In the latest Money Makers podcast, our series of in-depth conversations with leading professional investors, Jonathan Davis talks to experienced stockpicker Paul Mumford, who has been running what is now the £150m Cavendish Opportunities Fund, a small and midcap specialist, since 1988. He is also the author of a recently published book, The Stock Picker, which look backs entertainingly over the highs and lows of his 50-year career in the financial markets and explains why he is not too worried (yet) about Brexit, higher interest rates or Jeremy Corbyn becoming Prime Minister. He also discusses some of his favourite investment themes at present.
Revisiting AIM after a year of shocks
In the latest Money Makers podcast we catch up again with Chris Hutchinson, lead fund manager at Unicorn Asset Management, the boutique small cap and AIM fund management firm that boasts one of the best long term records in its universe. How has the fund coped with the fallout from Brexit and Trump’s election? What are the prospects for future returns? And why despite strong demand has the firm capped new applications to its market-leading AIM venture capital trust at just 10% of assets?
Notebook; lessons of the Leave vote
Yorkshire’s finest export
Yorkshire folk did not think much of immigration, if the Brexit vote result is to be believed. That is not the view however of one of the most successful British exports of recent times, a crusty Yorkshireman who went to America but never migrated back, and to our loss has since built a hugely successful fund management business in the United States from scratch. Jeremy Grantham co-founded Grantham Mayo Otterburn back in 1977, having earlier spent a short time working for Batterymarch, an innovative investment business in Boston, Massachusetts. Grantham Mayo, or GMO for short, now looks after more than $100 billion of other people’s money (yes, $100bn, you read that right). That is not bad going for a guy who, he once told me, started his working life as a “bedpan salesman” for his father’s medical supplies business in Doncaster.
Batterymarch’s founder Dean le Baron was a colourful and visionary figure who was one of the first to try and harness computer power in the management of investors’ portfolios, as well as pioneering the case for emerging markets. Although Grantham’s own firm has not followed LeBaron down the index fund path, he remains a fearless advocate of the need to use mathematical tools when managing money. His particular hobby horse is the concept of mean reversion, the idea that while all financial markets swing from periods of boom to bust and back again, valuations – whether measured as price earnings ratios, book values or other metrics – all eventually revert to their average level over time. But he also acknowledges that this can take years to happen and that in the meantime, momentum investing – the idea that you keep on buying those sectors or styles of investment that have done well recently – will go on producing good results for longer than anyone thinks possible. In the end, though, all such momentum trades blow up. Blow up was what happened with tech stocks back in 2000 and financials in 2007, and both outcomes were ones that Grantham had warned about, albeit well before they actually happened.
In his latest must read quarterly letter, in which like all good Yorkshiremen he dispenses trenchant advice, in the manner of a Geoff Boycott or Fred Trueman, Grantham attributes both the rise of Donald Trump and the outcome of the Brexit vote to a lack of social cohesion, the growing disparity between the minority of “have a lots” and the majority of “have littles” in society. This populist backlash has been widely commented on, but Grantham characteristically has a chart to show that it has been most visible in countries where the disparity between the richest and the average citizen has become most marked. The US and the UK are high up the list that list. If that correlation holds, watch out for more political trouble next in in Greece and Portugal and (more surprisingly) Australia and New Zealand.
As for the equity markets, he remains of the view that they are overvalued on mean reversion grounds, but they probably won’t come down to earth for a while, such is the force of the monetary measures (QE, cheap money and so on) that are being used to keep them in the stratosphere. “Despite brutal and widespread asset overpricing” he says “there are still no signs of an equity bubble about to break, indeed cash reserves and other signs of bearishness are weirdly high”. All the great market declines of modern times, he points out, when the stock market fell at least 50% – 1972, 2000, and 2007 – were preceded by “great optimism as well as high prices. We can have an ordinary bear market of 10% or 20% but a serious decline still seems unlikely in my opinion”. In other words, the message is: stay calm for now, but be prepared for trouble ahead. There is still too much gloom around to call this yet a huge market top.
