The Brexit Effect: The Signals Amidst The Noise

There are few events that grab markets past times consummate surprise but the determination past times British voters to leave of absence the European Union comes close. As markets fighting to adapt to the aftermath, analysts as well as experts are looking backward, likening the trial to past times crises as well as modeling their responses accordingly. There are some who run across the seeds of a marketplace seat meltdown, as well as believe that it is fourth dimension to cash out of the market. There are others who fence that non only volition markets bounce dorsum but that it is a buying opportunity. Not finding much clarity inwards these arguments as well as suspicious of bias on both sides, I decided to opened upwards up my crisis survival kit, last inwards occupation inwards August 2015, inwards the midst of some other marketplace seat meltdown.

The Pricing Effect

I am certain that you lot receive got been bombarded alongside word stories well-nigh how the marketplace seat has reacted to the Brexit vote as well as I won't bore you lot alongside the gory details. Suffice to say that, for the most part, it has followed the crisis dominion book: Government bond rates inwards developed marketplace seat currencies (the US, Germany, Nihon as well as fifty-fifty the UK) receive got dropped, gilt prices receive got risen, the cost of hazard has increased as well as equity markets receive got declined. The pic below captures the fallout of the vote:

While most of the reactions are non surprising, at that spot are some interesting aspects worth emphasizing. 

1. Currency Wars: If this is a battle, the British Pound is on the forepart lines as well as taking heavy fire, downwards some 10% over the final calendar week against the the States dollar as well as approaching three-decade lows, alongside the Euro seeing collateral harm against the the States dollar as well as the Japanese Yen.
2. Old EU, New European Union as well as the Rest of the World : The harm is greatest inwards the EU, but fifty-fifty within the EU, it is the one-time European Union countries (primarily West European, that joined the European Union prior to 2000) that receive got borne the biggest pain, alongside sovereign CDS spreads rising as well as stock prices falling the most. The novel European Union countries (mostly East European) receive got been wound less than Britain's other trading partners (US, Commonwealth of Australia as well as Canada) as well as the harm has been muted inwards emerging markets. At to the lowest degree for the moment, this is to a greater extent than a European crisis showtime than a global one.
3. Banking Problems? Though I receive got seen word stories suggesting that fiscal service companies are existence wound to a greater extent than than the residuum of the marketplace seat past times Brexit as well as that smaller companies are feeling the hurting to a greater extent than than larger ones, the bear witness is non at that spot for either proffer at the global level. At to a greater extent than localized levels, it is solely possible that it does exist, peculiarly inwards the UK, where the big banks (RBS, Barclays) receive got dropped past times 30% or more as well as mid-cap stocks receive got done far worse than their  large-cap counterparts.

While I did halt the assessment equally of Fri (6/24), the showtime 2 days of this trading calendar week receive got continued to live volatile, alongside a large downwards solar daytime on Mon (6/27) followed past times an upwards solar daytime on Tuesday (6/28), alongside to a greater extent than surprises to come upwards over the side past times side few days.

The Value Effect

As markets brand their moves, the advice that is existence offered is contradictory. At 1 cease of the spectrum, some are suggesting that Brexit could trigger a fiscal crisis similar to 2008, pulling markets farther downwards as well as the global economic scheme into a recession, as well as that investors should so cut down or eliminate their equity exposures as well as batten downwards the hatches. At the other cease are those who experience that this is much ado well-nigh nothing, that Brexit volition non fall out or that the Great Britain volition renegotiate novel terms to alive alongside the European Union as well as that investors should catch the marketplace seat drops equally buying opportunities. Given how badly proficient advice served us during the run-up to Brexit, I am loath to trust either side as well as decided to croak dorsum to basics to empathise how the value of stocks could live affected past times the trial as well as mayhap laissez passer on judgment on whether the pricing outcome is nether or overstated. The value of stocks collectively tin lavatory live written equally a purpose of 3 key inputs: the cash flows from existing investment, the expected growth inwards net as well as cash flows as well as the required render on stocks (composed of a hazard gratuitous charge per unit of measurement as well as a cost for risk). The next figure looks at the possible ways inwards which Brexit tin lavatory impact value:

Embedded inwards this pic are the most extreme arguments.  Those who believe that Brexit is Lehman-like are arguing that it volition Pb to systemic shocks that volition lower global growth (not but growth inwards the Great Britain as well as the EU) as well as increment the cost of risk. In this story, these shocks volition come upwards from banking problems spilling over into the residuum of the economic scheme or an unraveling of the EU.  Those who believe that Brexit’s effects are to a greater extent than benign are making a illustration that piece it may cut down Great Britain or fifty-fifty European Union growth inwards the brusque term, the effects of global growth are probable to live little and/or non persistent as well as that the hazard outcome volition dissipate 1 time investors experience to a greater extent than reassured. 

