Strategy & economics

Heads I win, tails...

16/06/2016

Richard Jeffrey

Richard Jeffrey

Chief Economist

Has a single event ever before triggered so many column inches of comment, assessment and polemic? And, inside investment managers around the world’s financial centres, will a single event ever before have prompted so many strategy meetings and so much scenario analysis? And I am also tempted to ask, with my email inbox filling up as I write, has there ever before been so much effort expended with so little added value resulting?

In my view, it is difficult, if not impossible, to substantiate any of the broader economics claims made by the two camps in the Brexit debate. That is not to say that the outcome will not have profound economic, political and investment consequences. However, there are simply too many ‘unknowns’ to be certain of both the shorter and longer-term implications of the referendum. This relates not just to a ‘leave’ result; even in the event of a ‘remain’ outcome, our relationship with our EU partners is likely to change.

The biggest problem when trying to structure portfolios is that, for both in and out results, it is easy to construct plausible arguments with very different, if not completely contrary, implications. Take one very simple example: the path of interest rates were the majority vote to be to leave the EU. Some argue that the Monetary Policy Committee would cut rates in order to help the economy negotiate the resulting uncertainty. Others suggest that rates would have to be raised in order to defend sterling. The issue is that economics analysis and assertion are being heavily influenced, if not determined, by political views, in an environment where it is hard to argue that anyone (or any organisation) is truly independent.

If this were not problematic enough, even the statement that markets normally react adversely to uncertainty is hard to maintain. Sure, the currency has shown slightly greater volatility, but the UK’s equity and bond markets have been remarkably unfazed. Would you have predicted that 10-year gilt yields would have been at the year’s low with opinion polls showing no clear winner in the vote? Or, that the equity market would be higher than at the start of the year (notwithstanding its heavy international orientation)? Or that sterling would be trading at a similar level against the dollar as at the end of 2015?

What I find interesting is that many current financial and economic trends which are being attributed to Brexit uncertainty can be equally well explained using more conventional arguments. Take the pound: its value is generally lower than earlier in 2015. However, a modest loss of momentum in the economy and the huge current account deficit more than adequately explain this trend. As for the real economy, one feature responsible for slightly slower GDP growth has been lower capital investment – supposedly the result of Brexit uncertainty on corporate investment plans. But the lower spending within the manufacturing sector (where weakness is most obvious) is equally-well explained by negative growth in manufacturing output over the past year (it has fallen in four of the past five quarters), which is, itself, a reflection of conditions facing the manufacturing industry worldwide.

Nonetheless, the current lack of concern in financial markets seems a little puzzling. It would be hard to argue that markets are wholly indifferent to the referendum outcome. It could be, of course, that investors are not taking opinion polls seriously (given their very obvious failings last year), and are simply not contemplating the possibility that the referendum outcome will be anything other than ‘in’. Whatever your view on Brexit, an ‘out’ vote would definitely result in an increase in uncertainty, and I find it hard to believe that this would not have a negative impact on asset prices, even if only temporarily.

Allowing for binary outcomes of major events in portfolios can often be difficult. Always the most effective solution is to look at fundamental value. We continue to see a fundamental lack of value in conventional government bonds, but regard inflation-protected bonds as providing useful insurance against the possibility that inflation picks up more than generally expected. Western equity markets offer reasonable value, so long as expectations remain grounded by relatively dull growth prospects. In this context, we remain cautious about the outlook for emerging markets – both manufacturers and commodity producers. And, as I wrote last month, it is important not to over-pay for yield and also to build in risk diversification through asset classes such as structured products, market-neutral funds and infrastructure funds. At the same time, given the possibility of greater volatility in conventional asset classes, slightly higher cash weightings are appropriate in the near term – with the possibility that this can be used to take advantage of any unwarranted weakness before or after the Brexit referendum.

This article is issued by Cazenove Capital Management which is a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Issued in the Channel Islands by Cazenove Capital Management which is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital Management unless otherwise stated.