A cautionary tale
A prominent hedge fund investor at one of the best known firms in London was at school with George Osborne and has been close friends with the former Chancellor ever since. Two days before the referendum he called Mr Osborne to enquire how the campaign was going. The reply he got: “We are very confident of getting a decent majority”. There was no reason to doubt his word. It would have been the easiest thing in the world for Osborne to say something less clear-cut, if that had been how the leaders of the Remain campaign saw it. As it was a private conversation with a friend of more than 30 years standing, this was not a case of “he would say that, wouldn’t he?” We know from many other sources that Osborne and Cameron were indeed highly confident of having won the vote. That confidence was shared by the financial markets and, it seemed, the bookmakers.
The moral: to be a successful investor, you need good information and good contacts. But when it comes to judging what the great British public is thinking, even the best information and the best contacts count for nothing. You might as well go down to the pub. Listen to what is being said there and you are likely to do just as well as the richest hedge fund manager. Thousands did just that, it seems. Although the weight of the money at the bookies was heavily weighted towards Remain, the number of individual bets on Brexit outnumbered those for Remain by a comfortable margin. The people not only spoke, but backed their vote with hard cash, just as hedge fund managers are supposed to do, albeit on a somewhat grander scale.
Impressive but meaningless
The analysts at FE Trustnet had the bright idea last week of looking to see which fund managers had outperformed the market both in the run-up to the referendum and in the month that followed. Needless to say there weren’t that many who managed both. Few fund managers had actively positioned their portfolios for Brexit and many have since been forced into hasty readjustments once the No vote came through. According to the Wall Street Journal, the dispersion in performance between stocks that have done well since the vote (such as utilities, drug companies and consumer staples) and those that have done poorly (such as banks, retailers, house-builders) has been the most extreme we have seen since the great financial crisis – the worst possible scenario for active fund managers.
Since most actively managed funds are also biased towards the midcap and small cap sectors, their poor performance relative to the Footsie index of larger companies makes it a racing certainty that most actively managed funds will have had one of their worst months for quite a while. (They had a decent run for a year or so before that however). Fully 14 of the 32 funds that did pass the FE Trustnet test (out of more than 230 in the UK All Companies sector) were index-tracking funds. By definition, although they can fall, tracker funds can’t underperform during a shock event, such as the Brexit result turned out to be. They also benefit from being more diversified than the average actively managed fund.
Credit therefore to Hugh Yarrow of Evenlode Income who topped the list of funds that did well both before and after the Brexit vote. He is a rising star that many fund analysts already speak highly of and this result clearly won’t do him any harm. Among the better known funds Newton Income and Jupiter Income (both under relatively recently appointed new managers, however) came out particularly well. That doesn’t alter the fact that a single month’s performance, even a dramatic one like the one we have just seen, is worse than useless when it comes to assessing whether a fund manager has genuine skill or has merely been lucky. Fund managers need to have worked through one and preferably two full market cycles (which means a career of at least ten years) before that kind of judgment can be made with anything resembling statistical confidence
Notebook: the “great humiliator” strikes again
The Great Humiliator is the phrase that Ken Fisher, my California-based money manager friend, likes to use to describe the stock market’s capacity to play with people’s minds and reputations. By that he means the market’s ability to confound, at regular intervals, the expectations of all investors, especially those with big wallets and lofty reputations. Nobody, feared or famous, professional or amateur, is safe from finding their predictions of what is likely to happen confounded by events.
Experience since the Brexit referendum has amply confirmed, for the umpteenth time in my career, the wisdom of that label. All the pundits who predicted immediately dire consequences from the UK’s decision to leave the European Union look a little foolish today. Yes, sterling has fallen by around 10% – which is certainly no small thing – and gilt yields have fallen sharply.
Both of those were predicted. Yet the major stock market indices (not just the Footsie but the 250 and All-Share indices too) are all trading higher than they were on the day before the vote. The Footsie is up by around 7%, thanks to the boost which a falling pound gives to the reported overseas earnings of its many large multinational constituents. That most definitely was not what the Bank of England, the IMF and many other reputable organisations were expecting.
Anyone with a typical balanced portfolio, a mixture of shares, bonds, cash and property, has come through Brexit remarkably well so far. According to Asset Risk Consultants, a consultancy which measures the performance of the great majority of UK private client brokers and wealth managers, the typical balanced portfolio in their sample returned more than 3% in the month of June. This was the best single monthly performance for more than five years – on that basis maybe we should have a referendum every year!
