You know you’ve arrived as an industry, an issue or a political candidate when you find yourself subjected to the satirical potshots of expat talk show hosts like John Oliver and trending as a Twitter topic in the same class as the dustup among Benedict Cumberbatch as the new portrayer of Sherlock Holmes and Harry Potter author J.K. Rowling against Monty Python creator John Cleese. But through all that noise, all that sound and fury, it’s time to take stock of the situation. Here are some key points to consider:
Were the hedges high enough? Thus far in 2016, institutional investors hedged their sterling exposures, and the demand for U.K. equities and gilts soared. The only noticeable change in behavior was in the currency markets, in which investors — wisely, as it has turned out — increased their hedge ratios to protect themselves against depreciation of the pound. The key question now is whether international investors respond to the uncertainty created by the “Leave” vote by also reducing their underlying holdings of U.K. assets.
Sterling loses its luster — again. So far this year the Brexit threat has meant that sterling has been 4 to 8 percent weaker against the U.S. dollar than shown by movements in expected U.S.-to-U.K. interest rate differentials. In the five days leading up to the Brexit vote, however, sterling appreciated sharply, removing much of this discount as markets moved to price in “Remain.” As that guess was wrong-footed, weakness in the pound has quickly resumed.
Ready for interest rate cuts? The Bank of England repeatedly warned how much of a risk Brexit would be for the economy and, more broadly, for the financial markets. So much, in fact, that market expectations of interest rate reductions became coupled with the probability of a Brexit vote. Now that Brexit risk has become a reality, it may be difficult for the Bank of England to walk back its rhetoric about the negative economic consequences, and markets will assume further policy stimulus as a result.
A reduced appetite for risk. Expect to see more investors become defensive after the Brexit vote. Recent research we at State Street Global Markets conducted on behavioral risk shows that investors became less risk-seeking ahead of the referendum across assets, though they did not become outright risk averse, as they were in January and early February. Given that Brexit has been flagged as a global risk event by so many policymakers, it may seem natural to curtail positions at least modestly, given that the risk has been realized.
Watch the symptoms, not the system. For much of 2016 Brexit has been the belle of the key risk event ball. This state of affairs is atypical: Usually, risk doesn’t announce its time of arrival. Rather than focus on the causes of systemic risk, we prefer to measure a symptom — namely, that markets become narrowly driven when systemic risk rises. Having remained elevated for a record period of time, from August 2015 to March 2016, systemic risk has finally begun to normalize in the past quarter. The removal of Brexit risk at the margin, we would assume, will encourage this process further.
What’s the next worry? Throughout the Brexit saga, one truth has rung clear: This issue isn’t the only one worthy of investor attention. During our roadshow in May and June, only 12 percent of global investors suggested that Brexit was their biggest concern. Investors still have a host of other worries to keep them occupied: from disorderly currency moves, Fed interest rate hikes and a devaluation of the yuan to a debt crisis and the ineffectiveness of central bank policies. Clearly, Brexit hasn’t been the only nail biter for institutional investors. Among these worries, in every location outside of London where we asked the question, the concern that most troubled investors was the idea that policy has become less effective. To that end, one of the challenges policymakers now face is how they deal with financial market fallout from the Brexit vote.
Michael Metcalfe is senior managing director and head of global macro strategy at State Street Global Markets in London.
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