Brent Sheather: Brexit risk-off?

Stock markets have taken a big dive on the Brexit surprise so the question is: how long will the new risk-off direction last? Photo / Chris Ratcliffe

So against the odds Brexit is a reality. Despite the fact that apparently only about 37.5 per cent of Britain voted to leave, leave they are.

How did this happen, what investment lessons are there for retail investors and what is an appropriate strategy for this post Brexit, increasingly uncertain world?

The first, obvious fact is that despite the theory that markets are efficient and usually can be relied upon to accurately discount the future as per the efficient market hypothesis (EMH), the market doesn't always get things right.

There is an old stock market saying that "it's rarely the bus you are watching that hits you".

This is particularly true in a stock market context because if you have your eyes on that bus thundering towards you it is likely that everybody else nearby is watching as well.

The above alludes to the EMH which argues that because the stock market represents the view of lots of experts it factors in all available information therefore it is difficult to outperform.

Nice theory but it didn't work too well as regards forecasting the outcome of the Leave/Remain decision.

So why did the markets get things so wrong?

The answer probably is that the stock market and analysts assume rationality and the decision to Brexit, given the economic consequences and uncertainty engendered thereby, doesn't seem all that rational.

But this ignores the fact that reality for someone working in the City with a £1,000,000 salary can be very different to that experienced by an unemployed person living in Birmingham.

The bottom line however is that we have seen democracy at work.

That brings to mind a quote on the subject by Winston Churchill: "The best argument against democracy is a five minute conversation with the average voter".

Kenneth Rogoff author of "This Time Is Different" argues, writing for the Project Syndicate, that "this isn't democracy, it is Russian roulette. A decision of enormous consequences has been made without any appropriate checks and balances.

Did the UK population really know what they were voting on? Absolutely not.

Indeed no one has any idea of the consequences. The current international norm of simple majority rule is, as we have just seen, a formula for chaos".

Stock markets have taken a big dive on the Brexit surprise so the question is is this a new trend and if it is how long will the new risk-off direction last for?

Will the central banks ride to the rescue again as they have done so often in the past or are the experts finally starting to grasp the fact that their QE policies have exacerbated the redistribution of wealth toward the wealthy and thus encouraged the rise of populist forces which have led to disasters like Brexit and potential disasters like President Trump?

The clear winners have been the traditional bolt-holes in times of uncertainty namely bonds, gold and the Yen.

Before we think of a strategy for the future let's look at how various asset classes have reacted to Brexit thus far.

The clear winners have been the traditional bolt-holes in times of uncertainty namely bonds, gold and the Yen. In NZ$ terms gold is up by 3.1 per cent in the month and for UK based investors it rose by around 13 per cent in the 24 hours after the Brexit result.

Not too many people own gold but lots own bonds.

As with previous crises of confidence the longer dated the bond the better the return so for NZ investors 10-year Government bonds were particularly sought after and the day after Brexit yields dropped by about 22 basis points to 2.34 per cent.

Year to date 10-year NZ Government bonds have returned 12.3 per cent which is nice to know when your global shares are down by 10 per cent.

The table below summarises some of the winners and losers thus far with prices as at the close on Friday 24th June. All returns are NZ$ adjusted.

The big losers have been the pound and shares and the more leveraged the stock, either operationally or financially, the greater the loss, with banks and miners taking the biggest hits.

Historically NZ and Australian retail investors have been big shareholders in the Australian banks because they pay large dividends. However high yields come with risk and because banks typically have thin slivers of equity and very large debts they tend to suffer disproportionately when the mood shifts to risk-off.

So should be we buying now? Of course we should but knowing whether to buy bonds or shares is more difficult.

Furthermore we need to remember that just because share prices are lower does not mean shares are cheaper. It may be that lower prices simply reflect a new reality of diminished profitability.

It's dangerous to compare where share prices were to where they are now and say that because they are lower stocks are cheaper. This assumes that the people or institutions which pushed down the prices are irrational and that may not be the case.

As a stockbroker I remember the day after the 1987 crash the phones went crazy as people picked up "bargains". The following day prices dropped again. The day after bargain hunters returned but in fewer numbers.

This process repeated itself until the buyers became despondent and the phones went silent - for about four years.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.