There is no better indication of the value of having a broadly diversified portfolio as insurance against both visible and unexpected risks. The whole point of diversification after all is to save you having to worry when supposedly bad things, such as our voting to leave was meant to be, do happen. For a while at least, it absolves you from the need to take any remedial action – which is helpful, since panicky reactions to unexpected events often turn out to be costly mistakes.
But what is new (or rather what the markets have just taught us once again) is that one of the biggest risks investors face is taking heed of experts who get things wrong. You need to insure against that too.
Everyone and no-one’s an expert
Of course it is early days, and the longer term fallout from the Brexit vote will take time to materialise. As we don’t yet know how or on what basis we will end up leaving the EU, many permutations are possible. (Don’t believe anyone who claims to know for sure). The most convincing of the many analyses I have ploughed through over the past six months is that of the independent think tank Open Europe, which concluded that after an initial setback, the long term economic impact of leaving will be somewhere between mildly positive and mildly negative, depending on how flexibly in practice we are able to adapt our trade and immigration policies. All the financial markets have really told us so far is that this judgment is probably correct.
But how then is it possible to explain the remarkable unanimity with which both official institutions and the great majority of professional economists have predicted that Brexit would be an economic disaster? The answer is that most economists work with similar mathematical models and share a broadly similar set of assumptions, which include the idea that uncertainty has economic costs and that anything which restricts trade is a negative. Feed those similar assumptions into a similar kind of model, and it is really no surprise that the results with an event like Brexit will be broadly the same.
But the trouble with all economic models is that the world economy is too complex for any one model, however sophisticated, to capture all the underlying dynamics of the billions of individual decisions that businesses, governments and consumers make every day. In reality, said the famous economist J.K.Galbraith, “economists make forecasts, not because they know, but because they are asked”.
Brexit is certainly not an isolated example of expert folly. Remember the well-publicised call by strategists at one of our leading investment banks back in January that clients should “sell everything except high quality bonds”? That too looks pretty dumb now (although the individual in question is still happily employed in his job, as far as I can see). It is always worth bearing in mind that there are so many media and City pundits competing for airtime these days that many feel they have to exaggerate in order to get noticed.
The underlying problem is a more fundamental one. A comprehensive study over many years by the political scientist Philip Tetlock discovered not only that experts generally make indifferent forecasters, but that the more high profile the expert, the more useless their efforts at prediction become – typically because they become over-confident in believing their own rhetoric. More recently he has suggested, in a new book, that ordinary people using intuition and common sense are more likely to predict the future successfully than any number of experts.
Lets hope that he is right. Personally, when thinking about the stock market, I prefer the approach of the late Jimmy Goldsmith, a successful investor who had a blunt approach when discussing investment ideas with his brokers or friends. “Don’t tell me what you think” he liked to say. “Tell me what you are doing”.He meant of course that while opinions may be interesting, deeds carry far more weight. An idea you have put your own money behind is a lot more convincing than one you merely talk about.
Once a contrarian….
On a similar theme, I am old enough to remember when regular monthly surveys of fund manager views were first introduced in the UK. At the time it seemed like a revolutionary move. At last we would know where the institutions which controlled most of the market were placing their money, making it easier for everyone else to know what to do. In practice it has turned out rather differently. Thirty years on the fund manager survey, now run by Bank of America Merrill Lynch, remains an invaluable source for gauging where professional consensus market opinion resides, but its greatest use is as a contrarian indicator.
In other words, where the big boys and girls in fund management have positioned their portfolios is often a good guide where not to put your own money. That is not necessarily a reflection on the fund managers’ skill or expertise (although there are certainly other reasons for challenging those attributes). If 80% of institutional investors are overweight in say the energy sector, and have placed their bets accordingly, it simply means that the weight of their money is already “in the price”, making it too late to follow them in.
Fund managers’ cash holdings are a particularly useful contrarian indicator. The more they hold in cash, whether because of uncertainty, fears about the level of the market or simply heightened risk aversion, the more positive the outlook for the equity market tends to be. In the latest survey, published this week, but completed shortly after the Brexit vote, cash holdings were at their highest levels since 2001. If past form is any guide, that could make for a positive market backdrop over the next few weeks. It may also help to explain why the dire warnings from the IMF and others have so far failed to dent the stock market’s performance.
