Ray Dalio, founder of investment first Bridgewater Capital, wrote an article for the FT in which he argued:
In deleveragings bad economic conditions typically lead to emotional reactions, social and political fragmentation, poor decision-making and increased conflict. When this occurs in democracies, the checks and balance system, which is intended to yield the best decisions for the whole, can stand in the way of thoughtful leadership and lead to ineffective “mob” rule. This dynamic can lead to a self-reinforcing downward spiral.
Frustrations increase, the established ways of doing things come under attack and frustrations over the ineffectiveness of government creates the perceived need for someone to gain control of the mess. Plato spoke of this dynamic. It was the reason Hitler was elected in 1933.
From Trump to Le Pen, the world seems to be getting more divided. This week, Briton voted to leave the European Union. The EU was created with the goal of allowing freer movement of goods, services, and people across member countries. The benefits of this are well-known: free movement of resources, productive allocation, an increase in overall economic welfare. This is not to say there aren’t losers. For those Britons who increasingly saw themselves as worse off, exit seemed to be the rational choice.
For others, the direction of history should move towards more integration, not less. If the original 13 colonies in America decided to call it quits, after the flaws of the Articles of Confederation became apparent, how different would the world be? The European Union, as it exits today, is a loose confederation that faces a similar decision. This choice will have serious ramifications on the world going forward. The Brexit vote should be viewed as an opening act for this main event.
In a polarized vote, split by age, class and geography, Briton voted to leave the EU. The immediate effects were drastic. The pound fell to levels not seen since the 80s, stock markets around the world dropped, treasures and other safe assets rallied, and France overtook the UK as the fifth largest economy in the world.
To understand why the reaction was what it was, we need to understand what the markets were pricing in. If everyone expected a leave vote to win, there would be no reason for markets to react the way they did. So why didn’t the markets expect a leave vote? Lets look at what the polling was saying.
Yougov had this to say before the vote:
Our current headline estimate of the result of the referendum is that Leave will win 51 per cent of the vote. This is close enough that we cannot be very confident of the election result: the model puts a 95% chance of a result between 48 and 53, although this only captures some forms of uncertainty.
Yougov had this to say after the vote:
As we wrote in the Times newspaper three days ago: “This campaign is not a “done deal”. The way the financial and betting markets have reacted you would think Remain had already won – yesterday’s one day rally in the pound was the biggest for seven years, and the odds of Brexit on Betfair hit 5-1. But it’s hard to justify those odds using the actual data…. The evidence suggests that we are in the final stages of a genuinely close and dynamic race.”
So how did the betting market arrive at 5-1 odds? Well if you take the polling of 51.5 and plug it into a normal distribution of say pnorm(51.5, 50, 1.5), you get .84 or 5-1 odds. This result was vastly underestimating the uncertainty inherent in the polling.
Andrew Gelman, a professor of statistics and political science at Columbia University, had this to say about the uncertainty surrounding the Brexit polls:
The difference between survey and election outcome can be broken down into five terms:
1. Survey respondents not being a representative sample of potential voters (for whatever reason, Remain voters being more reachable or more likely to respond to the poll, compared to Leave voters);
2. Survey responses being a poor measure of voting intentions (people saying Remain or Undecided even though it was likely they’d vote to leave);
3. Shift in attitudes during the last day;
4. Unpredicted patterns of voter turnout, with more voting than expected in areas and groups that were supporting Leave, and lower-than-expected turnout among Remain supporters.
5. And, of course, sampling variability.
None of this was accurately reflected in the odds. This says a lot about our ability to accurately predict referendums of this kind. In the past, we have put a premium on status quo reversion, that undecided voters will most likely choose what is known over what is unknown.
Right before the Brexit vote occurred, markets and the pound rallied. Investors assumed that status quo reversion would hold. Investors were ignoring uncertainty, and placing bets that had little upside even if they did pay off. Maybe if investors had a better understanding of uncertainty, they would have seen that giving remain an 84% probability was not supported by the evidence. By adjusting those odds to even 60%, and by having a simple understanding of the Kelly Criterion, investors would have been more inclined to place their bets on leave. Hindsight is 20/20 though, and what we should take away from this is that predicting the future is hard. We should be wary of overconfidence.
