Frequently Asked Questions
Call our team on +44 20 7321 1502
or email Client Services Team
Insight's clients and consultants have presented our specialists with questions ranging from the political to market implications of the UK's referendum result to leave the European Union (EU).
On Tuesday 5 July 2016, at a webinar focusing on the referendum result, David Hooker and Gareth Colesmith, Senior Portfolio Managers in Insight's Fixed Income Group, Rob Gall, Head of Market Strategy in Insight's Financial Solutions Group, and Andy Burgess, Product Specialist in Insight's Client Solutions Group, shared their views.
The following questions and answers summarise the conclusions offered in the webinar, which can be accessed here.
Q. Is there a political possibility of a reversal of the UK's decision perhaps through another referendum following negotiations or an early election?
David Hooker: Yes, though this is not a high probability outcome. Most Conservative candidates have suggested that they will respect the referendum decision. However, public opinion could change during the negotiation period, because of changed economic conditions or because they don't like the direction of negotiations. Therefore it cannot be ruled out. Even if it is not the base case, it is certainly possible.
One question is whether an early election might happen. If we were going to have a second referendum, you'd need to have another election, or tie in the question with the election. These are politically very difficult issues for the Labour and Conservative parties given the depth of division on this issue. There is a lot of political pressure.
Q. What does the outcome of the UK referendum mean for Europe in terms of future monetary policy moves by the ECB, and how serious is the impact of rising euroscepticism among other EU members?
Gareth Colesmith: With regard to future monetary policy, we believe the European Central Bank (ECB) is likely to keep policy very easy. We don't expect moves toward more negative rates - the ECB has reached effective limits where further moves will have more negative impacts for net margins of the banking system. We think rates will therefore probably remain where they are. We expect an extension to the quantitative easing (QE) programme, and maybe even an increase in its pace.
This is an issue given the moves in yields, particularly on the German yield curve where they are negative out to 15 years. The ECB is running out of German bunds to buy. It will need to buy something else - this could lead to an increase in corporate bond purchases, an extension to bank bonds, or something more radical like equities. It could also keep purchases limited to government bonds, but shift its allocations.
There is some speculation of a shift from a capital key to a market weight key which will be good for Italian bonds. More likely is a reweighting of the capital key, with the exclusion of Germany, which would be good for Italy to some extent but better for France.
As for rising eurosceptism, this has been a trend for some time. There are eurosceptic governments in Poland, Hungary, Finland and Greece. Typically these want to reform the EU, and perhaps return some power to national governments. That said, there aren't any governments looking to leave the EU.
There are some elections approaching. The first significant one is in Netherlands early next year. The eurosceptic PVB/Freedom Party is currently in the lead. Given the proportional representation system, they would need to form a coalition. More likely is a coalition of centrist parties. In the French election, we expect Marie Le Pen to do quite well. Ultimately, more is likely to be won by the centre-right parties. The German election is due in October next year. The Alternative for Deutschland party is rising, but they are nowhere near gaining power; Merkel remaining in power is more likely. In Italy, there is a referendum on constitutional reform in October 2016. Prime minister Renzi has said he will step down if the reforms are turned down - this could lead to fresh elections in Italy sooner than expected. There is a risk that the moderately successful eurosceptic Five Star Movement party could do well.
Q. Why has the decrease of the UK yield curve been higher?
Rob Gall: There has been a larger fall in UK government bond yields relative to elsewhere because we've seen revised expectations of monetary policy in lower rates and additional QE. The UK outlook in terms of growth has been mostly affected.
There has also been a bigger fall in conventional gilt yields versus index-linked gilt yields. There has been some knock-on effect in terms of inflation moving lower, which has produced the fall in real yield. The expectation is that QE will be centred on nominal gilts rather than index-linked gilts, and hence the UK conventional gilt yield curve has fallen more than in other markets or the index-linked gilt curve.
Q. Is there a possibility that the Bank of England QE programme will include purchases of corporate bonds?
David Hooker: Yes. The first UK QE programme was extended to corporate bonds. It was a very small part of the programme. Unlike the European market, the sterling credit market is relatively small and illiquid.
Q. Why has there been a delay in triggering Article 50?
David Hooker: There are reasons to delay triggering Article 50, other than it is the best negotiating card the UK has. No one is in a place to make a decision. David Cameron is in no position to do it having lost the referendum; we don't know who the next candidate is going to be in terms of leadership of the Conservative party. We'll have a better idea in September of the political view of the incoming cabinet. Also, while the UK has the advantage of making the decision to trigger, the government is able to begin direct negotiations. This will allow time for positions on both sides of the Channel to be established and find common ground if possible. It would help start negotiations if there was an agenda. Overall, delaying the trigger of Article 50 is partly due to UK politics and partly due to European politics.
Q. What do you think will happen to short-term rates and inflation?
David Hooker: The short-term effect of a leave vote is inflationary. There has been a sharp devaluation in the pound, but this began back in November 2015. This will lead to higher energy costs, food prices and import goods. It will take time to come through: we have not yet seen the impact of the sterling depreciation that started in November. We expect inflation to become an issue in the second half of 2017.
However, the long-term effect will most likely be deflationary. Beyond the initial effects, the Bank of England will look through the pick-up in inflation two or three years out, and the prognosis is for lower core inflation: lower economic activity will lead to lower inflation. It also depends on the credibility of the policy measures taken. The UK has to attract foreign capital to finance the budget deficit and the current account deficit.
If there is a true crisis of confidence in the UK, this could turn out to be highly inflationary. However, we are in a world where inflation is low, and it is hard to see the UK completely on its own with regard to prices. The wrong policy option could lead to 1970s style crisis. This would be in stark contrast to what is going in the rest of the world.
