Monthly Market Report - April 2016

23rd March 2016

With commentary from David Stevenson

One of the more curious aspects of modern investing is the growing evidence that across all forms of markets there's an obvious observer effect at work i.e. the simple act of observation in turn changes behaviour. The Hawthorne effect for instance argues for a form of reactivity in which subjects modify their behaviour in response to knowing they are being studied. Schrodingerís cat and Heisenberg principles suggest similar effects where the mere observation of behaviour changes outcomes.

These intellectual notions will probably be tested to destruction in the coming months of Brexit debate, specifically in relation to any damage to the UK economy and to wider markets. Many Remain enthusiasts argue that the UK will probably suffer immeasurable economic damage whereas Leave fans argue that negative impact will be short lived and manageable.

My guess is that the UK markets are about to offer a grand experiment of whether we need to fear fear itself! How will markets behave about the possibility of a Brexit? Will the fear itself prod markets into mayhem?

Over the last few weeks we've seen a number of big investment banks ruminating on the impact of Brexit for investor's. One of the most interesting reports comes from the French bank SG. They're brave enough to put some actual hard numbers on their estimates. They believe that there "could be a hit to exports averaging 2 Ĺ% pa for 10 years which would reduce GDP by 0.3pp pa". Some of the mechanisms for this lower growth are obvious - financial services would be hit as access to core markets is reduced. Foreign direct investment would be hit as well.

Then there's the fear that a Brexit would spark another SNP vote (a racing certainty given recent declarations at the nationalistsí recent party conference). The French bank also bravely admits that Brexit "would reduce the pace of immigration from the EU. This would reduce the potential growth rate of the economy". I say bravely because this is exactly what Brexit campaigners probably want!

In terms of market outcomes, the bank sticks with a consensus view on FX rates, which is that we would see GBP/USD trading below 1.30, and EUR/USD below parity. In bond markets investors should expect "the UK Rates curve to steepen beyond 10y... Credit spreads would widen in the UK, but maybe even more so in the periphery....". More controversially they argue that UK Equity markets could be supported by the weaker GBP. This goes against much of the consensus view, which is that the FTSE 100 Index would be hit hard on day one of Brexit.

But perhaps most importantly the French bank's analysts argue that the real big impact will be on market volatility itself - a Brexit might spark off political turmoil throughout Europe and their "Equity Volatility Strategists think that all of this is not yet priced in". Regardless of the hard numbers suggested in this analysis, this central insight is important - maybe we should fear fear itself? Perhaps the greatest danger is not the macro economic impact of Brexit itself but the resulting turmoil in financial markets worldwide?

Download the full Monthly Market Report here.

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