The mispricing of risk by analysts and markets
Britain’s referendum on EU memberships has negative implications for GBP, EUR, British economy and the European economy. What is bad for Europe is not good for the global economy.
In the event that Britain votes to leave the EU, it is expected that Sterling will sell off significantly against the USD and less significantly against the Euro. No one has a crystal ball and analysts are all over the place on the extent of the sell-off. Some think that on the downside perhaps a 10% reduction in value should suffice. Others think that GBP could fall to 1.15 to the dollar. Analysts hedge their bets by making longer term predictions when we are not asking them to do so. We want to know what will happen a day or two before the vote and critically on the day and a couple of days after. The answers are really quite complex. There are so many variables, that to predict actual exchange rates would be folly. Of course nervousness on the day and forced sell-offs or position covering and the powerful players will push markets too far; far from reason, simply because for a very short time no one will be willing to make a price. Liquidity may simply vanish in the world’s most liquid market.
Volatility in just a single pair GBPUSD induces volatility in other pairs: EURUSD, EURCHF, USDJPY and importantly EM currencies. Volatility doesn’t only imply large movements. Volatility leads to the biggest movements in the instrument under stress. In this case it is GBP. But GBP is linked to something else. The EUR, USD, JPY etc. If the USD is strengthening, that is not good for EM currencies. Flight to safety usually means higher JPY and higher CHF and generally higher volatility.
Unless it starts to become clear that the YES Vote is going to be more certain, volatility is expected to rise or stay elevated leading up to the vote.
Going into the vote reducing leverage is essential.
For companies with long term exposures to Sterling the situation could be more challenging. Importers will have to pay more to ship in foreign good. There may be constraints on how much they can raise prices. Brexit may be a good strategy to increase inflation expectations. Property in London will start to look cheap compared with Hong Kong, New York, Paris and Berlin if GBP is at 1.15 to the dollar. That could bring capital into the country and not just into property. UK companies may start to look cheap also. FTSE 250 should then benefit. Property prices may not fall with the demise of Sterling. A case could be made that property values will actually increase. Foreign investments into the UK, should surge; so much for self-control of the UK’s destiny that the leave campaign is touting. The owners are always in control!
For exporters things could turn out to be better. Every major economy is trying to devalue their currency. British exit will do it for Britain. But the British economy runs a trade deficit. Provided economic growth is not undermined, that deficit most likely will get bigger. Of course the economy could go into a tailspin. In this case imports could implode.
Recession in the UK will be deflationary. Gilt yields will shrink further or may not rise, given that GBP would have sunk.
As one can see there are many challenges in being able to predict. Markets are blunt instruments that attempt to discount future prices. We all have a rather narrow view of reality. The people who influence prices the most often have the narrowest of views, partly because they are guided by self-interest. Currency values, of course, influence the level of interest rates, which in turn tell us about how to discount cash-flows of business and thus how to value companies. The FTSE 100 is not representative of what the UK economy will do. Britain has been a home for foreign companies to raise capital and have their shares listed on the LSE. The FTSE 100 may not see the corrections that GBP is expected to experience in case of a NO Vote.
There is evidence of mispricing elsewhere. 10-Year German Government Bonds are trading close to zero yields. This is not just because of flight to safety. The ECB’s bond buying programme has been the primary influence. But that push to lower and lower bond yields doesn’t sit well with the stated aim of the ECB – which is to target 2% inflation. Either the inflation target is not going to be achieved or risk is mispriced.
These historic low yields are hugely detrimental to individual savers and Pension Funds – which in effect are holding our collective savings. The risk that some insurance company or a Pension fund won’t be able to meet its liabilities and file for bankruptcy is quite elevated. This type of risk, I believe, is not priced into current equity market prices, but may well be better priced into bond yields.
Sensible traders should let the storm pass by squaring their positions or take contrarian smaller positions in the eye of the storm. As we saw with the Greek crisis, in the end things are never as bad as markets make them out to be. But long before the end, financial markets can leave many in ruin. Of course there will be winners and some analysts will shine. Media will make folk heroes out of them, when in fact the probability of anyone being right about anything is close to 50:50.
The only thing that changes the odds is monitoring, measuring and managing risks close to real time. In times of high volatility, time shrinks.