Brexit was terrifying, messy, and volatile. As pundits, markets, and politicians tried to adjust to the new reality, panic selling took control, with people worried this was “the big one”.
With the scars of the global financial crisis yet to heal, large market dislocations always invite superlatives and invoke memories of crises still fresh in our minds. Would the immediate aftermath of the shock Brexit vote be another Lehman?
Yet, despite the shock and the violent market reaction initially after the vote, global risk assets, except the British pound, have recouped much of their lost ground, so reacting to the initial sell-off would have been very costly.
Rather than being forced to make decisions amid dramatic headline news and extreme market volatility, our approach was to go into the event prepared for either outcome. Given our exposure to European equities, the need for a hedge was even stronger.
We were puzzled how complacent markets were despite the polls pointing to a 50/50 outcome. As a hedge against the significant risk of a known unknown event, we had introduced long exposures to volatility, gold and Japanese Yen (against the Euro). These paid off, adding more than two per cent to the portfolio as risk assets sold off.
Throughout the events and dramatic market moves, we continued to ask and answer the following questions:
- Is volatility likely to go any higher than its initial spike?
Unlikely. Brexit was a shock, but it’s a certainty now and likely to have been priced into measures of market volatility. Our volatility models further confirmed this view with implied volatility moving significantly in backwardation (near-term contracts trading at a significant premium to longer maturity).
- Does Brexit change the macro outlook?
Unlikely. Firstly, the rise in volatility is unremarkable. It is well below levels reached during the global market decline that ended in February. And the same can be said of credit spreads. Secondly, the 2016 recovery in the MSCI Emerging Markets Index and commodities has not been thrown off course despite the rise of volatility and fear.
Perhaps the ongoing signs of stabilisation in China are providing a great offset to the political uncertainty in Europe.
- What has been the most significant change since Brexit?
The main change is much easier monetary policy conditions. While there is ongoing concern about central banks’ lack of ammunition, investors underestimate the various tools central banks have at their disposal to provide a backstop (and their ability to innovate).
For example, in a statement issued hours after the UK voted to leave the EU, the US Federal Reserve said it was ready to funnel dollars to other central banks via existing swap lines set up during the 2008 financial crisis.
Of course, the central banks’ influence on markets comes at the risk of making mistakes. For example the Fed’s insistence on hiking rates despite a rising US dollar and tightening global financial conditions. The fragile investor sentiment in the aftermath of Brexit has greatly reduced the risk of policy mistakes, with further US rate hikes likely delayed to much later in the year.
- Does Brexit change our outlook in European shares?
While Brexit was a shock, it doesn’t tell us anything new. In the midst of dramatic news headlines, it is important to take stock not just of the outcome but of the process. The real madness of the events around Brexit was the absurdly low bar for exit.
It required only a simple majority. Given voter turnout of 70 per cent, this meant that the leave campaign won with only 36 per cent of eligible voters backing it.
Does this tell us anything new about Europe? Not really.
The rise of right-wing populist parties has been evident around the world although more so in Europe. Brexit just reinforces that.
It is highly doubtful European leaders will play the same game of Russian roulette again. If anything, there is every chance the resulting economic and political disorder in Britain will give the right-leaning Euro sceptics in the rest of Europe buyers’ remorse.
Still, given our exposure to European shares, we have increased the size of short Euro positions as a guard against potential political spill-overs following Brexit.
All in all, the outlook for global economic growth, profitability, and monetary conditions will remain far more important influences than near-term political uncertainties.
Our favourable outlook on growth and growth assets is supported by accommodative global monetary policy, a positive macro backdrop (despite the recent shocks such as Brexit) and excessive pessimism.
A key cyclical risk is a potential ceiling in US earnings multiples but global valuations are much more reasonable and the likely earnings growth recovery should reduce the upward pressure on multiples.
Nader Naeimi is the head of dynamic markets at AMP Capital.