Take a look at this chart
Current market conditions are also, it has to be said, throwing up some remarkable oddities. Take a look at this chart for example, taken from the HL website, using its charting tool. Care to hazard a guess what security this is, one that has trumped the performance of the FTSE All-Share index (shown by the red line) over the past three years? It certainly looks like that of a company – maybe in high tech – which has been on a roll or, like Arm Holdings perhaps, just attracted a takeover bid.
Well think again. This high-flying security is actually a Government bond, traditionally regarded as one of the dullest and safest places to put your money! To be more precise, the chart shows the price of the Treasury 4% 2060 gilt. This gilt is money which the UK government has borrowed from investors with the promise to repay in full 44 years from now. The bond has risen by 70% since it was issued six years ago. The price is up 31% in the last 12 months alone.
Those who say that government bonds have changed from offering “risk-free returns” to “return-free risk” clearly need to think again. There is actually plenty of return: it is just that it is coming through as unpredictable capital rather than as predictable income. The gross redemption yield on the 2060 gilt, the compound rate of return you would earn if you were to buy the gilt today and hold it all the way through to the day the Government pays you back in 2060, is a miserly 1.5%.
Students of finance know that the longer the life of a bond, the more volatile its price. A low-interest rate environment magnifies that effect even further. But the recent behaviour of long-dated gilts is still extraordinary. The question we all need to answer is whether these dramatic returns are merely the rewards for extraordinarily high levels of risk, or are trying to tell us some as yet unclear good news story? If it can go up this quickly, the price of gilts can of course also fall at the same pace.
Notebook: taking stock post Brexit
This is one of my regular round ups on the state of the markets, this time following the Brexit vote, but keeping an eye primarily on the medium to longer term context. It is easy to get sidetracked by the excitement of a new event into losing sight of the important longer term trends. Get the right side of the longer term trends and you can survive any number of short term shocks and setbacks. There is also some value in looking to spot opportunities created by excessive moves.
The charts are from Fuller Treacy Money and reproduced with thanks. They are correct as at midday on 7th July 2016. The lighter line on the main panel in each chart represents the 200-day moving average. The RSI at the bottom of each panel represents a standard 14 day momentum measure (overbought above 70, oversold below 30, in broad terms). Further notes will look at some of the more dramatic individual stock and sector moves and the behaviour of some model portfolios.
Sterling‘s decline has been the most obvious impact of the Brexit vote. Against the dollar, it has fallen to its lowest level since the 1980s, at the height of the miners’ strike. It is down 40% since its pre-crisis peak in 2007. Short term it now looks oversold, but it is impossible to rule out further declines, at least until there is some clarity on how and when negotiations for Brexit are likely to begin. But note that sterling has been in decline for more than two years, long before Brexit.
Bond yields have fallen together right along the yield curve. I show here both the 10-year and the 30-year yields on conventional gilts. Both are trading at all-time lows, though also appearing oversold on a short term basis. The yield curve remains upward sloping for now. An inverted yield curve, when longer term yields are lower than short term one, is a traditional warning of impending recession, but we are yet to see that materialise.
The fall in yields has produced some remarkable increases in gilt prices, particularly at the longer end of the curve (which is inherent in the structure of the market when yields are already ultra-low). It is important to remember that yields have been falling all round the world, with at least three countries (the latest being Switzerland) now able to sell 50-year bonds at negative interest rates – an unheard of phenomenon. There is no better indication of the fact that the world is trapped for now in a low growth, low interest rate, deflationary environment.
It is not just conventional index-linked gilts that have done well. Index-linked bonds, a core component in the Money Makers model portfolios, have also performed well. With inflation still at very low levels, real (inflation-adjusted) yields have also declined – another global phenomenon. That in turn has helped the price of gold, which normally does well when real yields are falling and is also benefiting from its traditional safe haven status. As geared plays on the price of precious metals, mining shares have more than doubled from their lows.
