It’s been a great week for those looking to refinance or purchase a new home, but a tough one for income investors. Our takeaway continues to be the increasing importance of balancing income and safety.
As global stock markets tumbled in the wake of the U.K.’s “leave” vote, risk-averse investors flocked to the perceived safety of U.S. government bonds – pushing prices up and yields (which move inversely) to their lowest levels in nearly four years. Demand for safe-haven assets soared globally, with yields on 10-year German bunds and Japanese bonds in negative territory, while spreads widened for peripheral European bonds on fears they too could leave the EU. With the combination of risk aversion and global central bank liquidity efforts producing negative yields, we anticipate demand for U.S. debt is likely to remain, especially because foreign investors have few adequate alternatives. Indeed, 10-year Treasury yields hit a record low today.
Since mortgage rates are priced in relation to the yield on U.S. Treasuries, they also declined substantially. With the average rate for a 30-year fixed mortgage at 3.48%, this is only slightly above the November 2012 record low. Meanwhile, while risk aversion drove corporate bonds to sell off in sympathy with the equity market, the effect differed significantly by credit quality. Riskier areas of the corporate bond market declined more steeply, but investment grade securities remained fairly steady.
While definitely a negative for global growth, we do not anticipate Brexit triggering a repeat of the 2008 global financial crisis. In fact, all large U.S. banks passed the Fed’s latest stress test with flying colors just last week, and global central banks remain in liquidity mode. Rather, we think much of the investor fear which led to selling pressure in the stock market was simply fear of the unknown. We think that uncertainty may turn out to be a negative in terms of the implications for businesses in general, and perhaps financial companies in particular – clearly with some bank stocks, investors have been shooting first and asking questions later – but the true impacts remain to be seen.
Nevertheless, we expect some impact on the U.S. economy, as slowing global trade growth and a stronger U.S. dollar weigh on exports, keep long-term Treasury rates at historically low levels, and encourage the Federal Reserve to stand pat, we anticipate until at least its December meeting. We believe an economic slowdown is likely in the United Kingdom, as British businesses face uncertainty regarding the future terms of trade with their largest trading partner, while consumers will likely see inflationary pressure on imports following the pound’s precipitous decline. There is also uncertainty as to the future leadership of the major political parties, and the possibility of another destabilizing referendum on Scottish independence. On the continent, in our view, the vote creates economic risks for those nations where the United Kingdom is a key trading partner, financial risks for the European periphery which is already overleveraged and undercapitalized, and political contagion risks should this result galvanize euro-skeptics and lead to further disintegration of the European Union.
We think these escalated risks related to Brexit, and the high degree of uncertainty as to how they will be resolved, mean that ultralow interest rates around the globe will likely remain in place for the foreseeable future. In this regard, it can be tempting for income investors to “reach for yield” and end up accepting additional risks that jeopardize principal. In our view, this is not a sustainable approach to generating consistent income, which we see as the primary concern of those relying on income from their investments. Typically it is the riskier areas of the market, including high yield and international bonds, which are most vulnerable to unexpected events such as Brexit. In this extended period of uncertainty, we anticipate bouts of volatility are likely to continue to emerge. For investors looking to generate income while preserving capital, we believe these types of unanticipated events highlight the importance of owning high quality investment grade securities that balance income and safety.
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