A Very Tradeable Brexit
When the world's top finance ministers met at the recent G20 summit in Shanghai, they shined the spotlight Brexit as a truly global economic risk.
Financial markets may not need the reminder. Yet do investors continue to discount Brexit? This week, the online prediction markets Betfair and PredictIt both placed a 29% probability on the event.
In our work for asset managers, we focus on politics. Not merely for the obvious reason that Brexit is a political event, but because markets have such trouble correctly pricing politics. This creates opportunities for the investor.
To game out the politics of Brexit and its aftermath, we focus on two signposts: the totality of the polling data, and the British government's internal politics.
Most of the last month's polls showed a small but firm lead for the Stay campaign of around 5%. However, there's a large amount of variance between individual pollsters, anywhere from Stay winning by 18% to Leave winning by 9%. This phenomenon, called "house effects," is well known in the field of public opinion.
In the United States, most data-driven prognosticators like Nate Silver specifically correct for house effects in their models. Why British wonks have yet to take advantage of these key statistical tools is beyond us, but the smart analyst needs think deeply about which pollsters they pay attention to.
That's because some pollsters had better or worse luck in a similarly uncertain British campaign: the 2014 Scottish referendum. Survation, a traditional telephone pollster, did the best of the bunch, with its final polls showing No winning by over 5%. YouGov, an online firm, fared the worst. One YouGov poll taken two weeks before the vote had
the Yes side winning by 2%; No won by 11 points.
These roles as the polling valedictorian and the polling dunce may be repeating themselves in the Brexit referendum. The latest Survation Brexit poll has Stay winning by 15%. By contrast, a recent YouGov poll has Leave winning by 1%.
Second, the internal party politics of Prime Minister David Cameron's government will determine the post-game scenarios. It's quite possible Brexit is the majority choice of Cameron's own Conservative party. Public whip counts such as The Sunday Times's suggest that over 140 of 330 Tory MP's support Brexit, only 26 shy of a majority, as well with 6 of 30 Cabinet ministers. Many more are officially undecided.
This matters because, if a majority of Conservative MP's do indeed back Brexit, the obvious implication if Leave passes is that Cameron no longer has the confidence of the majority party in the House of Commons. It's difficult to see how Cameron would survive.
The magic number of 140 number also explains why figures like London Mayor Boris Johnson and Lord Chancellor Michael Gove have jumped to the Leave side. For hardball players in the world of internal party politics, it's a risk-free move. If Leave loses, they've endeared themselves to the Tory parliamentary majority. If Leave wins, they'll be positioned to lead the same group when it's clear Cameron will have to resign.
This all being said, here's what we're talking to investors about:
On the markets front, we'll pay close attention to technical indicators. Among these are the ‘Old Reliables' of the FX market -- two-year sovereign spreads against the UK -- which have shown strong divergence against sterling and have yet to roll over.
With sterling so oversold, we're particularly sensitive to data reports. We should expect markets to "climb the wall of worry" and respond more strongly than usual from the release of favorable data.
On the political front, we're watching the pollsters, as mentioned above, who have more accurately understood referendum politics. Focus on polling averages over any individual survey. But also realize who has a track record of better or worse performance in referendum polling. YouGov may always show a tight race, but if Survation does
too, that means something.
In the event of a Brexit and the departure of Cameron, the UK may become a stock-picker's paradise. Analysts will immediately slash their forecasts for GDP and hike them for inflation. This has implications for every listed company, and especially for credit analysts. Some corporates will run into debt trouble in the new scenario.
Seen this way, Brexit becomes very tradable for the market-watcher who understands the political catalysts.
