History repeats itself, first as tragedy, second as farce – Karl Marx.
Originally referring to Napoleon, this nostrum is now being played out in the UK, as an increasingly forlorn-looking Theresa May struggles to keep her fractious party together. Neither sides of the Leave/Remain divide (or is that chasm?) appear either happy with the current situation nor willing to compromise. She is starting to cut a John Major-like figure, as she watches events spin out of her control. Her recent White Paper has led to a stream of resignations, from Foreign Secretary Johnson, to Brexit Minister David Davis and a whole raft of lower level ministers and officials. Some commentators have dubbed her ideas as BRINO (Brexit in Name Only) and as a result of the chaos, there is now speculation, not as to if the Prime Minister is forced out, but when; most UK bookmakers now have her odds-on to be out of office by the end of the year, as opinion polls suggest a new swing back to UKIP from the Conservatives, which has led to an increased chancge of Labour winning any ensuing General Election.
There appear to be three options,- a hard Brexit, new elections or no Brexit at all; none of these appear palatable to a large proportion of the political class, which leaves the whole situation “fluid” (or a mess if you prefer). It is not clear how this is resolved; but a large, vocal group are bound to be disappointed, however it is settled.
So far, markets have been quite relaxed, presumably assuming that all will be well, (though behind the scenes, some are taking precautionary measures), but that may be about to change as things get more heated between Brussels and London, with a potential return to the wild days of June 2016.
As to the effects of all this, it is impossible to say; but one can try to identify the market-based probabilities of each of the 3 above scenarios, as this is what markets are constantly doing. For what it’s worth (and it’s not much), I would posit that a Hard Brexit could lead to a 15% fall in the value of Sterling, to $1.1135,(similar to the initial reaction post the referendum result), new elections might lead to a 10% fall to $1.179, (as a result of the uncertainty this news would create), whilst a Soft Brexit could lead to a 15% rise to $1.5065, as fears regarding the future trading status of the UK vis-à-vis Europe would be assuaged.
To arrive at a weighted average of all these possibilities, multiply the percentage chance of an events’ occurrence by the new price that would be reached should it do so; then add them together.
Sterling is currently at 1.31, so the implied probability of each is approximately [1.1135x 25% + 1.179x 30% + 1.5065x 45%= 1.31}.
Let us assume that the perceived odds change, such that a Hard Brexit is now a 40% chance, whilst a Soft Brexit is also down to a 30% probability, (with new elections remaining at 30%).
The new expected Sterling rate would now be (1.1335 x 40% + 1.179x 30% + 1.5065 x 30%] = $1.25, a 4.6% drop in the value of the currency.
This is of necessity subjective- one can easily ascribe differing percentage chances to of all these and different orders of magnitude (up or down) should they occur. But it is one way of doing “what if” scenarios, to try to model the effect of sentiment changes on market prices. Feel free play around with these numbers to better reflect one’s own views!
As for what this means for equity and bond markets generally, the outlook is even murkier- one could (relatively) easily have forecasted both the referendum result AND Donald Trumps’ victory and still lost money (since both were deemed by the commentariat to be bearish for risk assets). Adding in the second order effects of currency swings, the various market participants reactions to them and the resulting gains or losses in equities bonds across the UK (and Europe) is a herculean task, one which is doomed to fail.
Returns are equally determined by currency moves as by those of the underlying equity markets at present. One-year equity volatility- basis the All Share Index- and one year £/$ volatility are both around 12-13%, so equity price gains could easily be wiped out by currency declines. Of course, one could “hedge” one’s equity investment, but that increases the number of potential sellers of the pound, making a decline in its value even more likely.
For bond investors there is no such reprieve; 5-year bond price volatility is only 6.25% (for conventional gilts) which implies that the currency will be the overwhelming contributor to returns. So, in this instance, it might be necessary for non-UK investors to hedge the ownership of gilts -or sell them!
All of this explains why we advocate Global, rather than Home Biased investment portfolios. We have held this view for the last 4-5 years or so, but the interest of investors has only recently been piqued by Brexit. Owning a truly diversified portfolio involves not just a wide spread of assets, but an equally wide spread of sectors and currencies- the UK market is dominated by Commodity-related firms (BP, Rio Tinto etc) which are likely to move in roughly the same direction (and the same can be said of the US markets, given its tech-heavy exposures). As we do not know the future path of asset prices, the best policy is to own as much of everything as is practical and leave the market place to sort out the winners and losers. Likewise, owning a wide range of currencies provides the same benefit, as a fall in the value of one’s domestic currency leaves the value of assets held in other currencies higher (due to favourable FX translation effects). There is not much else one can do, unless one is to be tempted by the siren song of active management; but there is no evidence to support the belief that they will do any better than the market and a lot to suggest they do worse-in some cases, a lot worse.
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at firstname.lastname@example.org.
The views expressed in this article are the author’s own and not necessarily those of EBI Portfolios Ltd.
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