I would like to preface this blog post with the disclaimer that, we do not consider ourselves macro investors, nor do we believe we can forecast exchange rates with any precision. Having made that statement, I thought it might be interesting to have a look at how different markets are viewing the likelihood of the British people deciding whether or not to leave the European Union on 23 June 2016.
I always find it interesting how different markets can look at the same set of data and price in very different outcomes. For example, the Great British Pound has been on a downward trajectory against most currencies for the better part of 12 months. Exchange rates are determined by a range of economic indicators such as the level of interest rates or inflation, economic growth and a country’s terms of trade (with a healthy does a speculation and momentum). If the UK does indeed leave the Euro, most economists expect their GDP growth to slow in the following 12 month period.
The magnitude of the expected slow-down varies, but when the headline growth rate is expected to come in at the break-neck speed of ~2% year-on-year, any slowdown in growth will be material. Therefore, leaving the EU will likely hit economic growth and cause the Bank of England to return to their Quantitative Easing program, which is a negative for their currency.
Taking all of this into account, a falling exchange rate implies an increasing probability of the leave vote winning – as traders price in the negative economic effects and a lower exchange rate.
Now a 7% or 8% fall may not sound large in the grand scheme of things, however, in the foreign exchange world this is a material movement and clearly identifies the expectations of the market.
An interesting observation is made when comparing the exchange rate implied probability of a stay vote, with the opinion polls conducted by various industry participants. One would expect these two variables to be highly correlated, as a falling percentage of people who say they will vote to stay in the EU, indicates a higher probability that the UK will leave the EU and result in a lower exchange rate. However, as can be seen in the chart above, the percentage of respondents that say they will be voting to stay within the EU has remained fairly consistent – starting at around 45%, reaching a low of 38% in January, before returning to ~44% in the latest reading in mid-May.
Another market that is looking at the same data set, and has an enviable track record in predicting future political events, is the betting market. Betting markets in the US have correctly predicted the outcome of every US presidential election since 1868, bar one in 1916 which was an extremely close call. This market has remained fairly consistent in its implied probability, as the chance of the UK remaining in the the EU has spent the majority of its time with a probability of greater than 70%.
The latest odds, provided by Betfair, have the odds of the UK voting in favour of staying in the EU at $1.25 – implying a probability of 80%. Despite this very high probability, the pound still remains well off its recent highs against most developed nations’ currencies, possibly alluding to upside in the short-term if the vote goes as the bookies are expecting.
We hold British listed companies within our International Portfolio and despite both of them exceeding our expectations at an operational level, they continue to underperform our other holdings due to currency weakness. We do not base any of our investments on assumptions regarding currencies, however, we believe that this is a short term headwind, and over time, the underlying performance of the businesses will be reflected in their share prices.