Britain’s Brexit decision on Thursday, 23 June 2016, appeared to catch the financial markets by surprise even though the opinion polls had been warning of a very close vote.
On Friday, 24 June 2016, the British pound fell sharply, over 7%. The S&P 500™ fell over 3%, while U.K. stocks, European exchanges, and Japanese stocks fell much more. As Japanese and global equities declined, non-Japanese sellers of Japanese equities covered their FX hedges, and the Japanese yen briefly strengthened below 100 versus the dollar, before rebounding based in part on Bank of Japan intervention. The VIX had its biggest one-day rise since the Chinese-induced sell-off in August 2015. Bank stocks in the European Union took a beating, down 10% to 20%. On the flight-to-quality side of the ledger, U.S. Treasuries rallied big and gold surged. On Monday morning, 27 June 2016, the hangover was still severe, with the pound falling further, global equities moving down, and the “flight-to-quality” U.S. Treasuries rallying. The dust is not settling several days after the event, so it is time to take stock.
These political and market developments raise many questions, to which there are precious few clear answers. Despite the murky nature of what is to come, it is useful to have a starting place for the analysis, and this process is inherently scenario and probability-based. That is, in the spirit of Bayesian inference, our task is to provide some useful expert information around which to build initial scenarios and to assign them rough probability estimates, even if we hold those probability estimates with low confidence. As new information and facts emerge, our views, probability assessments, and confidence will shift appropriately.
Most traders, portfolio managers, and risk managers were well aware that the pound, equities, and other risk assets would see a big price change once the vote was tallied. A “Remain” vote would have rallied the pound and other risk assets, and the “Leave” vote, as expected, triggered lower prices for risky assets.
As argued consistently and persistently prior to the vote, event risk episodes are strikingly different than typical trading activity. With event risk, market participants have to cope both with a sudden price change and an upward shift in the volatility regime. Thus, when severe event risk is present, options can offer considerable advantages for risk management specifically because options embed a view on volatility. Let’s examine how this works in practice as we study the market reaction to the Brexit vote.
Prior to the vote, one knew the date of the event but not the outcome. One had to assess the probabilities of which way the binary election results would go. This created what is known in statistics as a bi-model distribution – i.e., two rather distinct outcomes with no middle ground. So, before the event, market prices reflected the probability weighted average of either outcome ‘A’ or outcome ‘B’, that is, market prices were stuck in the middle ground. Once the result of the referendum became clear, market prices moved quickly to reflect the uncertain implications of the ultimate result.
This event risk process is not a surprise, as much as it might look like one. And, understanding the way the statistical probability distribution will shift in event risk – from bi-model before the event, to a more normally-distributed single mode after the event – should not be a surprise.
Of course, we should note that there are two types of event risk – (1) we know the date of the event and not the outcome, and (2) we don’t even know the date or much about the event. The Brexit vote, along with U.S. presidential elections in November 2016 and the French presidential elections in the spring of 2017, as well as important data releases with known dates and unknown outcomes, are all examples of the first type of event risk. At least when the date and event are known, one can decide whether to buy/sell option that mature before the date (i.e., time or theta risk), or buy/sell options maturing after the event date (i.e., focus on volatility shift risk, or vega).
Scotland (62%) voted overwhelmingly to “Remain” in the European Union. The Scottish National Party (SNP) will argue that the facts have changed, and they will want a new referendum on whether Scotland should leave the UK. As of now, we estimate there is a 60/40 probability of a new Scottish referendum on Independence from the UK being called within the next two years, and 55% chance it may succeed. Both of the probabilities are, of course, highly subjective, made with little confidence, and subject to future re-evaluation. Nevertheless, Scotland leaving the UK is a real risk, and will probably depress investment in the region, including North Sea oil investment. Oil production in the North Sea has been declining already for a decade, so this may weaken the appeal of Brent crude oil as even a regional benchmark.
Northern Ireland voted 56% to “Remain”, while the outcome was determined by the much more populous England, which voted 53% to “Leave”. There is going to be considerable uncertainty in Northern Ireland as they assess their future inside the UK and outside the EU. The Irish Socialist / Republican Party, Sinn Fein, has announced they are going to push to have a referendum to let the people of Northern Ireland choose to join the Republic in staying in Europe, i.e., a United Ireland. While this is a remote possibility, the alternative could be a lot worse, a return to the sectarian violence which ran for decades. With the Irish Republic being the only physical border with the U.K., when Brexit occurs it is likely that customs and passport control stations will be installed, which could create further divisions and tensions between the north and south of the Emerald Isle, and see a return to violence. This is an important risk, even if of low probability and one that four former UK Prime Ministers (Cameron, Brown, Blair, and Major) warned against.
There are important anti-EU political parties in many European countries.
Spain just voted (Sunday, 26 June) and for now, chose a more establishment route. Separatists in Catalonia (Barcelona), however, are likely to feel empowered by the Brexit vote in their quest for independence from Spain.
The National Front Party in France has been gaining momentum in recent elections. Indeed, according to some opinion polls, Brussels is less popular in France than in the UK. Marine le Pen, leader of the National Front, even before the Brexit vote, was widely expected to run first in round one of the French Presidential election in late April 2017. [Note: the French have a free-for-all round one election for the President in late April, when every Party, small or large, runs a candidate. Assuming no candidate gets over 50% of the vote in round one, the #1 and #2 finishers advance to the second round a few weeks later in early May 2017.]
Other countries in Europe with strong anti-EU parties, such as The Netherlands and Austria, are likely to push for significant reforms in Brussels and even consider negotiating a change in their status in the European Union.