The contrasting fortunes of the FTSE-100 index (whose members derive 70% of revenues overseas and whose earnings are boosted by sterling’s decline) and the wider UK equity market (predominately opposed of domestic companies) has been marked since the referendum vote. Here are the Footsie and 250 indices over five years. The latter has fallen further in percentages terms than the former, which ironically, in the light of all the dire pre-vote warnings, is higher today than it was when the referendum campaign began, although still below its high around the end of Q1 2015. Both the FTSE 250 and most smaller cap indices had a long period of strength between 2012 and 2014. The recent setback needs to be seen in that longer term context.
Looking further afield, the US equity market (S&P 500) has been trading sideways for some time, but until the Brexit vote was finally threatening to break out of its trading range to the upside. The economic data looks reasonable, despite one recent, possibly rogue, monthly jobless figure. Emerging markets, which have sold off sharply since 2012, have meanwhile recovered strongly, helped by the recovery in commodity prices and (for UK investors) the strength of sterling. I have added to my position in Murray International, the global investment trust, and one of the prime beneficiaries, more than once since the start of the year.
Volatility, although it spiked after the Brexit vote, has fallen back to a relatively low level, well below those seen during the global financial crisis in 200708 and the more recent eurozone crises.
Conclusion: almost all these charts, with the exception of the last, point to either short term oversold or overbought conditions, which is what typically happens when the markets react to a surprise event. It is reasonable to expect some retracement from here in both equity and bond markets, creating trading opportunities. Commodities and emerging markets look to be establishing significant rebounds, and are trading above their 200-day moving averages. However, given how many issues about Brexit remain to be resolved, the uncertainty is likely to put a brake on any sustained equity market recovery in the UK until the autumn. If as expected Theresa May wins the Tory leadership campaign, the risk of political instability and/or some form of constitutional crisis will be eliminated, at least for now.
Chart of the week: Brexit and Europe
Brexit represents a potentially significant negative shock to a global economy that was already struggling for growth. Policy and political risks have risen following Brexit, and warrants a more cautious investment stance in the near term. The EU in particular needs to commit to protecting its still-tepid economic recovery and preventing any tightening of credit conditions via greater banking sector caution.
We expect such an outcome but are less clear about the timing and whether policymakers will act pre-emptively or only in reaction to significant financial market turbulence. One silver lining is that the Fed likely is now on hold indefinitely, which will help ease global financial conditions on the margin.
The UK and euro area financial sectors are especially vulnerable to heightened stress, given the former’s exposure to the UK economy and inflated housing market and the latter’s fragile capital base. A substantial deterioration in UK housing and/or tightening of bank lending standards would be ominous signs for the U.K. economy and indicate possible spillover effects elsewhere. The MRB Euro Area Financial Stress Indicator has risen modestly in the past two weeks, but is not yet signaling funding pressures. The ECB will need to act swiftly if stresses build meaningfully.
European leaders in particular will need to calm any fears about the fallout from Brexit if regional confidence and growth are to hold up. To this end, a continuing global economic expansion is contingent on the euro area contributing positively to growth.
The key risks would be financial contagion from the UK to the euro area (and subsequently to the rest of the world) and/or a gradual seizing up of corporate hiring and investment in light of political uncertainty. The former does not yet seem probable but could develop, while the latter will take time to become evident and materially intensify, but is increasingly possible.
Global growth risks have risen following the Brexit vote, but clear signs that policymakers are acting aggressively and in a concerted fashion, and the euro area is effectively ring-fencing any fallout from Brexit, would be signals that global economic growth and confidence is likely to improve. Until then, we recommend a defensive investment stance on a 0-3 month horizon. A prompt euro area policy offset and evidence of economic resilience are needed for MRB to shift back to a more pro-growth 6-12 month investment posture.
Peter Perkins, MRB Partners
MRB – The Macro Research Board (www.mrbpartners.com) is a partner-owned independent research firm, recognized as one of the world’s leading providers of well-researched and actionable theme-based macro strategy and investment ideas. Its chart of the week is a regular feature on Money Makers.
Notebook: D-Day minus one
Should you act ahead of the referendum?
Outlining one of five heuristics (or rules of thumb) that he says govern his approach to investment at a Kepler Partners investment trust conference last week, Nick Train of Lindsell Train offered this trenchant advice: “Every five minutes you spend on the investment implications of the referendum is five minutes wasted”.
