A puzzling price action
Needless to say that the result of the June 23rd UK referendum on Britain’s EU membership was unexpected by most in European markets and was certainly not priced in by credit markets. Instead, European markets were pretty complacent of the risk that such an outcome would occur and chose to see the bright side of the environment, namely a decent outlook for corporate credit fundamentals combined with highly supportive policies implemented by the ECB for fixed income assets (PSPP, CSPP, TLTROs, etc.). Consequently, at the end of June 23rd – before the close of polling stations – and despite several opinion polls showing Brexit was in the lead, credit indexes were broadly flat on the month. Admittedly, there was a significant – though orderly – selloff in the next couple of trading sessions, but the market has subsequently retraced a big chunk of its losses. It is quite shocking, in our view, that the iTraxx credit indexes ended the month tighter than where they traded one week before the referendum result when Brexit was a less-than-50% probability and the balance of risks much less skewed to the downside than today.
No silver lining for European credit
We acknowledge that the Brexit vote triggers relatively few immediate negative consequences for European credit. If anything, it greatly increases the odds that the BoE and the ECB would become even more accommodative than today via a new set of unconventional measures. Little wonder that a CB QE-addicted market reacts quite positively to such near-term prospects. However, we believe that Brexit creates a significant shock to the region’s economy as it remains highly leveraged and it still needs to restore a much stronger and sustainable growth. In this respect, we see three main areas for concern:
The bottom line is that (i) the Brexit process is unchartered territory, full of pitfalls and risks and (ii) the market will be in price discovery mode for some time as the story starts to play out.