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19 October 2017
Behavioural finance teaches us that it’s often only after we have already made a decision that we seek to rationalise it.
Moreover, when the issue is emotive, this process of rationalisation can become deeply skewed. There is huge potential for us to become victims of confirmation bias.
There are few more emotive topics in the UK than the country’s upcoming exit from the European Union. If anything, tribalism has hardened since the Brexit vote and many on both ‘sides’ seem more confident in their views than they were last year, at the time of the referendum.
These should be warning signs for investors. If we find ourselves ‘wanting to believe’ that Brexit will be a disaster, or a huge success, we can lose sight of what is already reflected in market prices, and how much we can really know about the future.
Today, the overwhelming consensus among economists and market participants is that the effects of Brexit will be negative. Analysis by HM Treasury suggests that the worst-case outcome – a reversion to trade tariffs under World Trade Organisation (WTO) rules – would lead to the UK economy being 9.5% smaller than it would otherwise have been by 2030.
The negative impacts of Brexit appear to be so obvious that an investor suggesting anything but a cautious outlook on asset prices might seem to be burying his or her head in the sand.
However, there are two problems with this reasoning. Firstly, forecasting future economic growth is notoriously challenging – even without great unknowns like Brexit. Secondly, the relationship between economic growth and asset prices has historically been very loose indeed.
The market almost certainly has the same information as you do. If the economists’ consensus is for negative Brexit outcomes, then how much of this is already factored into prices? It may be that the market is complacent, or indeed overly pessimistic.
It is always tough to admit what we don’t know – particularly when the suggestion that positive surprises are possible can be perceived as a political view. Combine this with a tendency for pessimism to be perceived as intelligent, and optimism as naïve, and there are strong emotional temptations to tend toward a negative outlook.
Investors should avoid these emotional impulses if they are to focus on what is really important.
In my first job at the Bank of England in 1987, the UK was in the first year of the Uruguay round of GATT (General Agreement on Tariffs and Trade) negotiations. The talks were due to finish in 1990, but were ultimately signed in 1994, with the creation of the WTO.
Markets occasionally focused on the talks, which were varyingly judged as going well or heading for collapse. When we look back at how markets behaved during this period, it is very hard to identify what lasting impact any part of the ‘journey’ to an eventual trade deal had.
Uncertainty over future trade agreements is normal for many companies. Moreover, trade negotiations do not progress in a linear fashion, so daily updates on ‘how the talks are going’ cannot be a useful predictor of the eventual outcome. It seems that there is little to gain from an obsessive focus on incremental newsflow about the negotiations.
Instead of trying to predict what the final settlement will look like, I would argue that looking for instances where markets are overly, or insufficiently, worried about Brexit will likely prove a more fruitful source of opportunities.
It is almost always seen as naïve to adopt a ‘wait-and-see’ approach, but, in my opinion, is just as often the best policy for the long-term investor.
The views expressed in this document should not be taken as a recommendation, advice or forecast. We are not able to give any financial advice. If you’re at all unsure about the suitability of your investment, please speak to a financial adviser.