UBS: Higher risk-adjusted Gilt yields signal good value

Risk-adjusted Gilt yields plummeted in response to the EU referendum…

… but have since recovered, even as risk-adjusted Treasury yields have fallen

Since then, Gilt yields have risen steadily, by approximately 90bp from the Augusttrough. The reversal in yields has been associated with fairly low volatility, resulting in improving risk-adjusted valuations. The recovery in risk-adjusted Gilt yields means that the gap to US Treasuries – which have seen risk-adjusted returns dropping post the US presidential election thanks to the big jump in volatility the outcome triggered in US markets – has narrowed to levels more typical for the last couple of years. Vol-adjusted Treasury yields have risen a little over recent days as vol has stabilised, but remain well below pre-election levels.

From here, UK economic slowdown should mean cross-market outperformance 

The return to more typical risk-adjusted Gilt valuations in our view reflects the past (upbeat economic data post the UK's EU 'leave' vote) rather than the future. Indeed, 30y risk-adjusted Gilt yields are roughly on a par with those of US Treasuries. This is hardly a reflection of a likely material slowing in UK private sector demand during 2017, and does not reflect our divergent expectations for monetary policy and activity in these two economies. Additionally, any increase in UK infrastructure spending is likely to be modest. As argued in our 2017 Outlook, we think 30-year Gilts will outperform Bunds and USTs in the year ahead. We also favour receiving 2y2y GBP IRS.

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