Markets have recently experienced some heightened volatility, which at times has been explained by commentators as being due to the changing expectations around the outcome of the UK referendum. Last week, equity markets globally experienced losses, while ‘safe haven’ assets, such as G7 government bond markets, rallied. The biggest currency move was an appreciation of the Japanese Yen, while Sterling weakened.
Although it felt like a bad week, the volatility experienced was not unusual in the context of the recent past. The growth scare/oil price related wobble in December/January, China’s “black Monday” and much of Q4 2014, were all more significant than the recent volatility.
You might be forgiven for thinking market moves had been more extreme, given the press coverage, but even without today’s move, the FTSE All Share is roughly where it was six months ago.
Sterling and Gilt yields look more significant, though it is quite difficult to unpick recent moves from longer lasting trends. At any rate, we tend to be sceptical when it is suggested that one market is more worried about a particular issue than another. Beyond the clichés about bond investors being more cautious, and rules of thumb about Sterling declines boosting UK corporate earnings (which should at any rate impact the FTSE 100 more than the all share), what might bond and currency investors know that equity investors don’t?
What a difference a weekend makes?
After a weekend to pause and reflect, markets have opened the week in a more optimistic mood. Sterling has recovered, equity markets have opened higher and bond yields have risen – for the most part all reversing what happened last week. This illustrates perfectly just how short term movements are driven by sentiment and investor emotions. The underlying fundamental news has not changed.
When attempting to explain what has been happening it is always easy to list the key events of the week and assume that they are the cause. This morning the “news” of a slight change in the polls is being mentioned as part of the reason why risk assets are recovering. However, we cannot know for sure that the calmer feel on Monday morning is due to the change in Brexit-poll results. In fact, given that everyone has been quick to highlight how unreliable polls are in light of the experience of the UK General Election, it is perhaps more likely that prices just fell too much last week; leading some investors to conclude that risk assets were attractive.
The longer term: fundamentals
What would happen to fundamentals even if we did know the referendum results? We can never be sure. Many economists are concerned that a Brexit vote will lead to downgrades to UK GDP growth expectations. But that view could change if sterling’s weakness acts as a stimulus to the economy, or if policy-makers react to the prospective weaker economic situation with new expansionary policies. The group ‘Economists for Brexit’ seem convinced that leaving the EU will be positive for the economy, through the boost to trade conducted under WTO rules. Has there ever been a time when economists agree with each other?
The longer term: prices
We also cannot know the timing of how financial markets will respond to the Brexit vote. The conventional view is that a ‘leave’ vote will cause sterling to be weaker, bond yields to be lower and the stock market to sell off. But these views don’t tell you anything about the magnitude or timing of the moves; they also ignore where prices have got to already.
As of last Friday, 17th June, sterling was already down by more than 10% against the Euro since mid-November, 10 year gilts had declined in yield from 2% to 1.15% this year. The FTSE100 was down just 1.3% this year, while the FTSE small cap index had fallen by 3%. These moves have taken place during a period when the polls have moved to reflect an increasing chance of the UK voting for Brexit. Does this mean that we can conclude that the confirmation of a Brexit vote implies more of the same? Does it mean that if the UK votes to remain in the EU that these moves are all reversed?
The longer term: everything else
Unfortunately forecasting financial markets is rarely that simple. The answer to those questions has to include an assumption that everything else remains the same. But the one thing we do know is that we will always be surprised at events and that something else could happen to change investors’ risk appetite at any point in time. Amongst the known unknowns are the Spanish election two days after the Brexit vote, and the US presidential election in November. November may seem like a long way off but changing probabilities on a major event can cause disruption well in advance of the actual event. Donald Trump’s arrival in Scotland on Thursday will be a perfect excuse for headline writers to focus on the US election.
The best we can do is remain calm, take a medium term approach, invest in assets that make sense and tolerate the volatility. Bonds look even more unattractive than they did at the start of the year. Equities look slightly more attractive in many cases. Further volatility may generate new opportunities for investors who are prepared to make decisions in the face of uncertainty. The volatility might be Brexit related, Trump related or something else that we don’t already know!
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.