Brexit: What would be the fixed income implications under no deal?

An acrimonious divorce between the UK and the European Union could result in recession, credit ratings downgrades and a flight from equities, fund managers warn, as the Government faces the task of turning nine months of Brexit rhetoric into action following the triggering of Article 50 this week.

The pound weakened on the triggering of Article 50, while gilts rose modestly with the 10-year gilt now yielding 1.16 per cent.

The UK has two years to negotiate the terms of its exit from the European Union, including the exit bill, the rights of EU nationals living in the UK and vice versa, and any transitional deal that would allow the country time to establish its new trading relationship with the EU.

The EU has already confirmed that it will not negotiate a trade deal with the UK until its exit has been negotiated, at odds with Theresa May, who stated repeatedly in her Article 50 letter that her Government sought to negotiate both simultaneously.

The “mood music” of Brexit negotiations will provide an early indication on the likelihood of the UK securing a favourable outcome, a Moody’s Investor Services report released last week says.

It states the credit implications of Brexit will be manageable under its base case scenario that an agreement broadly mimics most current trading and regulatory arrangements.

However, it warns collapsed talks or no deal at the end of Article 50’s two-year deadline would be credit negative for a number of sectors and issuers and that a reversion to World Trade Organization (WTO) trading rules would have negative implications for the UK’s sovereign rating.

The ratings agency downgraded the UK immediately after its vote to leave the European Union.

Moody’s warns sectors that face negative credit implications on failed Brexit talks include car and aerospace manufacturers, non-durable consumer goods producers and retailers that largely import their goods, UK airports and airlines, as well as UK universities.

“Any signs of an acrimonious divorce, with a hardening in rhetoric on both sides, would likely result in a deeper impact on demand and possibly a recession,” says Jim Leaviss, head of retail fixed income at M&G.

“In this scenario, monetary policy will likely remain highly stimulatory with the possibility of another round of quantitative easing, while the UK Government may also seek to stimulate the economy through loosening the fiscal reigns.”

Mike Amey, head of sterling portfolio management for Pimco, says if there is no clarity in one year businesses will be forced to assume there will be no deal and start preparing to trade under WTO rules.

Amey says they are underweight sterling and UK gilts.

Collapsed talks or a poor deal for the UK would result in a flight from equities and credit to the relative safety of bonds, and government bonds in particular, says Lloyd Harris, manager of the Old Mutual Corporate Bond fund.

Already May has said that the Government is prepared to walk away from a bad deal and Foreign Secretary Boris Johnson has said that the UK would be “perfectly okay” without a deal.

Harris warns no deal would present problems not only for UK issuers but continental European and US issuers that use London as a base.

“If negotiations collapse, issuers will still have to be fully operational, hence the reason for issuers establishing subsidiaries well in advance of this outcome.”

Regarding the most likely outcome, Harris says his guess is that a transitional deal will extend talks for five to 10 years, pointing out this year alone the European political diary means there are only 12 weeks during which negotiations can take place.

Richard Carter, head of fixed interest research at Quilter Cheviot, says banks make up 20 per cent of the sterling investment grade universe and would be a major area of concern in contrast with recent good performance.

“The sterling corporate bond market is made up of a variety of different issuers and sectors, with roughly half being UK-based companies and the other half coming from overseas.

“If there was a difficult Brexit, where no deal of substance was done with the EU and the UK economy suffered as a result, this would clearly have a negative impact on the market as a whole and in particular UK-focused issuers.”

Carter adds political shocks in France or Italy would have repercussions beyond the Eurozone.

Carter says their sterling exposure is concentrated in the higher quality end of the spectrum, but they are generally biased towards global credit over the UK with yields in the US offering better value.