This past weekend I was at the house of one of my fiancée’s relatives. They have a bit of land and we went riding on their ATVs. Myself and my fiancée both insisted on wearing helmets, as ATVs can be quite dangerous. The risk of not wearing a helmet is asymmetric. If you don’t wear a helmet you risk serious injury or death. On the flip side, if you do wear a helmet you don’t give up much. You don’t go faster. It’s not any more “fun”. The birds of the forest don’t sing a more beautiful song. The trees and the grass aren’t any more lush. You maybe save yourself from having a sweaty head and that’s about it. You risk a lot by not wearing a helmet and don’t save much in return.
For investors the Brexit event was similar. If you held British (or EU) stocks you were risking a lot for relatively little gain. Before the vote I saw predictions that the pound would drop from 1.45 to 1.30 versus the dollar if “Leave” won but in the event of “Remain” it might only reach 1.50. The graphic below shows one analysts prediction and how asymmetric the risks were.
Indeed, at the very beginning of the vote tallies it looked like Remain would win and the pound rallied a percent or two. However, once the tide shifted the pound dropped 5% (and continued falling throughout the evening).
The same with British stocks. If “Remain” won you still had a British economy being hurt by David Cameron’s renewed austerity push and a heavily indebted private sector. Likewise, with EU stocks if “Remain” wins you still own companies that are domiciled in countries with a dysfunctional monetary system being hurt by the EU elites push for austerity and balanced budgets.
We try to make investments where the risk/reward ratio is reversed. We want large upside potential and minimal downside risk. Soon after the financial crisis we invested in S&P Global (back then McGraw Hill) when the market was valuing it’s Standard & Poor’s credit ratings division at $0. If we were wrong and it was worthless well it was already valued at $0. If we were right we stood to make a lot of money. Or take our investment in Lockheed Martin when there were fears about defense budget cuts. The market was valuing Lockheed as if cash flows were going to decline by several percent for the next decade. If we were right and the DoD shifted money from the war budget to cover other expenses and armed conflict continued to break out in the world that eventually the defense budget would grow and we’d make a lot of money. If we were wrong, well years of budget declines were already priced in.
Those are the types of investments we love to make. I don’t want to risk my money (I’m invested right alongside clients) or your money for the chance of a small gain with the downside of a huge loss.
We had sold one British and one EU stock (a shorter term event driven investment) many months prior to the British EU Referendum. About two weeks prior to the vote we made the decision to sell the bulk of our British stocks and retained only two: British American Tobacco and Imperial Brands Group as well as a small position in Rolls-Royce.
The main reason we sold out was the asymmetric nature of the risk reward ratio but we also had other concerns that lead us to believe a Brexit was a higher probability then was commonly thought. (To be fair I’m not Nostradamus. I still thought it was likely Remain would win in a close vote). The British polling industry does not have a very reliable forecasting record (though they got this one right by and large!). In past referendums you generally see wild swings in the votes but as you get closer to the date of the vote you usually see a swing towards the status quo. Instead, we saw the opposite. At the two week mark we actually saw a significant shift in support for Leave.
However, the biggest reason we had as a client put it “a fire sale” was that we thought most major media outlets and the financial world was underestimating just how fed up the average person is with the status quo. The UK is very similar to the US in its economic situation. We both had huge housing bubbles and high levels of private sector debt prior to the great recession. We both recovered quickly compared to most other nations however, unemployment is still relatively high. We also both have high numbers of underemployed, income inequality is high, and private sector debt levels are still high. These problems have been festering for decades and people are now fed up with the status quo.
In the US we saw this manifest with a non-traditional political outsider, Donald Trump, winning the Republican nomination (although not official yet) and a self described Socialist from Vermont giving Hillary Clinton a huge challenge. In the UK we thought something similar might happen and the chances of a Brexit were higher than many thought. Indeed, I’ve seen some quotes of “Leave” voters saying that they voted “Leave” as a protest and didn’t think it would actually win. It’s these voters that we feared were being underestimated.
But now that “Leave” won what happens? In short, nothing much. David Cameron the British Prime Minister resigned so there will be new election(s). But other than that today is the same as yesterday. It will take years to sort out Britain leaving the EU and negotiating new treaties. In the meantime, it’s business as usual for most. What is relevant economically in my opinion is this:
- Some large multinationals will likely move jobs previously in Britain to other EU countries. In fact, saw a headline a few minutes ago saying Morgan Stanley was already planning to move 2000 jobs to either Frankfurt or Dublin.
- The British property market likely had some areas that were a bubble fueled by foreign investment. The uncertainty of a Brexit likely means some portions of the real estate market will cool off.
- The British Pound (GBP) fell in value. This will make British exports more attractive to the rest of the world. Given that Britain runs a trade deficit this will be a net benefit to the economy. However, I do have some concern about how this will play out. Will it mainly benefit large corporate exporters while British consumers hurt from buying more expensive imported goods? (A weaker pound makes imports more expensive.)
- David Cameron is out and that means so are his austerity policies. There is now the chance for a new Prime Minister and perhaps a completely new government to implement pro-growth expansionary fiscal policy (government spending or tax cuts).
I’m not sure how all these factors will interact. We have two economic negatives balanced out by one big economic positive and then the wild card of a new government. For Britain it will be a time of change but for investors in the rest of the world there is really not much to concern yourself with as long you don’t own a bunch of British stocks.
Some of you may have noticed I didn’t discuss the effects of a Brexit on the financial sector at all. Financial stocks, especially European ones, are taking some of the biggest hits today on a variety of fears. The reason why is this: What in the sam hill are you doing owning European financials? The EU is an absolute mess. We obviously don’t own any European financials and don’t really own any American financial stocks (unless you want to start counting something like S&P Global or PayPal as a financial) so I know almost next to nothing about the big banks and insurance companies in Europe.
Finally, I’ll add this. Everyone also seems to be in a rush to give a hot take on whether or not Britain should have left the EU and whether that was good or bad. A proper response from the British government with pro growth fiscal stimulus can and could make a Brexit an economically painless event for most Britons. I’m an American so my opinion was and is that Britain should have done just what they did. Hold a popular vote and let the British decide what the British will do. Cheers for democracy!