All over the UK and Europe fund managers are being asked for their views on Brexit. Many will answer: ‘we don’t forecast.’ The more ambitious might add: ‘markets don’t like uncertainty, so volatility might create opportunities.’
As human beings we find these same old clichés deeply unsatisfying; we want to believe that someone out there knows the answer. But is there more we can say? How can we begin to think about issues like Brexit as behavioural investors?
What are we looking for?
We don’t believe we can know more than the collective wisdom of the market about predicting the future of market fundamentals.
To claim you have an information edge in interpreting the Brexit issue is to suggest that you have a greater understanding of the will of the British population, more in-depth knowledge of the legal intricacies of the EU, and a personal understanding of how negotiations between political groups may play out. Finally you are arguing that you have all this and an intuitive sense of how asset prices will respond, even taking into account all the other things that might be happening in the world.
We think this is close to impossible. Instead the episode approach looks for instances where the market could be showing signs of bias, such as fear over what the short term might look like, extrapolation of the past, overconfidence in beliefs about the future and so on. How do UK markets look today?
Are there signs of panic?
Despite the headlines, the behaviour of the stock and gilt markets has not shown extreme signs of panic. Gilts have behaved in line with other developed government bonds:
While equity markets have struggled so far this year, but only in line with much of the rest of the world.
More interesting here is that much of the bear story on Brexit has centred on the damaging implications for UK growth, and for Sterling. However, we can see that the FTSE Small Cap index, which is more closely related to the UK economy, has outperformed the FTSE 100, a global index with approximately 70% of its earnings coming from overseas (and therefore a potential beneficiary of Sterling weakness). On top of that, valuations remain fair. It does not seem as if Brexit fears are having an undue influence here.
Overconfidence, inconsistent narratives and extrapolation
One area where we could see the emergence of an episodic opportunity is with regards to the currency. In spite of the notorious difficulty in forecasting exchange rates, it seems that it is almost a consensus view today that Brexit would mean a fall in the pound.
What is interesting about this is not the merits of the argument (though there are as compelling arguments for appreciation as deprecation), but the fact that the intensity of people’s belief in the argument has increased without the facts changing. Instead it seems this view has become more popular largely because Sterling has already been falling.
It is easy to put forward Brexit as the cause for this weakness, though there is certainly no sign that a UK exit has become more or less likely.
The common justification is that it is simply the fact that the referendum is nearer which is causing the weakness. If this is indeed the reason, then this would certainly suggest the type of short termism that could create opportunities. Similarly, the argument for Sterling weakness that has grabbed the most headlines, that uncertainty around the vote could cause an interruption in capital flows, would also imply that investors are not making assessments about the long term.
Changes in the stories investors tell themselves to explain the world can often be associated with emotional, rather than fundamental, shifts. Only a few months ago all that anyone wanted to talk about as a driver of currency moves between Sterling, US Dollar, and the Euro appeared to be interest rate differentials and monetary policy. The UK current account was largely ignored. With UK wages continuing to show encouraging growth and the Eurozone still seemingly more likely to ease rather than tighten, assuming a one way bet here could be dangerous.
As we all know, but can occasionally forget, an exchange rate involves two moving parts. To focus on a single influence on one leg of the exchange would certainly suggest overconfidence.
Brexit is a known risk, but with unknown consequences. At present there is little sign that behavioural influences are driving market moves in response to this, though the willingness to try to fit a narrative to what can be deeply chaotic moves in currency markets could suggest there is scope for episodic behaviour to take hold.
Ultimately, it could be deeply risky to try to forecast the future, though volatility may create opportunities.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.