This ‘deadline effect’ has been observed both in experiments and in a variety of real world negotiations including wages, prior to trials, and in online auctions (football fans might consider the number of player transfers that go through on the last day of the ‘transfer window’).
The effect has been put down to behavioural forces such as over optimism about bargaining power and straightforward procrastination, as well features of the negotiation itself, such the costs of not reaching agreement and how much the parties will have to interact in the future.
It is perhaps no surprise then that an apparent Brexit deal was agreed weeks before the latest deadline. Is this the reason why the reaction from markets has been muted? Sterling has strengthened, but not materially relative to recent history:
A basket of domestically-focused UK equity has recovered some of its underperformance relative to the FTSE 100 (interestingly, this basket had been pitched as a ‘Brexit hedge’ because it was less reliant on trade, but has actually underperformed, partly due to the positive impact a weak sterling has had on companies with overseas earnings):
Gilt yields have barely moved:
‘Deadline effect’ or something else?
Of course another explanation for the lack of market response could be that investors do not believe a deal will be agreed by the UK parliament.
Trade deals are different from the bargaining experiments done in labs, which often involve two players, or at least participants with full autonomy. Even real world cases such as wage negotiations, internet auctions or pre-trial negotiations focus on agents who, even if representing groups like trade unions, have aligned interests. This is not the case with Brexit, effective veto powers within the EU and domestically in the UK make the bargaining far more complex.
This has been put forward to partly explain why the history of trade negotiations shows many ending in deadlock, rather than last minute agreements. A study into WTO negotiations suggested that domestic politics were often a key element in the failure to get deals done.
The Brexit negotiations have already had one extension, and this is not unusual. Another observation from behavioural psychology is that of the ‘planning fallacy’, the human tendency to be too optimistic with regards to how long it takes to get a task done.
Most importantly, as Christophe wrote in 2016, the reality is that unpicking the true impacts of Brexit will take far longer than the negotiations of the withdrawal.
Another explanation for the muted market response – other things matter!
A third explanation is that, contrary to the nature of media coverage, Brexit isn’t the be all and end all for the UK economy and markets.
Gilt yields can be held down by the same forces that have driven government bonds in other parts of the world: fear of weak growth and anticipation of easy policy. Currency moves are determined by both sides of the exchange rate, not just the side in the news. Profits are central to equity returns, but so is valuation.
If the muted reaction to the deal illustrates anything, it is that the human tendency to focus on a single issue is unhelpful in investing. You might try to build a set of stocks as a ‘Brexit hedge’ as in Figure 2, but currency moves render it useless, you may see Sterling weakness versus the Euro as inevitable, but find that a German slowdown causes the Euro to weaken as well. Fear of Brexit risk on the day of the referendum might prompt you to sit on cash, only for there to be strong returns from taking risk over the next three years.
This is why most experienced investors try to avoid such bets predicated on forecasts. It is also why, when we are asked about the issue of the day our responses can often seem frustratingly non-committal. After years in the market we should be expect to be surprised, not by the issues that are dominating headlines, but those which we haven’t even thought of yet. The best way to navigate these challenges is a disciplined framework and an attempt to use valuation to build a margin of safety against any threat.