Last night’s Federal Reserve minutes noted that:
‘Participants generally thought that it would be prudent to wait for the outcome of the upcoming referendum in the United Kingdom on membership in the European Union in order to assess the consequences of the vote for global financial market conditions and the US economic outlook.’
They may be waiting for some time. Although the result of the vote is known, unpicking the genuine implications – and untangling this from simple market noise – is likely to be an evolutionary process that takes years. From a political standpoint, the uncertainty of if and when article 50 is invoked in the UK is only part of it.
The Lisbon Treaty outlines a two-year ‘sunset period’ in which the withdrawal agreement should be negotiated. However, recent history suggests that EU treaty negotiations have tended to take far longer, with all but one taking longer than 24 months. Even the process of the UK joining the EU (the accession in 1973) took longer than that.
From a behavioural finance standpoint this could be an interesting example of the planning fallacy. For investors, the implications are more practical. Understanding economic dynamics is always extremely difficult because the system is complex. So even with full knowledge of how the negotiations will play out, it would be close to impossible to forecast the way economic fundamentals will be impacted and how asset prices will respond.
Last week, Jenny discussed the idea of ‘unusual uncertainty‘ in and around the Brexit vote. She noted that the outlook is always uncertain, it is just that most of the time we don’t think of the true range of possible outcomes. Brexit was always a possibility, as are a whole range of other scenarios that we aren’t considering today. As human beings we become overconfident that we know roughly what the future will hold because it is too uncomfortable to accept that there is much that we cannot control. We seek as much information and analysis as we can find to make ourselves more comfortable, and therefore more overconfident.
The Fed’s desire for more information illustrates this; but the reality is that there will never be enough information. For investors’ success lies in accepting that risk can never be eliminated completely.
Accepting and negotiating uncertainty can mean looking for assets that compensate you for bearing it and through seeking hedges and safe havens.
Investors in gold and silver have seen spectacular returns so far this year, as have investors in mainstream government bonds. As human beings it is tempting to believe that this was obvious all along and be more certain than before about the characteristics of these assets going forward.
However this would be to fall victim to the same overconfidence and inappropriate certainty that can be dangerous. Safe havens are not always safe and hedges won’t always offset the black swan around the corner. You can see this in the changing behaviour of gold and silver since 2007: they weren’t much help in 2008, provided some safety in the Euro crisis of 2012, but until this year have been little help since then.
Treasuries have been a far more pleasant ride, but sentiment has changed significantly over this period. At the end of 2013, when investors were worried about a bond bubble and the ‘great rotation’ into equities, there was far less confidence that ten year Treasuries were a safety asset, even though the compensation for risk was twice as large.
The uncertainties around Brexit are large, but these risks are always present. China was the big issue a year ago; US recession grabbed the headlines in January and February. Either of these could potentially have a far larger impact than Brexit, as could things we are not even aware of today. Believing that we will eventually get to a point where we have enough information to reduce uncertainty could leave you waiting a long time.