Blondemoney has refrained from expending too much internet ink on the EU Referendum debate. Partly from personal reasons, as this question has vexed her brow ever since the first political awakenings of an overly precocious 9 year old; but also because markets take some time to get to the heart of the issue. Now, 16 days before the vote, we are delving right into the crux of the matter. Markets thus far have interpreted it like this:
1. It’s a risk, but we don’t know the date…
2…. oh we know the date but the Government want to stay in…
3…. hang on, the Mayor of London wants to leave?!….
4… oh no, it’s OK because most of the public don’t
5… we’ve now traded both “Remain” and “Leave”, GBP/USD has done an 800 pip round trip to 1.3900 and back to 1.4700, not enough money has been made and we want to leave it alone
Are the polls right? Are the betting markets right? Who knows, but markets are all about the balance of probabilities and right now we have toyed with the idea that Brexit is like a Y2K event (fearful but irrelevant), to being a possibility but an unlikely one. The one side of the distribution we haven’t done is that Leave is likely. Partly this is because the polls have remained around 50-50, without a clear consistent lead for “Leave”; partly it’s because the market learnt from Scotland’s vote that electorates usually pick the status quo; but there is one other reason. Blondemoney fears it is because many in the financial industry simply can’t believe that the UK would commit what it believes to be financial suicide.
This would be a category mistake. This question has not, and never will be, purely an economic one. Why ask it, if it were purely economic? No, it’s the realm of politics, which as we know never fails to surprise financial markets (let’s see how they get on with the risk of a Trump presidency in the months ahead).
Markets do learn, however. The Greeks played so many games that eventually Grexit became an impossibility, rather than an inevitability. The 2013 US Government shutdown was a shutdown for market risk, not an explosion of it. This time it appears they have learnt the lesson that polls are unreliable and that any panicking vote away from the status quo will lead people to be more likely to vote conservatively (with a small c). Hence ignoring the side of the distribution where “Leave” is more likely to win. Markets have learnt that if that occurs, as in Scotland, it forces out the silent majority to vote.
Aye, there is the rub this time. What if we don’t get enough of a panic towards leaving that the Remainers turn out? What if the Leavers are already more motivated to turn out than Remainers anyway? What if no-one much turns out to vote? Much has been made of the 85% turnout for Scotland’s referendum, but does anyone remember the 41% who voted in the AV Referendum? (yes that was an actual thing, in May 2011, and the government won that one too)
The excellent YouGov have created an Interactive Turnout prediction tool. If you put the turnout at 41%, skew the average age of the voters to slightly older than estimated (don’t forget the Glastonbury Festival takes place over the vote), then quite easily you can get a 51% Leave outcome even with an underlying poll vote of +7 for Remain:
The point for financial markets is this. The “Leave” outcome is not zero. With polls mistrusted, there has been an over-reliance on betting markets, because it gives an actual number and is where actual money is staked. This has led to a belief that the odds are what is priced into the market. No, they are what is priced into the betting market, and the odds of Leave at 19% were never going to be sustainable. Now, around 27% they are approaching something more realistic. Sterling has been the place where these risks have been most priced in the financial market, but right now there’s not too many people playing. That’s why GBP/USD is prey to small flows going through and outsize 100-150pt moves on thin air. We still have just over 2 weeks to go. It is unlikely this liquidity is going to get any better; it is therefore unlikely that the “pricing” of risk will become any cleaner.
Expect further discontinuous moves in GBP; and try to use your own judgement to de-risk your portfolio accordingly. Ask yourself this: “Leave” is not a zero risk – how would your portfolio fare if it were 50-50?