“Prediction is very difficult, especially if it’s about the future” – Niels Bohr The Danish physicist Niels Bohr wasn’t talking about financial markets, but he might as well have been.
"Prediction is very difficult, especially if it’s about the future" – Niels Bohr
The Danish physicist Niels Bohr wasn’t talking about financial markets, but he might as well have been. The future is uncertain and unpredictable at the best of times, but it seems that the range of outcomes we face today – where economics and politics intersect with financial markets – is especially complex. This is a challenge for tactical asset allocation. In a world where polls and forecasts have repeatedly wrong-footed investors and political shifts open up scope for the unthinkable to happen, it should be clear that defining a single ‘house view’ and building a portfolio around it is a dangerous tactic.
This mode of thinking drives our tactical asset allocation process. Instead of making a bold prediction about the future state of the world and building a portfolio around a ‘house view’, which will thrive or suffer based on the accuracy of that view, we acknowledge uncertainty and shades of grey. We look to build several possible, plausible scenarios – meaningfully different to each other, but covering a wide range of different potential future states of the world: some better; some worse. We analyse and try to understand how economies and markets (stocks, bonds, currencies and more) may behave in each scenario and finally we attempt to judge how likely each scenario might be. This allows us to build portfolios that can do well across a wide range of scenarios – doing better in those we judge most likely, but still looking to mitigate downside in those we judge less likely. Forecasters and tactical asset allocators need to be humble and build in the possibility of being wrong! It allows us to understand what markets may be already pricing in or take a view on whether an asset class is already pricing in a very benign economic situation or overreacting to a challenging political situation. It allows us to rapidly update our thinking as events unfold and scenarios evolve and become more or less probable. We are already prepared for scenarios which we judge less likely, but if events unfold so that they become more probable then we are ready and have a framework for understanding market movements.
Instead of making a bold prediction about the future state of the world and building a portfolio around a ‘house view’, which will thrive or suffer based on the accuracy of that view, we acknowledge uncertainty and shades of grey.
The uncertainty around Brexit demands this sort of approach. There are many plausible routes from here to different destinations, each with wildly different implications for the economy and financial markets – perhaps especially for the Pound. We make no attempt to judge what’s right or wrong, follow personal political preferences or ascribe a high probability to what we think should happen. Rather, we look to understand what is likely to happen and what is plausible but less likely and, crucially, keep revisiting those scenarios and re-assessing probabilities as events unfold.
Forecasters and tactical asset allocators need to be humble and build in the possibility of being wrong! It allows us to understand what markets may be already pricing in or take a view on whether an asset class is already pricing in a very benign economic situation or overreacting to a challenging political situation.
We currently consider five scenarios for the evolution of Brexit over the next year or so. They will change and evolve, but here’s a brief summary as they currently stand:
1. Glorious Britain: Europe’s domestic strains (and the advance of populist politics) force changes in European Union (EU) policy on migration. This means the EU is able to offer concessions to the UK. Meanwhile, the UK economy proves resilient, with exports and capital investment propping up growth. There’s ‘give’ on both sides in negotiations, but perhaps more so from the EU. This allows the UK to carve out an attractive deal to preserve services’ exports to Europe. Sterling could recover strongly in this scenario, perhaps close to pre-Referendum levels.
2. Hard Road to Soft Brexit: ‘Project Fear’ was not bluffing in this scenario. After Sterling’s fall, inflation bites in 2017, driven by higher costs for imports. Inflation hits household’s real incomes and growth expectations decline – perhaps exacerbated by weak foreign capital investment into the UK. Fears of a very hard Brexit could undermine Sterling further, leading to a vicious circle. Discontent over the economy could become strong enough to shift the political landscape dramatically and towards a more moderate position – the softest of a soft Brexit, perhaps a Norway-style deal, with the UK remaining in the European Economic Area (EEA), accepting some free movement and paying into the EU budget. Sterling could recover meaningfully, but would face dark days on the way, potentially to new lows.
3. Dunkirk Spirit*: a variant of the previous scenario. The economic landscape plays out similarly, but the political response is different. Instead of weakening in the face of economic pain, the country resolves to pull together in adversity and leave whatever the terms. This is a road towards a hard Brexit; Sterling could plumb new depths and gilt yields fall sharply.
4. Muddle-through: here, the government aims for a hard Brexit, but it’s hard to build consensus with business and moderate Conservatives. Negotiations with the EU are fractious and slow, while fears grow over future trade barriers and access to the single market, creating domestic economic uncertainty. The focus shifts towards a transitional deal – which potentially becomes a long term deal in a classic fudge.
5. U-Turn: both sides take a hard stance in negotiations, but a deteriorating economy weakens the UK position. Legal and political challenges to the government’s position and a growing recognition of the scale of the task involved in Brexit start to shift opinion. It becomes politically, economically and bureaucratically expedient to delay triggering Article 50 (or indeed to revoke it), perhaps with a change of Prime Minister or government in the UK. The Pound can rally in this scenario.
We will all have our views of how likely each scenario may be – or of scenarios that could be constructed differently – but the intention is that all are plausible scenarios, rooted in current events and evolving as needed. Our investment team currently sees a Muddle-Through as the most likely scenario, but it’s a close call. The second and third scenarios are also reasonably likely in our view, with a slightly higher probability that a Hard Road evolves towards a soft Brexit rather than towards Dunkirk Spirit. The other scenarios appear less likely to us at present, but not impossible. However, the bigger point is to give a sense of our framework and how we make tactical decisions. If events on the ground require us to adapt a scenario, to reassess how markets will react in a scenario, or to shift our probability assessment, we are able to do so rapidly. However, we are still in a position where significant thought and analysis has gone into modelling the scenario: for example, we don’t think a Glorious Britain scenario is very likely, but we acknowledge that it’s possible and that we expect Sterling would be very strong indeed in such a world. That has to be reflected in our portfolio positioning; and that scenario would only need to become a little bit more likely to make Sterling appear significantly more interesting to investors.
With so much uncertainty, it’s plainly absurd to take a firm view today on what will happen; but we can attempt to chart what could happen, and reflect those possibilities in our portfolios.
As we write, the situation remains very uncertain. The government has not yet outlined its negotiating priorities and its stance on the single market, although Parliament has secured a commitment for ‘the plan’ to be published in early 2017. Legal challenges are still being fought – not just the government’s appeal to the Supreme Court over its right to trigger Article 50 without an Act of Parliament, but also legal challenges over Article 127 and whether the government has a mandate to take the UK out of the EEA. Likely on its way to the European Court of Justice in Luxembourg is a vital case looking at the question if Article 50 can be revoked once triggered. That clearly has huge implications for any future parliamentary or referendum vote on the terms of Brexit. If Article 50 is irrevocable, such a vote would be a Hobson’s choice – leave on the agreed terms, or leave with no deal at all. However, if it can be revoked, such a vote would be a real choice, between leaving and – if the terms of departure appear too unattractive – remaining under the status quo. With so much uncertainty, it’s plainly absurd to take a firm view today on what will happen; but we can attempt to chart what could happen, and reflect those possibilities in our portfolios.
Deputy Chief Investment Officer
*Footnote: we always name our scenarios to make discussion easier – our Dunkirk Spirit name is not intended to trivialise the sacrifices of the past by comparison with the political choices ahead today.
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