Based on media projections at the time of this writing, the United Kingdom voted to leave the European Union in a historic referendum. Heading into this vote, the consensus from financial markets, political analysts, and economists was that voters would opt to stay in the European Union, but a different outcome ensued. In this edition of Market Thoughts, we discuss this development’s implications for investors and the likely capital market response.
The Brexit vote, as it has been referred to, represents what investors call a asymmetrical set of risks. Markets had anticipated that the UK would remain in the European Union, and speculation from early exit polls released during U.S. equity market trading hinted that the consensus would be correct. Global equities rallied on Thursday, while government bonds and safe haven currencies sold off. However, as polling station reports came out after the U.S. equity market close, the “leave” campaign victory became apparent. With that development, stock, bond, and currency markets sharply reversed their tone, with global stocks selling off and bond and gold prices soaring.
When capital markets incorrectly anticipate an event, whether it is individual equity traders taking the wrong view on a stock ahead of an earnings report or something larger like the Brexit vote, understanding what happens next is critical to good financial decision-making. Having started my career on a large institutional trading desk, I have seen several instances where positioning was unbalanced heading into an event, resulting in knee-jerk, emotional responses and bad outcomes. Markets follow a process of price discovery that balance buyers and sellers, so let’s explore this sequence in light of today’s events.
The first step in the price discovery process is what we will call the liquidity step. This represents the immediate market reaction to a given event. Certain investors with very short time frames find their portfolio positioning on the wrong side of the event, and they must unwind that positioning out of necessity (e.g. to meet a margin call). The fact that the “leave” news developed during an illiquid period in trading, when U.S. markets were closed and before Asian and European equity markets opened, adds to market volatility. In sum, the initial market reaction has a lot to do with liquidity or, in some cases, lack thereof.
The second step in the process is also subject to more short-term behavior. I will refer to it as the reactionary step. This step is carried out by investors who may not be facing a margin call or other immediate liquidity need, but cannot tolerate a given investment position and want it gone. They are willing to get rid of that position in a somewhat indiscriminate manner.
The third price discovery step is the speculative step, where investors try to assess the news’ broader implications. In the case of the Brexit vote, this includes what the vote will mean for the UK and the global economy. Will other countries seek a referendum about European Union membership? Does this mean that the UK will need to renegotiate its trade agreements, hampering British multinationals’ earnings and their stock prices? What does this mean for Asian and American companies? The Brexit vote’s reach and precise economic and capital market impact will not fully manifest in a few short hours, but that will not stop investors from guessing.
The fourth step is what I would call the digestive step, which is when more data and context unfolds, and price discovery follows a more fundamental path. Of course, markets move well before all the data and context arrive, and some of the initial views may prove to be correct. The digestive step involves understanding the potential scenarios that could unfold in the wake of a given event, weighing the risks of each scenario against a given portfolio or set of investment positions.
Tying the above framework to today’s events, the first three steps are happening almost concurrently. The British pound has fallen by more 10 percent at the time of this writing (the largest percentage move in history), oil is down 6 percent, and Japanese stocks have fallen more than 8 percent. These moves occurred before an official vote tally was released, before the European Union provided formal comment, and long before market liquidity in the form of U.S. and European equity and bond investors arrived at their offices.
The digestive step will take more time. We expect to hear from various central banks (especially the Bank of England and European Central Bank), EU officials, and other policymakers about several aspects of the Brexit vote, perhaps most importantly if this referendum will truly result in Britain leaving the European Union, or if an alternative fate could develop. We respect this situation’s complexities and the fluidity of this development, and, alongside our team of analysts and research partners, we will continue to watch and assess.
Based on current information, we do not see today’s developments as an insurmountable impediment to the global economy’s path, but we do see it as a setback to a tepid growth outlook. Our investment committee has met on this topic several times in the past month, including twice this week. Our view heading into yesterday’s vote was that the global economy had an opportunity to exceed growth expectations in the second half of this year, led by emerging market economies and reflected in U.S. corporate profits. The Brexit vote result may challenge that scenario, but it is premature to draw a firm conclusion. We will continue to evaluate our views and their impact on you as a client.
Hopefully the above primer on price discovery helps you think about this and future market events, both positive and negative. As a long-term investor, hopefully you can avoid participating in the first three steps of the price discovery process, focusing instead on a calm and measured assessment of whatever news is front and center in any given day.
We will keep you posted on our thoughts about Brexit’s implications. In the meantime, please let me or your financial advisor know if you have any questions or concerns.
Eric J. Freedman
Chief Investment Officer