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Potential Initial Impacts of Brexit on the Educators Mortgage & Income Fund

By Derek Amery, Fund Manager, Head of Canadian Fixed Income, HSBC

While the ultimate political and economic impacts of the UK referendum are unclear, the surprising result has had a significant impact on global financial markets. The UK and European Union now face intense political and economic uncertainty and this has, and will, drive heightened risk aversion by market participants. This uncertainty will also have an impact on European and global policy.

Market Impacts:

The most obvious impact was the sharp correction in risk assets. In the lead-up to the vote, financial markets ignored the polls which suggested a very close race, choosing to believe what they wanted to believe (a “Remain” victory), and to bid up the prices for risk assets such as equities and corporate bonds at the expense of defensive assets such as government bonds. In the wake of the “Leave” victory, equity markets and government bond yields are down sharply. Corporate bond yield spreads are wider, as corporate bonds have under-performed government bonds.

With respect to the Educator’s Mortgage & Income Fund, the biggest initial impact will be the positive impact of lower bond yields. Lower bond yields and higher bond prices will generate better returns in the near term. As a defensive, fixed income investment, the Fund will benefit from lower bond yields that result from heightened risk aversion and a flight-to-quality from investors. Over the medium-term there will be heightened volatility and markets will have “risk-on” episodes, however generally speaking we believe that the uncertainties caused by Brexit will keep bond yields lower for longer than they would have been in the event of a “Remain” outcome. Thus over the medium-term fixed income investments should benefit from lower for longer yields which will help to support better returns in the Fund.

The higher degree of risk aversion will present a challenge for the credit sectors of the fixed income markets, but after some initial spread widening, we believe that fixed income markets will return to focusing on stable fundamentals and improved valuations, and that over the medium-term will weather the Brexit storm reasonably well. The risk to this outlook lies in the possibility of greater-than-expected political fallout and contagion in Europe, and we will be watching this situation closely.

Policy Impacts:

Uncertainties generated by this situation should keep global monetary policy rates lower for longer than previously anticipated. Bank of Canada Governor Poloz was quoted in a recent speech saying “the outcome of the Brexit referendum next week poses new risks at the global level that could mean a shift in view. ” The next scheduled BoC meeting is July 13th, when we can expect an update to the Bank’s monetary policy report and growth and inflation forecast. Canada’s direct trade ties to the UK are limited, but a tightening in global financial conditions and heightened global economic and political uncertainty pose risks to local business confidence, hiring and investment, which have already been struggling with the collapse in energy and global commodity markets. While the over-stretched consumer and very strong housing markets in Canada limit he Bank’s willingness and ability to providing additional monetary policy support at this point, we believe that the impact of Brexit will keep the Bank of Canada on hold for the foreseeable future. We also believe the impact on Federal Reserve policy will result in a more gradual, prolonged tightening cycle, with policy rates ending up lower than anticipated before the UK referendum.

Fund Strategy Impacts:

Given our expectations that heightened uncertainty will cause both policy and broader bond yields to stay lower for longer, we believe that short-term bond yields represent somewhat better value than they did before the Brexit vote. In addition, we feel that near-term risk aversion may continue to push bond yields lower, to the benefit of fixed income assets. As such, we are less defensive on the direction of interest rates and have added duration (interest rate exposure) to the Fund. This was actually our view heading into the election and we had this strategy in place prior to June 23rd’s results. Over the medium-term, we still believe that bond yields at historic lows offer little value and that they will move higher over time, but that in the short-term there is a risk that yields are pushed lower by a flight-to-quality. We believe that credit fundamentals and valuations will continue to support corporate bonds even during a period of heightened risk aversion, and thus we continue to maintain our corporate bond exposures. That said, we will monitor risk sentiment and market liquidity closely and move to reduce our credit risk exposure if the environment deteriorates going forward.

The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering of tax, legal, accounting or professional advice. Readers should consult a financial planner and their own accountant and/or legal advisor for specific advice related to their circumstances. Educators Financial Group will not be held responsible or liable for any losses, costs, damages or expenses incurred by reason of reliance as a result of the aforementioned information. The information presented was obtained from sources that are believed to be reliable. However, Educators Financial Group cannot guarantee their completeness or accuracy. ©2016 Educators Financial Group

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