I run across the truth equally falling somewhere inwards the middle.  I hollo upwards that doomsayers who run across this equally some other Lehman receive got to render to a greater extent than tangible bear witness of systemic risks that come upwards from Brexit. At to the lowest degree at the moment, piece Great Britain banks are existence difficult hit, at that spot is lilliputian bear witness of the upper-case alphabetic lineament crises as well as marketplace seat breakdowns that characterized 2008. It is truthful that Brexit may opened upwards the door to the unraveling of the EU, a bad sign given the size of that marketplace seat but buffered past times the fact that growth has been non-existent inwards the European Union for much of the final vi years. If the European experiment hits a wall, it accelerate the shift towards Asia that is already occurring inwards the global economy. I also hollo upwards that those who believe that is but some other storm inwards a teapot are besides sanguine. The Great Britain may live only the 5th largest economic scheme inwards the basis but it has a punch that exceeds its weight because London is 1 of the world's fiscal centers. I hollo upwards that this crisis has potential to boring an already anemic global economic scheme further. If that slowdown happens, the central banks of the world, which already receive got pushed involvement rates to null as well as below inwards many currencies volition run out of ammunition. Consequently, I run across an extended menses of political as well as economical confusion that volition impact global growth as well as some banks, primarily inwards the Great Britain as well as the US, volition observe their upper-case alphabetic lineament stretched past times the crisis as well as their stock prices volition react accordingly. 

The Bigger Lessons

It is like shooting fish in a barrel to acquire caught upwards inwards the crisis of the minute but at that spot are full general lessons that I depict from Brexit that I promise to occupation inwards molding my investment strategies.

1. Markets are non but counting machines: One of the oft-touted statements well-nigh markets is that they are counting machines, prone to mistakes but non to bias. If nix else, the way markets behaved inwards the lead-up to Brexit is bear witness that markets collectively tin lavatory endure from many of the biases that private investors are exposed to. For most of the final few months, the British Pound operated equally a quasi bet on Brexit, rising equally optimism that Remain would prevail rose as well as falling equally the Leave drive looked similar it was succeeding. There was a to a greater extent than straight bet that you lot would brand on Brexit inwards a gamblers' market, where odds were constantly updated as well as probabilities could live computed from these odds. Since Brexit was also 1 of the most highly polled referendums inwards history, you lot would await the gambling to live closely tied to the polling numbers, right? The graph below illustrates the divide.
   
