Katrina King – Director, Research & Strategy
Uncertainty is the enemy of efficient markets, and the impending vote on whether the United Kingdom will ‘remain’ in the European Union or exit (Brexit) will stir considerable volatility no matter the outcome.
The debate comprises a heady combination of economic posturing, nationalistic fervour and time-worn European geopolitics, and finding objective views amongst the maelstrom is difficult.
But with a gaze focussed on market impacts the QIC Global Liquid Strategies (GLS) team has taken a systematic approach. We’ve analysed the likelihood of a vote to Brexit, the potential impacts and the pre-emptive market moves available to the nimble investor.
We view the potential risk of a Brexit as significant, and something that cannot be ignored. Our base-case points toward a vote to ‘remain’, but, as the referendum approaches on Thursday 23rd June, polling has shown a steady drift. Two major polls over the weekend pointed towards the ‘leave’ vote having the majority, albeit with a narrow margin, and some markets are already reflecting that potential.
Short-term UK bond prices are heading higher and German ten-year bond yields dipped into negative territory for the first time this week—the move to safe-haven assets is picking up steam.
At these stretched prices UK front-end rates are well above our model of fundamental valuations, on a basic level this offers the potential to take short positions. However our modelling has gone further; we’ve captured the transitory influence of the potential for a cut in interest rates that may be needed if the vote to leave succeeds.
While these combined factors still reflect the expensive nature of these bonds, this transitory interest rate forecast has reduced our conviction towards taking a large short position.
Sentiment and projections are driving markets right now, but it’s important to remember recent experience showing the dangers of relying too heavily on poll results. Pollsters failed to accurately reflect voters’ sentiment in the run-up to the UK general election, the Scottish referendum and the Greek vote to accept EU bailout terms. There is a tendency, it seems, to underestimate the status-quo.
But betting odds, that most objective of polls, are shortening rapidly with punters eyeing a 62 per cent chance of a ‘remain’ vote. (See Figure 1)
In the short term, uncertainty is the greatest threat. Too many unknowns will have negative impacts on confidence and investment. The pundits, for weeks now, have been blaming slips in equities and weakness in sterling on the vote’s negative sentiment.
What’s clear is that if Brexit happened, it would be a major risk-off event, one of the biggest markets have seen for some time.
Sterling would almost certainly depreciate. Volatility in the pound is currently gyrating at levels not seen since the 2008 financial crisis. Noting of course that volatility will rise either way, with a likely appreciation should a vote to ‘remain’ win the day. It is the extent of the fluctuations on currency markets that will determine the broader impacts.
Higher beta currencies like the Australian and New Zealand dollars will also sell-off, although the Aussie dollar is showing remarkable resilience this week.
But at its heart this vote is about nationalism, and the result will see a degree of unwinding of the EU’s hard-fought efforts to liberalise trade. Re-instated import barriers will see higher prices for traded goods, and inflation will rise. The UK also has a record-high current account deficit of 7 per cent of GDP, making capital outflows a dangerous prospect.
“It would uncouple the world’s fifth-largest economy from its biggest market.” The Economist magazine says.
A cut in interest rates will be needed, and the likelihood of increased fiscal spending will grow. Break-even inflation trades will profit, as will currency and bond markets in the US and Japan (driven by the dash to safe-haven assets), and there is a very real risk to sovereign ratings of European economies.
George Osbourne, the Chancellor of the Exchequer, didn’t mince words as he delivered the Treasury’s assessment of the short term impacts of vote to Brexit. The report predicts the UK would fall into a recession, GDP would be 6 per cent smaller and unemployment would rise by around 800,000.
“A vote to leave would cause an immediate and profound economic shock creating instability and uncertainty which would be compounded by the complex and interdependent negotiations that would follow.” Osbourne suggests.
While uncertainty breeds volatility, there are methods to increase downside protection for portfolios, as well as opportunities to trade market fluctuations.
The GLS team maintains its base-case that Britons will vote to ‘remain’, but we acknowledge the challenges in accurately predicting voter behaviour. As such we’ve performed a range of scenario testing on our individual portfolios in an effort to understand the potential impacts of risk-off events that would stem from a vote to leave. The impact would largely be mitigated by addition of hedges and we believe currency markets will be one of the best ways to reflect these positions. It’s a liquid market and a simpler way for investors to express volatility around the event.
We continue to implement our highest conviction trades from our scorecards. Given the tangible risks we will increasingly rely on options as we move to cap our downside.
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