A Brexit induced recantation

Exactly two months have now passed since the Brexit referendum. After taking a long holiday to recover from the shock and regain some perspective, it is now an appropriate time to review what has happened, and what hasn’t, since June 23. As a quintessential member of the metropolitan, intellectual, immigrant, moneyed elite that was angrily repudiated by a majority of British voters, this referendum was a profound emotional trauma. It may not be surprising, therefore, that my initial reaction as the horrifying (to me) results were still coming over the news wires, turned out to be completely wrong.

Contrary to my emotionally-charged prediction that Brexit would precipitate a politically-driven global bear market, almost all asset prices have risen substantially in the past two months. Instead of panicking about the start of a populist anti-globalization backlash, investors around the world have treated Brexit as a non-event, preferring to focus, as I did myself until the Brexit vote, on the fact that economic and monetary conditions remain remarkably benign and stable, especially in the US. As a result, equity prices have risen strongly not just in America, Europe and emerging markets, but also in Britain, where the domestically-oriented FTSE-250 mid-cap index has rebounded almost as strongly as the sterling-sensitive FTSE 100. Last Monday, both FTSE indexes peaked (temporarily?) within 3% of their 2015 all-time highs.

In fact, only two important prices—sterling and yen— have moved in the expected direction. And even these moves have been much less dramatic than anticipated, continuing for only two weeks after the Brexit vote. Since the first week of July, both sterling/dollar and dollar/yen have settled into narrow trading ranges without much sign of further panic or market pressure. The euro, even more surprisingly, has been entirely stable, worth exactly the same today against the dollar (US$1.13) as on the day of the referendum, when the markets confidently expected Remain to win.

Why did my expectations of a global bear market caused by the politics of the Brexit vote turn out to be so wrong, as did the many predictions of fatal damage to the eurozone? There seem to be four broad explanations, none of which justify my initial over-reaction, although the last one does suggest that caution about the present risk-on enthusiasm may still be appropriate, especially in the next two months.

1) Economic data has been even more supportive of an equity and euro rally than it was prior to June 23, when I was a card-carrying member of the risk-on faction. China, the eurozone and Britain itself have defied bearish economic predictions that were so prevalent in the first few months of the year. But the most important news for the markets is always about the US economy and the data released since June 23 has been especially encouraging. It is no coincidence that the post-Brexit slump in sterling abruptly reversed and the S&P 500 broke out to new record highs after the July 8 US payrolls. This release refuted fears of a US recession and confirmed the seemingly unbreakable linkage between short-term volatility in monthly payrolls and global equities. It was also helpful that Chinese and European Union figures since June 23 have been decent and no UK official data has so far confirmed the collapse in consumer and business confidence implied by surveys.

2) Investors can thank their lucky stars for monetary policy. The combination of decent US-led global growth with Brexit-linked uncertainty about the future has transformed “lower-for-longer” into “lower-forever”. The Goldilocks combination of steady growth with low inflation can no longer be dismissed as a fairy tale and now looks like a permanent way of life. In the post-Brexit world of previously unthinkable events, negative interest rates no longer seem surprising, or even unusual. NIRP terrified investors in Europe and Japan a few months ago; but now it is accepted as a permanent feature of the “New Normal” and banks are adjusting their business strategies to cope.

3) The politics of Brexit has played out very differently than most people, including me, expected. In Britain, a new prime minister has taken charge faster than seemed possible. Theresa May’s ability to handle this new job remains untested and she will be challenged to manage her slender parliamentary majority once Brexit negotiations begin. But for the moment, investors and public opinion are ignoring such details, partly because the Brexit timeline stretches beyond investors’ time horizons, as it seems possible that the UK may delay the start of the two-year “Article 50” withdrawal process until late 2017, after the German and French elections. If this is the case, then Britain will remain in EU until the end of the decade, which in terms of normal financial timescales is almost too far ahead to be formally factored into calculations. Nobody can say at present whether this newfound indifference to Brexit will turn out to be wellfounded realism, complacency or wishful thinking, but it is definitely not the attitude that I expected in the panicky hours immediately after the vote.

A bored indifference has also dulled investor sentiment about the US presidential election and the precedent set by Brexit for the possible disintegration of the euro and the EU. Far from confirming my prediction that Brexit would be feared as a leading indicator of such anti-establishment upheavals in America, Italy and elsewhere, investors now seem more relaxed about politics than before June 23. Judging by prediction markets and betting odds, a Trump Presidency is considered about as unlikely as a win for Brexit was two months before the referendum. And judging by many investors’ comments, it would not make much difference to the US or the global economy even if Trump did win. Would Trump really start a trade war with China, expel undocumented immigrants, suspend NAFTA, run trillion dollar deficits or carry out any of the other scary policies that dominate his campaign? Nobody knows and almost nobody seems to care.

Similarly, in Europe nobody seems to care any longer about the high probability that Matteo Renzi will lose his constitutional referendum or that Italian bank bailouts will be blocked by EU bureaucrats or that mainstream French politicians will turn aggressively against the euro to prevent a hemorrhage of voters to the National Front. It could well be that none of these political shocks will happen. It could be, on the other hand, that investors have become complacent about politics simply because the market reaction to Brexit has proved unexpectedly mild.

4) When the unexpected happens, markets often suffer a panicky over-reaction in the very short term, but then underreact in the medium term. The reason why trend-following strategies tend to work is that prices can take many months to fully reflect big changes in the fundamentals and investors often spend years in denial about historic transformations that almost nobody predicted or nobody fully understands. Brexit could yet turn out to have been a tectonic shift of this kind, especially if it is followed by anti-elitist upheavals in other countries. It could be, in other words that the market’s behavior in the two months since Britain’s referendum shock, will be no more a guide to the future than was the first few months of trading after the initial rumblings of the 2007 subprime crisis or the dot-com burst in 2000.

On balance, a continuation of the bull market, powered by the US expansion and hyper-stimulative monetary policy, is the most likely scenario for the next year or so. But with the US election and the Italian referendum now only two months away, the full consequences of Brexit being hard to deduce and equity prices being higher than ever, caution seems more appropriate than courage, at least until we know the name of the next US president on November 8.