The most likely scenario is lower inflation, following the currency impact, given lower demand.
Q. Do you think the Bank of England has the tools to keep that scenario in check?
David Hooker: Yes, they certainly have enough tools at their disposal. Mark Carney has indicated that he wants to keep rates positive and we are already approaching the lower limit, with markets pricing in a level of 0.1%.
Gareth Colesmith: The Bank has enacted QE before, and has scope to bring in other policy measures. QE is predominantly centred on government bonds, and corporate bonds and other assets could be included. Another option is the Funding for Lending Scheme, which was used to encourage bank lending by reducing cost of capital for banks. There are also other policy levers that central banks have used elsewhere. We could also use some form of helicopter money - this would be much easier to do in the UK in the post-referendum world than in the eurozone, given there is only one Treasury and a single monetary policy.
David Hooker: There could also be a fiscal response. George Osborne has abolished the requirement to reach a budget surplus. A £20 billion-per-year programme to fund infrastructure investment via long-dated gilt issuance has been mentioned.
Q. What upside can we expect from the decision to leave the EU?
Gareth Colesmith: There are not many upsides. From the UK corporate point of view, the best that can be hoped for is a Norway-style deal, which has many of the features of the current EU system without having a seat at the table. The alternative World Trade Organisation-type deal would be quite detrimental to UK trade, at least in the short term. In the very long term, it is hard to say. The UK may be able to form new trade deals with other countries, but realistically we need at least a decade to pass these through.
Q. Can you offer any insight into what to expect during the negotiation period?
Gareth Colesmith: Once there is a functional UK government again, we will have a clearer idea of what they will be pushing for. It is starting to become clear that the UK wants some restrictions on the free movement of people, while maintaining access to the single market. The key depends on who the prime minister is and which of these they prioritise. Theresa May is focusing on access to the single market and protecting the City of London; Andrea Leadsom seems to favour the restriction of movement of people.
The EU will be reluctant to give way on fundamental freedoms. Similar to Switzerland, the UK won't get access to the single market without accepting those freedoms. Ultimately we believe the EU will offer a range of options, from a Norway-style system to a complete exit for the UK. It is up to the UK government to decide. Whether they try to take the decision to another referendum or a general election is impossible to say at this stage. The view of Angela Merkel is very important during these negotiations.
Q. What will recent announcements from rating agencies spell for the gilt market and investors?
David Hooker: We expect very little. The announcements have already come out and the market took little notice. The UK controls its own currency and has the ability to control its own interest rate, and can therefore print money to pay back the debt, inflate debt away through domestic policy, or it can repay the debt. In a world where we are seeing deteriorating credit quality among governments, the AAA status that George Osborne targeted matters much less today.
Rob Gall: At the margins, there might be some effect on derivative contracts where specified underlying collateral is required to be AAA-rated. There may be substitutions required or changes to contract notes.
Q. Do you expect relative credit spreads between UK and European credit to widen substantially given macro and different monetary stimuli?
Andy Burgess: It is important to distinguish between the country, rather than the currency, of the underlying issuer within credit markets. For example, in 2016 UK financials have underperformed, irrespective of their currency of issuance. There are some other dynamics at play - the ECB supporting euro-denominated non-financial debt is supporting markets there relative to the UK. Meanwhile, the Bank of England is looking at more non-conventional measures which could potentially include the purchase of corporates which could mitigate spread differentials. For us, the US credit market is the most attractive of the developed investment grade markets, rather than the UK which is much smaller and less liquid.
Q. How much freedom does the UK really have with fiscal policy given its current status?
David Hooker: Given the UK is running a large current account deficit and large budget deficit at a time where there is a political vacuum, and the central bank has announced further easing before we have seen the impact of the vote on the economy, one would expect that more fiscal stimulus would be treated badly by markets and a higher premia in terms of bond yields would be required. Yet after the response to George Osborne's speech to abandon targeting a budget surplus at the end of parliament, markets didn't react at all.
Carney has proposed buying gilts in the QE programme to effectively fund government for another year - there seems to be little restraint from the markets in terms of any reaction to aggressive fiscal easing. Whether this is sustainable in the long term is open to debate. In the short term at least, markets have effectively given the government the green light.
Robert Gall: Over the last few years, the most that overseas investors have bought of UK gilts is about £80bn. Even if international investors stop buying UK gilts, if there is a QE programme of £100bn, then that is more than replaced. Also, domestic demand for gilts in terms of hedging activity continues. Even though classical economics would tell you that the UK's fiscal position should be challenging, there will be no problem selling gilts - even at these yield levels.
Q. Given that there are French and German elections next year, does this leave the UK in a bad position for negotiating with the EU if Article 50 is triggered later this year?
Gareth Colesmith: Yes. The timing of when to trigger Article 50 is the only card the UK has to play in negotiations.
The issue is that there is a fixed two-year period after Article 50 is triggered which can only be extended if there is a unanimous vote from the remaining states. If during that two-year period there are election campaigns, leaders will not have time to have negotiations. They will be busy focusing on other things during the run-up to those elections. This is why the UK referendum was held in June as European leaders wanted it dealt with ahead of these upcoming elections - they knew that there would not be the time to negotiate with David Cameron for the concessions he wanted.
Realistically, unless we were to trigger Article 50 very soon and have a few months of negotiation into the winter, it is not unreasonable to think that we may not trigger Article 50 until the autumn of next year because we are not going to have negotiation partners who are going to be able to negotiate. If we trigger Article 50 quickly it would put the UK in a difficult position.
*Please read important information about Insight's data collection policies HERE before sharing your personal information with us on email.