European markets are still digesting the shock result of the UK’s Brexit referendum. How should investors in European fixed income and equity markets navigate the turmoil?
In fixed income markets, the Brexit vote and resulting spike in investor risk aversion spurred a sharp sell-off in Europe’s corporate bond markets. This resulted in higher yields and wider credit spreads—with high-yield bonds selling off more sharply than their investment grade counterparts. The safest government bonds were key beneficiaries of investors’ flight to safety.
European stocks also sold off hard in the first two trading days after the Brexit result. Investors are demanding a higher risk premium for the political uncertainty in the region and discounting lower earnings growth because of a higher risk of recession in the UK and possibly the rest of Europe.
Amid the unprecedented political uncertainty what should investors in European assets do? Where can they find the bonds best placed to play their crucial defensive role in portfolios? And how can they best ensure the strong positive returns they need from their equities? We believe that staying active is essential to navigate the regional risks and to uncover opportunities that are being created in the uncertain environment.
Pulling All the Bond Levers
When markets are driven by uncertainty, bond investors need to be able actively to shift the two biggest levers in their portfolios: credit and interest-rate (or duration) calls, which tend to counter each other.
Credit performs best in ‘risk on’ environments, while duration works better when ‘risk off’ prevails. At times, higher-yielding bonds with low credit ratings and closer correlations to equity markets will offer most value. But investors need some interest-rate exposure because the longest duration bonds tend to perform best when equity markets pull back. Easing up the credit lever means the duration lever needs to be squeezed more firmly.
Seeking Out Shock Absorbers
At the same time, investors have scope to seek out better ballast from their bonds. The yields on offer from some of the longer-dated European government bonds, which dominate key regional bond indexes, are so low that they’ve very little room to fall any further when turbulence strikes. In Europe, yields on German government bonds with up to 15-year maturities are now negative. Our analysis suggests that when bond yields fall meaningfully below 1%, they’re much less able to dip significantly further when investors flee to safe havens. So ultra-low-yielding government bonds, like Bunds, are proving less effective shock absorbers when equity markets slide.
Investors who actively seek out exposure to higher-yielding bonds issued by governments outside “core” Europe may capture better ballast to offset equity market falls. Higher-yielding UK government bonds (Gilts), Australian government bonds and also US Treasuries all significantly outperformed Bunds during the recent turbulence.
While the current volatility is dominating market sentiment, it’s important to consider the wider environment in which European bonds are trading. The European Central Bank is still carrying out its quantitative easing program, buying €80 billion of sovereign, covered and corporate debt every month. This has already helped ease market stress and it will continue to reduce the spillover effect from Brexit into European bond markets, in our view.
Searching for Equity Opportunities
The European equity sell-off was not indiscriminate. Stocks of companies most obviously at risk—especially in the financial sector—were down most, while more defensive names fell less, or in some cases rose.
Markets also quickly distinguished between companies most hurt by the sharp fall in the British pound and the euro. Generally speaking, companies with earnings mostly or entirely in those currencies were punished more than those that generate more revenues in other currencies. In our view, stock markets have done a reasonable job of reflecting the changed outlook, especially given the lack of any clarity about when and how the political process of negotiating the UK’s future relationship with the EU will move forward.
But has the crisis created new opportunities for equity investors? We think so, particularly in the following three areas:
- Large-cap European names disproportionately affected by investors selling the index. Investors following systematic risk parity or risk control strategies are forced sellers when markets fall sharply, often using index-tracking ETFs or other passive instruments for their trades. This can cause the prices of some large-cap stocks that make up a big portion of the index to fall more than any fundamental change in their prospects warrants.
- Financial stocks that are less exposed to the economic cycle. Some well-capitalised retail banks with strong franchises, especially in northern Europe, may offer even better returns after the sell-off.
- Energy companies with revenues in US dollars and limited domestic European exposure. The oil price fell in the wake of the UK vote along with other risk assets. But our research suggests that tightening supply, not sentiment, should be the main driver of oil prices over the coming months.
The UK’s referendum vote has been very unsettling for equity and fixed income investors alike. At times like these, we believe that portfolio managers must move carefully both to protect their capital in areas now at greater risk, but also actively to search out potential new opportunities to generate returns.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.