In a little under a month Britain goes to the polls on whether or not it will remain in the European Union. Brexit has been one of the most important debates around the world in 2016. You cannot open a paper without seeing something on the referendum. The debate has intensified recently, even Mark Carney, the Governor of the Bank of England, has warned that Brexit could potentially cause a recession in the UK.
The situation is frankly complicated. The reality is that forecasting the long-term economic implications is guess work, retaliations from Europe could be unpredictable and the current European zombie economy does not provide much clarity on how strong Europe could be without UK and vice versa. The renegotiation period could last years, putting both economies at risk.
How are the markets responding to Brexit?
The peak in uncertainty on Sterling against the Euro will come in 2 months’ time. The price of hedging the FX rate, defined as implied volatility derived from FX options, is not cheap, which means hedging the FX rate over the next 2 months is very expensive and uncertainty is at a multi-year high. The price of that uncertainty does not reach current levels, even if looking as far ahead as 10 years. This is extreme, we are likely to see a normalisation of the market in as little as a year.
The level of uncertainty is also reflected in the spread between buyers and sellers of this hedging contract. Sellers of upside risk in the Euro (contracts that makes money if the Euro appreciates) are reluctant in selling at a cheap price indicating market makers, basically the investment banks, are keen to sell the insurance, but they want a very high safety buffer to initiate the bet.
Looking at the pricing of extreme events, FX options could offer insights regarding what market participants think. Investment professionals think in terms of Risk Reversal, a strategy to protect against extreme unfavourable price movements, or how investors position themselves for crash events. Even in this case hedging crash risk for downside on sterling highlights a very expensive trade, with the level of uncertainty (implied volatility) more than 6 times the current level, a staggering number.
Investors are clearly concerned, but the wise long-term investor should try to avoid this highly risky bet, at a minimum they should try to reduce the FX risk. Diversification will play a key role in minimising the surprises.
What are the political expectations for the EU referendum?
Looking at current political expectations, Betfair indicates that there is an 80% probability that the UK will remain in the EU. However, the amount of bets placed so far only adds up to £13 million. This helps to show us how the general public view Brexit. This result is constantly changing, at its peak the probability of the UK remaining in the EU was 50%, it then reached 85%, then went back down 60% (with even the Mayor of London backing Brexit). In the last few weeks it seems staying in has started to trend upwards, likely due to the warnings in the media.
What are the possible outcomes of the referendum?
If we were to assume that the UK left the EU we are likely to see difficulties in the equity market. Dividends stocks, typically in defensive sectors, might outperform other equity indices. On the fixed income side, it might be risky to own UK government bonds, instead investors could seek German government bonds given its risk-free role when fear is high in the market. Sterling is likely to suffer, but even the Euro could face difficulties due to the political and economic implications within the Euro area. Gold might jump given its characteristics of being safe heaven and the only non-fiat currency.
If the UK were to stay in the EU we would likely have a bull scenario for equity. Small cap stocks would likely outperform large cap stocks, especially in the UK and across continental Europe. Investors would retreat from government bonds, we will likely see heavy selling of UK and European government bonds. In this case both the Sterling and the Euro should appreciate after the political drag of Brexit. Gold might suffer slightly, but given the current global accommodative monetary policy, the losses are unlikely to be pronounced.
We advise investors to be cautious, the long-term investors should remember the fundamentals of economics and try to mitigate short-term currency risk. This way she or he will be able to enjoy the upcoming European football cup in France without too much stress.