   While the odds inwards the Betfair did motility alongside the polls, the odds of the Leave military camp winning never exceeded 40% inwards the betting market, fifty-fifty equally the Leave military camp acquired a little Pb inwards the weeks leading upwards to the vote. In fact, the betting odds were as well as so pasty that they did non shift to the Leave side until almost a tertiary of the votes had been counted. So, why were markets as well as so consistently incorrect on this vote? One reason, as this story notes,  is that the large bets inwards these markets were existence made past times London-based investors tilting the odds inwards favor of Remain. It is possible that these investors as well as so wanted the Remain vote to win as well as and so separated from this alongside a dissimilar hollo for of catch that they were guilty of confirmation bias (looking for pieces of information or sentiment that backed their view). In short, Brexit reminds us that markets are weighted, biased counting machines, where if large investors alongside biases tin lavatory get prices to deviate from fair value for extended periods, a lesson mayhap that nosotros learned from value investors piling into Valeant Pharmaceuticals.
2. No 1 listens to the experts (and deservedly so): I receive got never seen an trial where the experts were all as well as so collectively incorrect inwards their predictions as well as and so completely ignored past times the public. Economists, policy experts as well as key banks all inveighed against exiting the EU, arguing that is would live catastrophic, as well as their warnings brutal on deaf years equally voters tuned them out. As person who cringes when called a valuation expert, as well as finds some of them to live insufferably pompous,  I tin lavatory run across why experts receive got lost their cache. First, inwards almost every plain including economic science as well as finance, expertise has acquire narrower as well as to a greater extent than specialized than ever before, leading to prognosticators who are incapable of seeing the large picture. Second, piece economical experts receive got e'er had a mixed rail tape on forecasting, their mistakes straight off are non only to a greater extent than visible but also to a greater extent than populace than ever before. Third, the mistakes experts brand receive got acquire bigger as well as to a greater extent than mutual equally nosotros receive got globalized, partly because the interconnections betwixt economies agency at that spot are far to a greater extent than uncontrollable variables than inwards the past. Drawing a parallel to the investment world, fifty-fifty equally experts acquire to a greater extent than forums to live public, their prognostications, predictions as well as recommendations are getting far less honour than they used to, as well as deservedly so.
3. Narrative beats numbers: One of the themes for this spider web log for the final few years has been the importance of stories inwards a basis where numbers receive got acquire to a greater extent than plentiful. In the Brexit debate, it seemed to me that the Leave side had the to a greater extent than compelling narrative (of a render to an an one-time Great Britain that some voters constitute appealing) as well as piece the Remain side argued that this narrative was non plausible inwards today's world, its counter consisted by as well as large of numbers (the costs that Great Britain would human face upwards from Brexit). Looking ahead to similar referendums inwards other European Union countries,  I am afraid that the same dynamic is going to play out, since few politicians inwards whatever European Union province seem to desire to brand a full-throated defence of existence Europeans first. 
4. Democracy tin lavatory disappoint (you): The parallels betwixt political as well as corporate governance are plentiful as well as Brexit has brought to the surface the age-old debate well-nigh the merits of straight democracy. While some (mostly on the winning side) celebrate the might of gratuitous will, those who receive got never trusted people to brand  reasoned judgments on their futures catch the vote equally vindication of their fears. In corporate governance, this tussle has been playing out for a while, alongside those who believe that shareholders, equally the owners of populace corporations, should command outcomes, at 1 end, as well as those who fence that incumbent managers and/or insiders are to a greater extent than knowledgeable well-nigh businesses as well as should so live allowed to piece of work unencumbered, at the other. I am certain that at that spot are many inwards the corporate basis who volition aspect at the Brexit results as well as cheer for the Facebook/Google model of corporate governance, where shares alongside dissimilar voting rights give insiders command inwards perpetuity. As person who has argued strongly for corporate republic as well as against entrenching incumbent managers, it would live inconsistent of me to observe fault alongside the British populace for voting for Brexit.  In a democracy, you lot volition acquire outcomes you lot practice non similar as well as throwing a tantrum (as some inwards the Remain military camp are doing correct now) or threatening to motility (to Canada or Switzerland) are non grown-up responses.  You may non similar the outcome, but equally an American political consultant said after his candidate lost an election, "the people receive got spoken... the bastards".

The End Game

I receive got non bought or sold anything since the Brexit results for the uncomplicated ground that almost anything I practice inwards the midst of a panic is to a greater extent than probable to live counter productive than helpful. To those who would fence that I should motility my coin away from Europe, the markets receive got already done that for me (by mark downwards my European stocks) as well as I run across lilliputian to live gained past times overdoing it. To those who assert that this is the fourth dimension to buy, I am non a fan of blind contrarianism but I volition live looking at UK-based companies that receive got pregnant non-European operating exposure inwards the promise that markets receive got knocked downwards their prices besides much. Finally, to those who posit that this is a fiscal meltdown, I volition maintain a wary optic on the numbers, looking for early on signs that the worst illustration scenario is playing out. In my view, banking concern stocks volition live the canaries inwards the coal mine, as well as peculiarly as well as so if the harm spreads to non-UK banks, as well as I volition croak along to approximate equity hazard premiums for the S&P 500 as well as mayhap add together the Great Britain as well as Deutschland to the listing to acquire a mensurate of how equity markets are repricing risk.

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