How will Brexit impact bond markets and interest rates?

In this second article of special investigative two-part financial series we look at what Brexit really means and how the decision that shocked the world may impact us.

As expected the initial impact on bond markets, following Britain’s decision to leave the EU, has been a “flight to quality”. As markets hate uncertainty investors have sought the perceived safety of markets including the US and Germany. Yields in both these countries have fallen as demand for their bonds has increased. (See Table 1 & Table 2)

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Table 1: US 10-yr Treasury (Source: investing.com)

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Table 2: German 10-yr Bund (Source: investing.com)

In the European peripheral countries that were at the centre on the European debt crisis in 2011, there has been a spike in their yields as concern of a European Union collapse takes hold. (See Table 3 and Table 4)

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Table 3: Greek 10-yr Bond (Source: investing.com)

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Table 4: Italian 10-yr Bond (Source: investing.com)

However as illustrated in the above graphs, at this time, the impact has been fairly muted compared to during the Global Financial Crisis of 2007.

Credit spreads (see Table 5) in the U.S. and Europe have widened, especially in high yield. Based on credit default swap levels, it looks like energy and financials will be the hardest hit. However here too we expect the impacted to be moderate.

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Table 5: Global Credit Spreads (Source: PIMCO)

In Australia the impact may be less direct

What is the impact on interest rates?
Many central banks have been supporting their economies by maintaining low levels of interest since the outset of the Global Financial Crisis. The decision by Britain to leave the EU is likely to result in many central banks continuing or increasing their support. This is especially likely in Britain and the US.

In Australia the impact may be less direct. Wholesale Australian bank funding costs will track increasing European spreads given Australian banks have a large dependence upon those markets, so out-of-cycle bank rate hikes may occur even as the RBA eases. This, along with further expected falls in commodity prices, will put increased pressure on the Reserve Bank to cut rates further.

So, what does this all mean?
The key impact on bond markets is likely to come from the increased uncertainty that has gripped all financial markets. However, it is important to keep this development in perspective. Whilst credit spreads have widened and trade sizes are smaller, bond markets continue to function as normal. We do not believe Brexit poses a threat to the financial infrastructure, including the settlements process, pricing and the ability of fixed interest funds to strike a Net Asset Value (NAV). In stark contrast to the Grexit vote last year, where widespread capital controls and bank solvency were at stake, Brexit involves no such risks. Nor is it likely to compare to the Global Financial Crisis of 2008 which saw credit markets freeze up.

There are a number of major implications for Australian Stocks

How will Brexit impact Australian Equities?
There are a number of major implications for Australian Stocks. Firstly, a global economic slowdown will impact all Australian stocks from an earnings, valuations, risks and sentiment perspective. On a more specific level, those stocks which have earnings coming from either the UK or Europe will be at increased risk of downgrades and finally companies which have leverage to financial markets will also experience a negative impact to earnings. Our overarching view is that markets will continue to experience high volatility, increased uncertainty and most likely a continuation of previous themes where investors favour safety, yield and quality.

Resources
Companies with  large Commodity and Energy exposures Including BHP, RIO, WPL, STO, OSH and S32 will all be impacted by lower commodity and oil prices as markets fear slower global growth moving forward. We also highlight stocks such as ILU, which have over 25% of revenues coming from Europe, as a risk.

BHP and RIO do not specifically have a large exposure to the UK, however because they are listed on the London stock exchange and therefore compared with UK businesses and alternatives within the FTSE indices, these stocks will most likely be under pressure on this relative basis.

Diversified financial companies as well as banks face risks from multiple sources

Financials
Diversified financial companies as well as banks face risks from multiple sources. The Australian banks will most likely face increased funding pressure as Europe and the UK is a source of funding for the major banks. The diversified financials are subject to the market malaise, lower investment returns, and exposure to underlying listed assets. The increased volatility will impact earnings and returns and has the potential to negatively influence fund management fees and corporate activity going forward.

We highlight the highest risk to earnings is to CYBG (CYB) with 100% exposure to the UK and we highlight that Research recommended selling CYBG post listing. In the case of Henderson Group (HGG) while the group is predominantly exposed to the risk of FUM (“Funds Under Management”) outflow due to Brexit and a recession, HGG will benefit from their exposure to USD, EUR, AUD and translating their earnings back to a weaker GBP. Similarly, BT Investment Management is also exposed to the UK market, both through FUM invested in the UK and a UK client base, but they have an added earnings risk of translating a weaker GBP into AUD.

Other financial services stocks such as Computershare (CPU) (projected 600m GBP Revenue over 7 years – UKAR acquisition) has more than 25% of earnings from the UK/Europe, QBE 15% of revenue from the UK and 20% from Europe and Macquarie approximately 10% of earnings. While Iress (IRE) with over 25% exposure of earnings at risk given their financial planning and software businesses.

Industrials
It should be noted that not all earnings would be UK/Euro based and therefore more likely to experience a lower earnings number and potential growth number than an absolute collapse in earnings. This is clearly dependent on the stock and the percentage of earnings exposed to the UK/Europe. The negative or contagion affect from a European slowdown would have a far greater impact on global stocks like Brambles 35% of revenue from Europe/UK, Amcor 30%, and airline stocks negatively impacted by travel like Qantas and Virgin as UK and Europeans face slower economic growth and weaker currencies.

Real Estate
Other stocks we would highlight which potentially face earnings risk should there be a recession in the UK/Europe, in the property space include the likes of Lend Lease (LLC) 10% of earnings, Goodman Group (GMG) with 25% assets in Europe and Westfield Corp (WFD) 25% of earnings.

Bear in mind that WFD earnings are made up of medium to long term leases which are more stable, while LLC has pre-sold a number of apartments and settlement is more of an issue.

Healthcare
Generally the healthcare sector should benefit from their defensive nature and the stronger USD protecting income especially Resmed (RMD) and CSL, however the likes of Cochlear (COH) with 40% of revenues coming from Europe and Ramsay Health Care (RHC) 35% exposed to Europe and the UK are slightly more at risk.

Other companies
In the case of Breville Group (BRG), the rest of world (includes UK business) is 25% of EBIT, but as ROW includes the distribution business we estimate actual exposure to UK at less than 10% of earnings, though this is the growth driver going forward. Domino’s Pizza has 25%.of revenue from Europe, will be at risk of a general global or Macro slowdown, whereas domestic only stocks will be impacted by the macro slowdown and the potential negative impact of market sentiment.

In summary
Overall the impact of BREXIT we feel will have a far larger impact from a sentiment and economic growth perspective as uncertainty and risk linger and the question of the future of the EU remains in focus. We believe market performance will remain volatile, a risk-on/risk-off environment will continue and Investors will continue to favour yield and certainty.

We are of the belief that volatility and global market events will always be present and that over the long term risk will be rewarded to those who invest in high quality companies, presenting reasonable growth, solid financial with good management will benefit in the long run.

What are your biggest concerns regarding Brexit? Let us know in the comment section below.

Research Analyst – Jake Bowmer, Eric Chim, Alex Harris, Elan Miller, David Pobucky Approved By – Paul Saliba

Research Analyst Disclosures

I, David Pobucky, Elan Miller, Jake Bowmer, Eric Chim, Alex Harris hereby certify that all the views expressed in this report accurately reflect my personal views about the subject investment theme and/or company securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
I, David Pobucky and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: HGG
I, Elan Miller, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: BHP, RIO,
I, Jake Bowmer, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: Nil
I, Eric Chim, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: HGG,
I, Alex Harris, and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: Nil

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