What it means going forward
Briton has four options going forward: 1) Take the Norwegian approach and preserve full access to the EU at the cost of observing EU regulations with no say in making them, 2) Take the Canadian approach and establish a free-trade deal that could take years, 3) take the American approach and adhere to WTO rules which would bring back many mutual tariffs and non tariff barriers, or 4) overturn the Brexit vote. Whatever Briton chooses, it is likely that life will go on and people will continue to produce and consume. The promise of end times has been oversold.
The important thing for us is what Brexit might say about the world going forward. Anatole Kaletsky, in a recent article, put it this way:
If Brexit wins on June 23, the low odds accorded by experts and financial markets to successful populist revolts in America and Europe will immediately look suspect, while the higher probabilities suggested by opinion polls will gain greater credibility. This is not because US voters will be influenced by Britain; of course they will not be. But, in addition to all the economic, demographic, and social similarities, opinion polling in the US and Britain now face very similar challenges and uncertainties, owing to the breakdown of traditional political allegiances and dominant two-party systems.
Statistical theory even allows us to quantify how expectations about the US presidential election should shift if Brexit wins in Britain. Suppose, for the sake of simplicity, that we start by giving equal credibility to opinion polls showing Brexit and Trump with almost 50% support and expert opinions, which gave them only a 25% chance. Now suppose that Brexit wins. A statistical formula called Bayes’ theorem then shows that belief in opinion polls would increase from 50% to 67%, while the credibility of expert opinion would fall from 50% to 33%.
This leads to the third, and most worrying, implication of the British vote. If Brexit wins in a country as stable and politically phlegmatic as Britain, financial markets and businesses around the world will be shaken out of their complacency about populist insurgencies in the rest of Europe and the US. These heightened market concerns will, in turn, change economic reality. As in 2008, financial markets will amplify economic anxiety, breeding more anti-establishment anger and fueling still-higher expectations of political revolt.
The world became a different place after the Brexit vote. The probabilities of Donald Trump winning the presidency, of Scotland and Northern Ireland winning independence, of the EU breaking apart, and of populist uprisings gaining even more influence, have all increased in light of the Brexit vote.
What it means for us as investors
Ray Dailo, in that article from the beginning of this post, puts it this way:
While we hope that most people and their leaders will approach these difficult challenges calmly and collectively, we would not be meeting our fiduciary responsibilities if we bet on this happening without clear evidence of it. We are not alone in having and expressing our concerns in what has come to be known as “risk-on” and “risk-off” market movements.
Dailo is saying that we need to go where the evidence takes us. The long-term implications of Brexit are wide-ranging, from end of the world to business as usual. Anyone who says they know what happens next is probably lying or foolish. We, as investors, shouldn’t put much weight on any of these forecasts. Instead, we should simple seek to understand how the likeliness of future outcomes has changed.
In the immediate aftermath of the vote, the important things to us will be the psychological response and how it relates to the distribution of future outcomes. Whenever there is a gap between these two, there is an opportunity.
Long term, Brexit probably wont have much financial impact on the world. Briton and the EU might produce a little less than they would otherwise, but the world will keep spinning.
However, the political and psychological ramification of the vote should not be underestimated. For us as investors, opportunities are created when psychological responses don’t match up with reality. If the market prices in oblivion, but we only see a 2% likelihood of that, we should act accordingly.
In closing, I want to share a comment from the FT that went viral shortly after the vote. It reminds us that there are real human consequences to all of this:
A quick note on the first three tragedies.
Firstly, it was the working classes who voted for us to leave because they were economically disregarded, and it is they who will suffer the most in the short term. They have merely swapped one distant and unreachable elite for another.
Secondly, the younger generation has lost the right to live and work in 27 other countries. We will never know the full extent of the lost opportunities, friendships, marriages and experiences we will be denied. Freedom of movement was taken away by our parents, uncles, and grandparents in a parting blow to a generation that was already drowning in the debts of our predecessors.
Thirdly and perhaps most significantly, we now live in a post-factual democracy. When the facts met the myths they were as useless as bullets bouncing off the bodies of aliens in a HG Wells novel. When Michael Gove said, ‘The British people are sick of experts,’ he was right. But can anybody tell me the last time a prevailing culture of anti-intellectualism has led to anything other than bigotry?