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Looking stupid and unpopular on Brexit

One thing that behavioural finance  teaches us is that it’s often only after we have already made a decision that we seek to rationalise it.

Moreover, when the issue is an emotive one, tied up with how we view ourselves, our group identities, and sense of moral values, this process of rationalisation can become deeply skewed. In these situations, there is huge potential for us to become victims of confirmation bias.

There are few more emotive topics in the UK at the moment than Brexit. If anything, tribalism has hardened since the vote and many on both ‘sides’ seem more confident in their views than they were last year.

These should be warning signs for investors. If we find ourselves ‘wanting to believe’ that Brexit will be a disaster, or a huge success, we can lose sight of what is already in the price of assets, and how much we can really know about the future.

Peer pressure

Human beings have a huge desire to be liked and a fear of looking foolish. A number of experiments (most famously the Solomon Asch experiment) have shown that we frequently override our own judgements when they don’t conform to the consensus.

Today the overwhelming consensus among economists and market participants is that the effects of Brexit will be negative. The below, from the Institute of Fiscal Studies shows the range of forecast Brexit outcomes across various scenarios. For example, HM Treasury analysis suggests that the worst case outcome (adopting WTO rules) would lead to UK GDP being 9.5% lower than it would otherwise have been in 2030:

Figure 1: Brexit consensus

This month a new paper offered an up to date summary of the consensus views, the contents of which we can guess by its title: “Brexit: The Economics of International Disintegration.”

It’s therefore highly sensible to have a negative scenario as your base case, other things being equal: “When the experts are agreed, the opposite opinion cannot be held to be certain”. But is this of much use to investors?

What can we know?

Understandably, journalists can get frustrated when talking to fund managers as there is a tendency to caveat statements, and emphasise uncertainty. Today the negative impacts of Brexit seem so obvious that an investor suggesting anything but a bearish outlook on asset prices seems to be burying his or her head in the sand.

However, there are two problems with this reasoning:

    1. It is an ‘other things being equal’ view of the world. Even if we could place total faith in any one of the studies above, they represent a forecast of how much GDP will be lower than it otherwise would have been. This presents us with a problem, because as we know, even trying to forecast the level of GDP without Brexit is an unenviable task. Moreover, for investors, the relationship between
    2. GDP outcomes and asset prices can be very loose indeed.The market almost certainly has the same information as you do. If the economists’ consensus is for negative Brexit outcomes, then how much of this is already in the price? It may be that the market is complacent, or it could be overly pessimistic, however this is a very different question to that being asked in the studies above. It is also the question of greatest importance for investors.

These are critical points to appreciate, but they can be very painful to say out loud. It is always tough for the ego to say we don’t know something. This is particularly tough when even suggesting the possibility that surprises can be positive as well as negative can be perceived as a political view.  Combine this with the tendency for pessimism to be perceived as intelligent and optimism naïve and there are strong emotional temptations to tend toward the bearish rather than the agnostic.

These are the types of emotional pressures that investors have to avoid if they are to keep their attention on what really matters.

What’s in the price?

Are investors complacent about possible negative effects of Brexit? The notable impacts of last year’s vote have been well publicised. Sterling weakened considerably.

Figure 2: The Brexit effect on Sterling?

And UK stocks with a domestic focus have been weak relative to other global markets, and versus the global-facing companies which dominate the FTSE 100.

Figure 3: The Brexit effect on UK equities?

After the vote, UK Gilt Yields began to trade significantly below their US counterparts, and only recently has this gap begun to decline.

Figure 4: The Brexit effect on Gilts?

Together, these moves suggest that markets are looking through recent data and forecasting a deterioration to come. In equities relative weakness has come against a background of continued recovery profits in from the weakness into early 2016.

Figure 5: FTSE All-Share Earnings Delivery

Similarly, Gilt yields have, probably correctly, ignored the inflation caused by last year’s currency declines. However, current low levels suggest an expectation that rate rises were unlikely in spite of improving macro dynamics.

Asset prices therefore suggest little complacency about possible negative impacts of Brexit in today’s prices, and make a more negative view than the market a relatively bold forecast given the state of fundamentals today, and the degree of pessimism already implied by asset prices. At the same time, the risks to a possible challenge to interest rate expectations should the Bank of England begin to focus more on the current data and less on Brexit fears could be material, as evidenced in recent moves.

Market perceptions will wax and wane, creating opportunities

In my first job at the Bank of England in 1987, the UK was in the first year of the Uruguay round of GATT (General Agreement on Tariffs and Trade) negotiations. The talks were due to finish in 1990, but were ultimately signed in 1994, with the creation of the WTO.

Over the 8 years of negotiation, markets occasionally focused on the talks, which were varyingly judged as going really well or heading for total collapse – before attention then moved on to other topics.  When we look back at asset price behaviour throughout this entire period, it is very hard to identify what enduring impact any part of the ‘journey’ to an eventual trade deal had.

Prior to that, The Tokyo round of GATT talks had lasted from 1973 to 1979. More recently the Trans-Pacific Partnership negotiations began in 2008, and was signed in February 2016, only for President Trump to sign a memorandum for the US to withdraw in January 2017. Christophe wrote last year about the increasing length of time it is taking for EU negotiations.

Uncertainty over future trade agreements is the normal state of affairs for many companies. Moreover, trade negotiations do not proceed in a linear fashion, so today’s information on ‘how the talks are going’ is not a useful predictor of the eventual outcome.

It seems that there is little to gain from an obsessive focus on incremental news flow about the negotiations, while seeking to out-bear the market leaves little scope to benefit from other possible outcomes.

Instead, looking for instances where markets are overly, or insufficiently, worried about Brexit seems likely to be a more fruitful source of opportunities than an attempt to predict the final outcome. It is almost always unpopular, and viewed as naïve, to adopt a ‘wait and see’ approach, but is just as often the best policy.