This is eminently sensible for a long-term investor. Why? Because the referendum is a one off event whose precise outcome, it has become clear, cannot be predicted with confidence in advance; and nor – even more importantly – can we be certain about the consequences of whatever vote materialises.
There are simply too many imponderables. Only if you believe the direst warnings of the Remain camp about the consequences of a vote for Brexit (I don’t), and only if you believe such an outcome is a real possibility (which it is), is there a case for making changes to your investment portfolio. But even then it is worth pondering Nick’s general question: “Even if you know with absolute certainty what is going to happen, can you really be sure how the markets are going to react?”.
The important question is not what you think might happen, but where what you think sits in relation to what the market has already discounted. Against that you, as with all insurance, you have to set the cost of making changes that turn out not to make much difference. While this kind of decision can be make or break for professional traders and fund managers whose livelihood is determined by their fund’s relative performance, historical experience does not suggest that genuine long term investors gain much by such an exercise. If your largest holdings are companies like Unilever (which they are in Nick’s case), the logic for owning them is not going to be affected in any material way by the referendum vote.
What does seem likely is that sterling will take a further hit in the immediate aftermath of a vote for Brexit, and by implication will rally if there is a decisive vote in favour of Remain. That will be taken as evidence of a loss of confidence in the prospects for the UK economy. But as on past occasions, such as our exit from the ERM in 1992, the weakness of sterling will in turn act as a self-correcting mechanism that works in the opposite direction. The ability of the exchange rate to act as a pressure valve is precisely why the UK has performed better than most members of the eurozone, trapped as they are in a single dysfunctional currency zone.
Opportunities also created
Binary events like the referendum are however positive for investors in one sense, in that the surrounding volatility can create opportunities to buy shares or funds you already know you want to own at attractive prices (a different issue from betting on the outcome of the referendum itself). One such case that I have acted on is Alex Darwall’s investment trust Jupiter European Opportunities (JEO), which has had a period of relative poor performance and, for this and reasons of wider market nervousness ahead of the referendum vote, has drifted out to a 6-7% discount, despite normally trading at a premium.
The trust ticks nearly all the boxes a long term investor can want – a simple investment strategy, indifference to index performance, relatively low turnover and a talented and committed manager who has a substantial proportion of his personal wealth invested in his funds. As often happens, the investment trust Darwall runs has outperformed its sister open-ended fund by a significant margin (245% versus 196% over ten years to the end of May 2016), and this despite charging a performance fee. Although Money Makers does not give investment advice (how can it, not knowing who you are or any details of your personal circumstances?), I merely report that for me the opportunity last week to top up my SIPP holding of JEO at 486p and 502p seemed too good to miss.
Tracking the result
How to prepare for the results of the referendum vote itself? Open Europe, the independent think tank, has published a helpful guide for night owls and political junkies on how the count is likely to go. You can read it here. Unlike in a general election, there will be no exit poll on Thursday evening, leaving pollsters and pundits with several hours to speculate and chew over how the vote has gone.
While the first result (most likely from Sunderland) will come in pretty soon after the polling booths close at 10pm, it won’t be until 3am or 4am that the tea leaves will start to become clearer. The outcome should be known with fair certainty by 5am. One interesting point noted by Open Europe is that most of the regions that are expected to favour Leave will have their results come in relatively early, which suggests two things. One is that unless Leave have built up a significant lead by say 4.30am, there is probably no chance of them emerging as the winners. The second is that even if Remain do hold on to win, and the margin is relatively narrow, there is likely to be a point in the middle of the night when the results to that point are suggesting that the opposite outcome is ahead.
In other words, it could be a roller-coaster ride for supporters on both sides, unless their brains are already calibrated to make the necessary adjustments for social and economic status, political alignment and all the other factors that make a straight read through from the polls so difficult. Tracking the bookmakers’ odds through the night should provide a clearer picture, I suspect, as they will to some extent incorporate those necessary adjustments.
Would Brexit really rattle markets?
