Realpolitik is the art of designing policy based on practical rather than ideological considerations: what works, not what we think should work. Pragmatism is an important part of investing and tells us that positioning too aggressively around political events like Brexit and the US election is risky, because both the result and the market outcomes are difficult to predict. Given a low probability of correctly predicting either, we need to see evidence of significant mispricing in order to introduce large positions in our portfolios.
Two big events are looming, the US election on November 3rd and Brexit, with a practical deadline of 15 October and an actual deadline of the end of this calendar year. We need to be realistic about our ability to forecast the outcomes of these events. The track record of both professional forecasters and betting markets is poor and has only been getting worse: Trump’s election in 2016 and the Brexit referendum were both highly unexpected outcomes and, in the case of the former, so was the market’s positive reaction.
The odds of a trade deal between the UK and EU have fallen in recent weeks, with the latest round of trade talks yielding little progress and with the UK government seeking to pass new legislation that goes against aspects of the Withdrawal Agreement. Under the terms of the agreement, signed in January, Northern Ireland is part of the UK customs territory but remains more closely aligned with EU regulations in order to avoid the need for customs checks along its border with the Republic of Ireland: in short, a soft border has been drawn down the Irish Sea. Ensuring that border is not too strong is a concern for the UK government as well as Unionists in Northern Ireland and this is what the new legislation aims to qualify. Whether or not the legislation is approved by Parliament at the first time of asking, it demonstrates what the UK government is prepared to do to ensure the free passage of goods between the UK mainland and Northern Ireland; it thus serves as a reminder that reducing the most restrictive barriers to trade is in both side’s interests, otherwise the Irish problem will not go away.
In terms of the market moves, a no deal Brexit with the sudden raising of barriers to trade would be unambiguously bad in the short run for both the EU and the UK, given the large amount of trade that goes on unencumbered between the two currently. However, one needs to consider the extent to which this is already priced in, given the weak performance of UK assets in the years following the referendum. UK assets have a meaningful risk premium built in and sterling and mid cap stocks adjusted lower in response to the news last week. Today’s entry point is attractive, plus there is still time for a deal as long as both sides can be pragmatic about what is needed: at this stage a ‘skinny deal’ would suffice, with phased introductions of customs checks on areas not covered by the deal and hence time for further agreements to be introduced in key areas, rather than one comprehensive deal by the end of this year. For these reasons we are comfortable to stay invested in the UK in our portfolios.
In the US, a win for the Democrats would seem to be the less market-friendly outcome given Biden’s pledge to fund his “Build Back Better” programme by raising taxes, but it will remain to be seen which campaign pledges ultimately become policy and markets may react positively to the prospect of more predictable policymaking. There are more signs of mispricing in the US, with US assets having significantly outperformed post Trump’s tax reforms and deregulation, some of which is likely to be rolled back under a Biden presidency. Further, the US stock market has become concentrated in a few mega cap tech stocks, which are in the crosshairs whichever party eventually wins in November. With markets priced richly despite these risks, we have index put options in place beyond the election in our eligible portfolios.
Politics matters but, as investors, how we approach binary events like elections is more important. In the absence of clear mispricing, we will not take an extreme position in either direction, given the low probability of us correctly predicting the outcome. Overall, today we still think it is right to stay invested in portfolios while building a diversified defensive bucket. We will let our partners know should that change.