We debate the likelihood of a Leave vote based on the polls and turn out estimates. We also outline what positions we're taking in our portfolios in the run up to the Referendum. Sterling is rapidly becoming a key tool to hedge the risks.
"Events, dear boy, events", former Prime Minister Harold Macmillan is reputed to have said to a journalist asking him what is most likely to blow the government off course. It seems ‘events’ are now the only things standing between the UK and the continuation of its membership of the European Union. Both opinion polls and the betting odds have moved steadily towards ‘Remain’ over the past month. The details suggest that a significant number of Tory voters, who were originally the main proponents for leaving the EU, have changed their minds. Commentators suggest the possibility of economic hardship is the key issue driving voter intentions, possibly supported by robust anti-Brexit statements from the Governor of the Bank of England, the Treasury and, for good measure, the International Monetary Fund.
What events might derail this trend? The biggest risk is, curiously, not in the issues themselves but in the numbers turning out to vote. The smaller the turnout, the more likely it is that we vote to leave the EU. This occurs because those most likely to vote are also most likely to vote to leave the EU – principally older age groups. Younger age groups are more likely to want to remain but are also less likely to vote. The critical threshold is thought to be about 50% of those registered to vote. Simply put, below this level we ‘Leave’ and, above it, we ‘Remain’. Are you sitting comfortably? While the turnout for general elections is usually at or above 60%, the turnout for European Parliament elections is nearer to 35%. When it comes to Europe, as a nation we just don’t care. The referendum is not just about Europe, however, it is about "Europe for the rest of our lives". That should ensure a larger turnout than 35%, but how much larger? This question is where the risk really lies and, given that the referendum is such a one-off event, it’s unlikely that conventional political science can supply the answer. We are into the realm of forecasting with extreme uncertainty; consequently the odds quoted in favour of staying or leaving the EU may not be reliable.We are into the realm of forecasting with extreme uncertainty; consequently the odds quoted in favour of staying or leaving the EU may not be reliable.
Our principal portfolio protection has been to reduce our exposure to Sterling in favour of other currencies. If we vote to leave, Sterling may come under speculative attack, as traders extrapolate the likely consequences for foreign investors in the UK. The UK economy might also slow, due both to pre-Brexit uncertainty and post-Brexit fears. That would leave the UK with one of the largest trade deficits in the world and no offsetting inflows of capital. By reducing our Sterling exposure in favour of other currencies we can at least prevent some potential decline in portfolio values. However, in this outcome there might be a lot more going on than just the pound falling. Stockmarkets might also be falling, driven by sales of shares of UK-based exporters and fears that Brexit might lead to further departures from the European Union and, possibly, even the break-up of the Eurozone itself. This is not a pleasant scenario, and would require more than an under-weight to Sterling to protect portfolio values. But remember, the likelihood of this happening is probably only somewhere between 20% and 45%.
We re-evaluate our Sterling position on a regular basis. Since we took the position, Sterling has risen by about 3% so far, as the trend towards ‘Remain’ has become apparent. This has reduced Balanced portfolio values by about 0.5%, by slightly less in the lower-risk portfolios and by more in the higher-risk portfolios. Sterling is likely to be increasingly volatile as the referendum approaches, meaning these figures are likely to change quite a lot, sometimes in favour and sometimes against investors. At the moment we feel this is a cost worth bearing, given the risks we are confronted with. Meanwhile, if we feel the risk of ‘events’ is changing as we near the day of the referendum, we will make changes.
These kinds of problems are why we make tactical asset allocations decisions at 7IM, decisions that take us temporarily away from our long-run portfolio settings. Tactical decisions don’t always go in favour of our investors, but it’s important that we make them. The alternative is some kind of "auto-pilot" that, at times like these, could make us all very nervous.
Chief Investment Officer
Seven Investment Management LLP is authorised and regulated by the Financial Conduct Authority. Member of the London Stock Exchange. Registered office: 55 Bishopsgate, London EC2N 3AS. Registered in England and Wales No. OC378740.
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