How to Play the Brexit Vote

By Brian Dolan, Head Market Strategist, DriveWealth It’s Going to be a Close One

First off, for those who are unfamiliar with Brexit, it refers to the impending June 23 referendum in the UK on whether to stay in or leave the European Union (EU). Learn more here. A vote to leave (Brexit=Britain+Exit) the EU is likely to undermine the UK economy in the years ahead and has the potential to trigger intense global market volatility. Everything from currencies to stocks and bonds would be impacted, as investors flee risk assets (stocks, commodities, and FX) and seek refuge in safe haven assets, primarily bonds outside of the UK.

Recent worldwide market declines have been attributed to concerns over a Brexit, as the most recent polls suggest the ‘Leave’ side is now ahead of the ‘Remain’ vote. Survation, a UK polling firm, released results today that show the ‘Leave’ vote at 45% vs. 42% for the ‘Remain’ side (see the chart below). Other polls have shown similar leads for Brexit, but the number of ‘don’t know/undecided’ responses remains high at around 13%, meaning the vote is anyone’s guess.

brexit

Source: Bloomberg; DriveWealth

However, UK odds makers, such as Ladbrokes and Betfair, are still placing the odds of a Brexit on the short side, posting around a 60% likelihood that the UK will remain. These betting companies indicate they expect Brexit to become the favorite in the next few days if the trend in recent wagers continues. Underlying the current odds favoring ‘Remain’ is their view that the undecided voters will swing in favor of the status quo (Remain) when it’s time to vote. A similar scenario played out in the 2014 Scottish referendum on whether to leave the United Kingdom. I’m strongly inclined to go with that view, and I’ll even go out on a limb and predict a 58%-42% win for ‘Remain.’

Volatility Can Bring Opportunity

Markets are clearly very sensitive to the outcome of the referendum and as long as polling indicates a Brexit lead, risk sentiment is likely to be distinctly negative. That has seen the British pound (GBP) lose about 5%, Euro Stoxx 600 about 10% and the UK’s FTSE 100 index decline by about 7%, all in the last two  weeks. US and Asian stock markets have also been negatively affected. On the safe haven side, gold is at its highs for the year and US Treasury yields are back at lows last seen during the market turmoil at the start of the year.

Should Brexit prevail, negative volatility is widely expected to increase. Analysts have suggested that GBP could lose between 10-20% immediately following a Brexit vote, while both UK and European shares would be expected to decline further. Other global stock markets are likely to follow suit, potentially triggering a worldwide cascade lower that could easily spiral out of control in the short run. Global central banks are said to have prepared coordinated steps to insure liquidity and possibly intervene to stabilize currency markets.

That’s the worst case scenario. In my own view, Brexit will not happen, and I think markets are more likely to bounce back quickly if the vote is in favor of Remain. That suggests current market declines represent buying opportunities in the most beleaguered risk assets, stocks in general, and European & UK shares and GBP in particular. The timing, as always, will be the hard part and I would suggest staggered entries into long positioning on remaining weakness in the final run-up to the June 23 vote, and keeping some ammunition dry in case Brexit happens and markets fall further. (Results are likely to be known in early Asia on June 24.)

Brexit and Beyond

Even if Brexit does win, I think opportunistic long-risk entries would still be the best strategy to pursue. The world will not end the day following a Brexit vote. It may seem that way for markets for a few days until the dust settles. In reality, it will take several years for the UK to ultimately sever ties with the EU and all the other negative fallout to occur, leaving plenty of opportunities to take advantage of panicked markets offering discounted valuations. (That said, I wouldn’t touch GBP with a ten-foot pole, one way or the other.)

To my thinking, the biggest risk is that I’m right: Brexit loses, and risk assets rebound sharply. But what if that rebound proves short-lived and is quickly reversed, meaning risk assets fall back again? That would suggest current weakness is not solely the result of Brexit fears, but a much more ominous signal. In my view, it would suggest markets are re-living the experience of the start of the year, when global growth concerns weighed heavily on investor sentiment, leading to widespread liquidation in global stock markets.

We’ve had ample signals the global recovery is sputtering, with US underperformance the most notable of the negatives, reinforced by a cautious Fed statement just yesterday. In the weeks following the UK referendum, we’ll get several key updates out of China (Caixin PMI, manufacturing PMI), which could also trigger volatility if they show weakness.

How will we know that a larger market sell-off may be in the works? Assuming Brexit loses, subsequent declines below the lowest low prior to the Brexit vote would be a signal that markets are looking beyond Brexit and don’t like what they see.