Belgium, which is essentially an artificially put-together country of one part French (Walloon) and two parts Flemish speakers, will face serious economic disruption, as the EU bureaucracy in Brussels may have to shrink, due to losing the financial support from the UK. Belgium is a heavily indebted country with severe political divisions already, so a split up of Belgium should not be ruled out, although of low probability.
In short, while the UK is leaving the EU, the implications for the EU are potentially even more serious than for the UK. Because the implications for the EU are so serious, however, this probably means that the EU will take an especially tough attitude in the Brexit negotiations toward the UK and seek penalties for leaving. That is, they want to make sure that all the voices for leaving Europe are fully aware of how high the costs will be.
London may well go through an intermediate period of great uncertainty which could depress trading activity from London. This is not a given, however, as the UK regulatory authorities, Parliament, and the Bank of England, may all move to create incentives for more, not less, financial activity to be transacted in London. The UK may offer tax incentives and simplified regulations to effectively compete and discourage any shift in business to the European continent or elsewhere.
The regulatory shifts may turn out to be based on two different approaches to regulation. The British have always tilted toward a principle-based approach to regulation, while Washington and Brussels often err in the direction of a rules-based approached. We do not want to argue the merits of either approach here. Our intention is just to highlight that British may go for a more flexible approach that allows the regulatory authorities to treat each case in terms of its own systematic risk. Given the complexity of modern, electronic, globally integrated markets, one can make a case that a greater tilt toward principle-based regulation and an abhorrence of financial transaction taxes may give London a compelling boost to its growth, despite Brexit.
Also, one should consider that Paris and Frankfurt are not major financial centers. The labor laws in Germany and France will keep non-EU banks from expanding there. Trading is electronic now anyway, so banks can be very selective about where they base their employees.
Dublin, interestingly, is likely to be a major beneficiary of the Brexit vote. Ireland is inside the EU to stay, and Ireland has a very “light touch” regulatory policy regarding fund managers. We are not sure banks will move toward Ireland, however, the asset management business is already there and that could grow substantially at the expense of London, Paris, and Frankfurt.
Finally, we note that the EU will be re-thinking its approach to regulation, too, as it will be worried about how the UK votes impacts future elections in France, Spain, Germany, Italy, etc. Transaction taxes are probably dead. Other possible changes are not so clear. In short, we are going to have years of regulatory uncertainty within the EU, and that will make it very hard for Paris or Frankfurt to take business from London.
The fall-out from the Brexit vote in terms of the leadership of both the Conservative and Labour Parties is unfolding quickly.
David Cameron announced his resignation as Prime Minister and leader of the Conservative Party very early on Friday morning, 24 June 2016. He will stay in office until the Conservative Party chooses a new leader. The Party conference will put two names forward, and early favorite is Boris Johnson, who was a leader in the “Leave” camp. The situation is quite fluid, though, and so a number of candidates may put their names in the ring over the coming months. Whoever is chosen as leader of the Conservative Party will become Prime Minister and will lead the UK in negotiations with the EU on the terms of exit. This is likely to be a highly controversial task and could lead to being voted out of office at the next Parliamentary elections.
The Labour Party is also coming in for its share of the blame for the Brexit vote. Labour is largely pro-Europe. Labour, however, did not campaign very hard – lukewarm actually – for the “Remain” camp as they preferred to let David Cameron squirm. This is a classic case of needing to be careful for what you wish. A change in Labour Party leadership is also likely, and could come relatively soon.
Then, there is the probability of new Parliamentary elections. The Fixed-Term Parliaments Elections Act of 2011 set the term of Parliament at five years. The Conservative Party won a surprise majority on 7 May 2015, and the next general election would be May 2020. We note, however, that since both major parties are quite fractured by Brexit, it is possible, although with only perhaps a 30% probability, that an alliance of members of Parliament from the “Remain” camp on both sides of the aisle, plus representatives from Scotland and Northern Ireland could decide to repeal the Fixed-Term Parliaments Elections Act and call new elections. Any action such as this would probably come in 2017, after new leadership is installed in the two major parties.
The impact on the UK economy will be quite large, especially on the financial sector in London. A short recession is highly likely. UK bank stocks were down as much as 20% at the worst of the night. Europe will also see a growth setback, and it will test the ECB’s vision of whether to deepen their moves in negative rate territory. In any case, from the ECB to the Bank of Japan, central bankers will be studying how they can provide more support through QE, as well.
The negative impact on the US economy will not be large, but it will probably be noticeable, especially in terms of business investment activity. Uncertainty surrounding major trading partners – UK and Europe – is never a positive. We do not expect the US to enter a recession, however, we are in a period in which 1% to 1.5% real GDP growth is the expectation. This scenario probably means slower job growth and little to no inflation pressure. Thus, the Brexit vote will scare the Fed, so no US rate hike in 2016, and maybe not 2017.
One answer is that significant amounts of Japanese stocks are owned by non-Japanese asset managers and hedge funds and are typically all or partially hedged for yen/dollar risk. Japanese investors appear to also have a small tendency to hedge the FX risk associated the local stock market. The hedging is driven by a belief (we share) that Prime Minister Abe and the Bank of Japan want to have a weaker yen. Policies that weaken the yen, may work to help exports (in theory, at least) and thus assist the economy. When equities fall, for any reason -- including non-Japan reasons such as Brexit -- as foreigners (and some locals) sell their Japanese stocks they also simultaneously close their FX hedges, which means buying back their yen short, so the yen rises when equities fall and vice versa under Abenomics.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
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