Footsie's verdict on Brexit

One of the most egregious of cognitive biases is the confirmation bias - our tendency to see what we want. We’re seeing examples of this today, with Brexiteers cheering FTSE’s rise whilst Remainers point to sterling’s fall.

In truth, these are two sides of the same coin. One reason why the Footsie has risen might well be that sterling’s fall is expected to be permanent, and so will raise overseas earnings – which account for around three-quarters of the FTSE 100’s total earnings. It’s no accident that today’s biggest risers include a lot of overseas earners, such as Pearson, Standard Chartered and Royal Dutch.

We can put this in more sophisticated terms. Uncovered return parity (pdf) tells us that, in the absence of shocks, equity returns should be equalized across countries so that a relatively strong stock market should be accompanied by a weaker currency and vice versa.

But of course, that phrase “in the absence of shocks” is doing a lot of work. If a country were to enjoy a positive growth shock, its stock market should rise relative to others in common currency terms. This is because investors would buy the equities in the hope of rising dividends, and perhaps the currency too in anticipation of higher interest rates as a consequence of that faster growth. 

So, is this what the UK has enjoyed? No. Quite the opposite. Since June 23, MSCI’s index of UK stocks has fallen by 3.3 per cent in US dollar terms* whilst the MSCI world index has risen 2.7 per cent.

This underperformance of six per cent is consistent with the sort of long-term hit to GDP which NIESR and the CEP (pdf) expect from Brexit. Is that a coincidence?

Granted, Brexiteers are right to say that the lower pound will stimulate exports and output. But Remainers are also right to say that the pound has fallen precisely because investors expect weaker growth as a result of Brexit: it’s fall in the last few days might well be due to the perceived increased prospect of a “hard Brexit”.

The fact that UK equities have under-performed in common currency terms since June 23 tells us that the stock market believes that, on balance, the latter effect outweighs the former. This is consistent with empirical evidence which tells us that past falls in sterling haven’t had a huge impact on net exports**.

If stock markets are saying anything, it is that they agree with mainstream economists that Brexit will harm the UK.

Let’s put this in context, though. The UK’s underperformance since June is actually quite small in the context of its under-performance since mid-2014. That’s due in part to the UK’s bigger weighting in mining stocks. But it might also be because expectations for relative growth were falling even before this June: small caps and the FTSE 250 are well down in dollar terms since mid-2014.

I must, however, caveat all this massively. Drawing strong inferences from noisy and complex phenomena is dangerous, and downright daft when those inferences are politically motivated. And paying attention to short-term market fluctuations is almost to invite error – in particular, the mistake of myopic (pdf) loss aversion (pdf). Charles Kindleberger used to say that “Anyone who spends too much time thinking about international money goes mad.” The same applies to stock market moves.

* I’ve updated this to include today’s rise in UK shares and fall in sterling.

** Yes, the UK economy did nicely after we left the ERM in 1992. But this was probably due more to the monetary and fiscal easing than to the pure exchange rate effect.

Comments

[Patrick Kirk]

People have to say something in order to get web traffic and and the old "its cold in London and the FTSE is up so the cold is causing the FTSE to rise" narrative pattern of reporting is being used.

[Brad Fisher]

For what it is worth here is my prediction. Britain will opt for "hard" Brexit with complete control of immigration. Parliament will pass a law establishing an "Australian/Canadian" style quota system for immigrants. The government will then declare "job done" on Brexit. Then it will turn to the EU and say "I tell you what I can do for you". They will then - in exchange for free trade access to the EU - offer to set the quota on EU citizens so high as to make no difference. Somebody at the EU will complain about the cost of health care for all those pensioners in Spain. Money will exchange hands.

And Bob's your uncle, Britain will have left the EU - but will still be in the EU.

There will of course be a lot of nashing of teeth and rending of clothes along the way.

Cheers

[Donald A. Coffin]

Nick Rowe at Worthwhile Canadian Initiative also comments on something similar:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2016/10/the-brexit-news-boom.html

[rogerh]

Any fool can drop the exchange rate - but what do you do with the temporary advantage it buys you? Do you encourage a return to an England of Miss Marple, warm beer and cricket with hovels and poverty hidden from view. Or do you use the advantage? to re-industrialise, educate more effectively and accept the necessary concrete and tarmac.

Neither way represents a free lunch - but lunches in parliament are heavily subsidised. So I think the Tories will go for the Miss Marple route as long as they can.

[Dave Hansell]

Listening to the baying mob in Birmingham being fed red meat from a rabid rostrum and a cheerleading media which has morphed from a fourth estate to a fifth column against democracy its obvious to a blind man on a galloping horse that we have gone way past Miss Marple and are heading full tilt past Uriah Heep land towards Edward I.

A party and a group of people who pontificate about red tape and bureaucracy are being cheered to the rafters by a brain dead section of the populace over forcing companies to register foreign workers whilst at the same time seeking to reintroduce cadet forces into schools and restricting the rights of what are clearly regarded as feudal British (read English) subjects from working and studying abroad. They'll be introducing restrictive quotas on who and how many can leave the UK the rate they are going.

We are certainly inhabiting the process explained by the late Milton Meyer in 'They Thought They Were Free.'

http://www.press.uchicago.edu/Misc/Chicago/511928.html

[gastro george]

"Any fool can drop the exchange rate - but what do you do with the temporary advantage it buys you? Do you encourage a return to an England of Miss Marple, warm beer and cricket ..."

Apparently, yes. The government has already said that we should be exporting more jam and marmalade to France.

[Dave Timoney]

Interesting that the commentary on the fall in sterling / FTSE gain has largely addressed the impact on the balance of payments in terms of the potential for trade. We may be missing the bigger picture.

The worsening of the current account since 2011 has primarily been driven by declining foreign investment income. A fall in sterling should improve this in the short-term - i.e. dollar and EU receipts will be worth more in pounds - and this may extend into the medium-term if sterling stays low vs the dollar and euro.

The steady decline in transfers (i.e. investment receipts leaving the country) is likely to get worse if a hard Brexit curtails FDI, but this paradoxically means the BoP may improve, essentially because the UK economy contracts and we become more dependent on foreign receipts.

"Success", in Tory terms, may mean the country becoming even more of a rentier economy.

[joe]

There is a huge difference from forecasting the overall trend of the FTSE (220 day moving average) and its day to day fluctuations. The £ has been devaluing against the $US since long before June23. After June 23 it has plummeted and is drifting further down. Bank rates going down and £65B of quantitative easing plus the fact that bond yields are so low tends to make the stock exchange the only game in town. The books also won't be balanced by 2020 which further weakens sterling.

Most in the market who understand business better and realise that devaluation will make our balance of trade worse as we no longer have the basic mass industries that would benefit from devaluation. We will still import German cars, say, even if they are 10% more expensive because we do not make similar cars with the necessary car snob appeal. The effects are current masked as firms are currency hedged 6 months ahead and have stocks at the old prices. Customers are still in a full employment stage and still spending on credit.

It is not worth saying what the true early effects of even the vote are until early 2016 and what the effect of investment halts and actually leaving won't be revealed for several years.