banks have also seen high volatility following the Brexit result, but they have been very volatile year to date, with investors seemingly relentless in chasing down the weakest links. This includes Italian and Portuguese banks with high non-performing loans and capital deficits, and given existing solvency concerns and risk-off sentiment it’s no surprise these names are down. The sell-off in banks with stronger balance sheets and high dividends looks less justified, and after what was more indiscriminate selling on Friday, we are beginning to see differentiation return.
Q: Do we expect sterling to fall further, and what will be the impact on UK gilts?
Amey: As mentioned earlier we expect the UK’s growth rate to decline to close to zero. Therefore, we believe the Bank of England will be far more influenced by anaemic growth than any rise in inflation that results from sterling’s fall.
At current levels we believe sterling looks fairly reasonable and we do not expect a sharp bounce back. The general uncertainty is likely to prevent this as currency markets tend to be the principal mechanism for pricing political risk.
In terms of the impact on gilts, rates are down around 40 bps since before the vote, and we struggle to see any strong upward pressure given the likely rate cuts from the BOE, and the potential for additional quantitative easing. We do not, however, believe rates will go negative.
Q: Many have drawn parallels between the UK voting to leave the EU and the rise of Donald Trump in the U.S. Do you expect a similar market reaction in the event Trump wins the Presidency?
Balls: Who becomes U.S. president is a question of significant global importance and so the election of Donald Trump, where there is much uncertainty surrounding his views and suggested policies, would likely elicit a negative reaction from markets. Hillary Clinton by contrast is a much more known candidate. Overall, the EU referendum in the UK reinforces the need to pay attention to populism and political risks in the coming years, including in the U.S.
Q: Do we see buying opportunities in any sectors where valuations have significantly declined? What are the broader implications for portfolios?
Balls: The banking sector has seen the most dislocation in valuations, and we expect to find good opportunities there. More broadly we have a positive view on corporate credit, particularly of higher quality sectors, and in asset-backed securities – relatively low risk and high quality exposures that our colleague Dan Ivascyn calls “bend but don’t break” spread positions. We also continue to think that U.S. TIPS are attractively priced and offer valuable protection against the possibility of higher U.S. inflation over the coming years.
Amey: The overall takeaway is that populism is becoming an increasing risk to politics and markets, and therefore our investment portfolios. Right now we think the impact of Brexit will be largely contained to the UK, but we are less than a week into a post-Brexit world and we need to monitor the situation carefully. As such we will seek to take advantage of opportunities, while proceeding with caution.
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