Brexit wrong-foots some reserve managers

The vote taken by the British public to leave the European Union (EU) on June 23 wrong-footed many reserve managers and sovereign wealth funds, and sent shockwaves through global financial markets with sterling at one point on Friday hitting a 30-year low against the US dollar.

"For some reason the market underestimated the chances of Brexit going ahead. I guess the market will recover slightly due to stop loss and stop profit orders, but then will have the tendency to remain lower," said the head of reserves at a mid-sized European central bank.

Many reserve managers did not significantly scale back their sterling portfolios immediately ahead of the British referendum, although some that had exposures via external asset managers had those exposures trimmed. Others used derivatives to hedge their sterling positions.

The British rejection of the EU sent European banking stock reeling, caused gilts to move dramatically and sparked a rapid rise in the value of the Japanese yen.

"We expected that ‘Leave' would be bond positive in the first stage as the Bank of England would step in. The market reaction was somewhat larger than we expected [Friday] morning," says the head of reserves at another mid-sized European central bank. "In the 10-year  euro bond and US Treasury markets, the initial 30-basis points market reaction due to flight to quality was in line with our guesstimates."

A survey carried out by Central Banking Publications, and published in HSBC Reserve Management Trends 2016, found "Brexit fears weighed on sterling" but also found evidence that some reserve managers "felt that this was priced in by the market, making the pound more attractive". A total of 32 reserve managers viewed sterling as more attractive versus 25 that found it less attractive in February 2016 compared with a year earlier.

That trend has been reversed up to a point. "To sell sterling assets will be a popular trade until the UK has a prime minister in place that can start the exit proceedings. I guess then things will smooth out," said a senior reserves manager at a Middle Eastern central bank.

But then assets might start to look cheap. "While the UK has economic issues, I do not foresee huge trade and economic problems to overshadow this divorce. In fact, I see value in buying sterling were it to slip under $1.30 – the closer it is to 1.25 the better," the Middle Eastern reserves manager added.

Despite increased uncertainty about the outlook for both the British and eurozone economies at a time when it is too early to tell the full extent of their separation, sterling assets are likely to remain a small part of reserve portfolios. "Even if the UK is downgraded it is still among G10 countries and therefore it still should be considered as a kind of diversifier to the other parts of your portfolio," says a reserves manager at a European central bank.

He added that portfolio managers will either take a binary view and de-risk everything labelled ‘Made in UK' or be more open-minded in terms of portfolio diversification, especially as UK assets are now relatively "cheap" and it is "not clear" if Brexit would have a "negative impact on assets".

Downgrade sell-off?

As Moody's Investor Service said it had put the UK's sovereign rating on review for a downgrade, reserve managers – which in the past tended only to invest in triple-A government bonds – expressed some tolerance to a UK sovereign downgrade. "We do not consider changing our sterling portfolio immediately, but the UK's possible credit rating downgrades can easily put this topic on the table. A one-notch downgrade is a minimum that we will see, with a risk of more rating actions," said a European reserves manager.

Asked what rebalancing would be expected in the weeks ahead, particularly people's willingness to invest in sterling gilts in the face of downgrades, a European reserve manager said it depended on the extent the UK would pull away from the EU: "All UK assets will be considered as risky assets including sterling bonds. But sooner or later, the EU will be in question, the role of Germany as well, because it is naïve to believe that Germany could be the only functioning cylinder of the EU engine. Italy and Spain will suffer more than the UK."