Ever since March when the pound dropped some 5% against the dollar and the euro, it has been the accepted wisdom that “Brexit” would be a negative for financial markets. That drop alerted investors to the reality of the looming UK referendum on remaining in the EU and the topic has featured high on investors’ worry list ever since.
The investment banks were quick to publish dire predictions about the economic consequences of Brexit soon followed by the Treasury, who claimed that it would cost the average household the equivalent of £4,300 a year by 2030. This then led them to predict that popular realisation of the long term consequences of Brexit would so affect behaviour as to cause a short term recession. International financial and economic organisations added their warnings but the argument is far from settled.
There has been no shortage of independent economists and former Chancellors of the Exchequer with views ranging from that Brexit would make little difference to those claiming it would be of significant log term benefit to the UK. The intuitively most sensible view has come from the highly respected Roger Bootle and his team at Capital Economics who argue that whether it turns out to be a plus or a minus depends very much on how the UK government manages any exit.
The market predictions have been equally lurid. BlackRock, guided by Rupert Harrison, a former chief of staff to the current chancellor, warned of a sell off in the pound, UK equities and UK property. Bank of America predicts that it would trigger a 15% drop in European, including UK, equities with currency weakness extending that fall to 20% for European equities and 25% for UK equities. UBS Wealth warns that FTSE 100 could fall 10% over the next year despite an 8% boost to corporate earnings from the pound falling to $1.25 and 1.2 Euros but rise 5% if the UK votes to remain.
The evidence from markets as opposed to from experts is much less convincing. It shows that a lot of risk is already priced in, implying that there is little downside whatever the outcome of the vote. In April, sentiment towards sterling, based on the pricing of currency options, reached the lows last seen at the height of the financial crisis in 2008. JP Morgan’s “Brexit basket” of UK stocks deemed most at risk had under-performed the FTSE100 by nearly since December. Further downside looked limited.
So it has proved. Sterling dipped below $1.40 in March, probably driven as much by the realities of a mounting current account deficit as by Brexit worries, but then recovered. When the opinion polls appeared to swing back towards Brexit in early June, sterling dipped to $1.44, then bounced. The direction of sterling appears highly correlated to the ebb and flow of the polls but the magnitude of the moves, despite lurid media headlines, has been modest. The FTSE 100 is trading about 10% above the February low, lagging the US market, as it has persistently for the last 25 years or more, but not obviously moved by political sentiment.
This should not be surprising. About two thirds of the profits of FTSE 100 companies are derived from overseas so any fall in sterling boosts the sterling translation of overseas profits, as UBS Wealth concedes, and gives a competitive advantage to exporters. Brexit may or may not have a negative long term economic impact on the UK but, even if it does, the implication for UK profits is less obvious. Business surveys show that larger companies, as represented by the FTSE 100, are much more concerned than medium sized or smaller companies or those that are unlisted. So companies more dependent on the UK economy are actually less concerned about Brexit than larger ones who appear well insulated from any impact on the UK economy.
No historical parallel is totally reliable but 1992 provides some interesting lessons. In the run-up to the May election, investors fretted about the likely election of a Labour government led by Neil Kinnock, as was confidently predicted by opinion polls right up till polling day. From late morning of election day, the market started to rally and by early afternoon, many hours before the polls had closed, the stock market was correctly predicting a Conservative victory. The markets jumped on the news but fell back the next week when the reality of endless recession sunk in; sterling was stuck in the Exchange Rate Mechanism which required prohibitively high interest rates.
When sterling was forced off the ERM that Autumn, equities soared, interest rates fell and the economy started to recover against the prediction of nearly every economist and investment sage. The lesson for 2016? If the vote is for “remain,” equities and sterling may fail to rally sustainably as investors switch their focus to other issues. If the vote is for “leave,” the strength of a consensus of official experts does not guarantee that it is right.
Investors and businesses are holding back from investment decisions in the belief that the outlook will be clearer after June 23rd. It won’t be. The best investment decisions are usually made when risk appears to be highest and therefore priced in. Waiting to charge in or out with the herd almost never pays off. Place your investment bets now and then sit back and enjoy the humiliation of all those experts after June 23rd; their humiliation if the vote is for “leave” and their disappointment if it is for “remain.”
Max King has been an investment manager for 30 years, the last 11 of which have been at Investec Asset Management.