Both the tricky two-year Brexit negotiations that will start this week and the string of European votes between now and September are asymmetric risks. The likely market response to the possible outcomes of each is not balanced. Even more importantly, the asymmetry of each event points in a different direction - in Europe, the upside potential is greater than the downside risk; here in Britain, the opposite is true.
In France and Germany, I think the more likely surprise is the market-positive one of mainstream candidates emerging victorious in their elections. The Dutch result suggests that when they actually stand at the ballot box Europeans have a preference for moderation over extremism. Marine Le Pen will probably make it to the second round but, like her father, she won’t clear the final hurdle.
Le Pen’s principal mistake seems to have been her promise to take France out of the Euro. It is at odds with the wishes of nearly three quarters of the French population. Now Francois Fillon looks to be effectively out of the race, her likely opponent, Emmanuel Macron, can make inroads into Le Pen’s strong support among the young. In Germany, the only question is which mainstream candidate will win.
In Britain, I reckon the risks are skewed the other way - the chance of the Brexit negotiations going badly looks far greater at the moment than the Government delivering an unexpectedly good result. There are just too many reasons for the EU27 not to give us a good deal.
That’s not what the stock markets in London and across the Eurozone are currently telling us. The FTSE 100 is flirting with record highs as investors focus on the benefits of a weak currency and the unexpected resilience of the UK economy so far. But few economists believe the good news will survive the end of the phoney war.
Consumers have enjoyed a brief respite as earnings have risen faster than inflation for a couple of years. But, as we saw last week, prices have regained the upper hand. GDP will ease back to 1.7% this year while inflation is set to exceed 3% this year. This will be the weakest expansion since 2012. Businesses, too, are likely to become increasingly cautious about hiring new workers and investing in new capacity. The looming prospect of a second Scottish referendum could see growth slow even further in 2018.
Crossing the channel from Britain to Europe is like walking through the looking glass. Businesses across the Eurozone are firing on all cylinders with activity across the single currency area hitting a six-year high last week. Employment is growing at its fastest rate in nearly a decade.
You would never know this from investment fund flows. Despite the good economic news, investors’ cash has been leaving European markets week in week out for over a year. American investors were net sellers of European mutual funds in 50 out of 52 weeks in 2016.
This is curious for a whole range of reasons. First, European equity markets are particularly geared to improving global growth - a 1% increase in global GDP equates to an 11% rise in European corporate profits, Goldman Sachs estimates. Second, valuations remain low by historical standards and compared with pricier markets like the US. Third, European stock markets are unusually weighted to banks, which are performing better and will be major beneficiaries of rising interest rates as the European Central Bank, inevitably, reins in its super-easy monetary policy.
The scope for disappointment is, therefore, materially greater for investors in the UK stock market than in European shares. Markets will most likely shrug off the official notification of Britain’s intention to quit the EU this week. But over the next two years the chance of a succession of bad news headlines shaking investor confidence is real.
In Europe, the opposite is true. Investors have priced in a cocktail of bad outcomes, from continued economic stagnation to deflation and President Le Pen. The likelihood of none of these happening looks greater than ever. The risk/reward balance in Europe looks much more interesting.
Weak sentiment is even clearer in the markets where investors trade instruments to protect their portfolios from volatility. The cost of protecting against market falls spikes in April and May for European markets while remaining flat for the S&P 500. This says that markets are principally worried about politics. If the elections don’t deliver the outcome markets fear, a period of relative outperformance beckons.
Asymmetry matters a great deal in investment for the simple reason that when you lose 50% of your money you have to make 100% just to get even. This is why Warren Buffett always likes to quote his teacher Ben Graham’s advice: ‘Rule number one in investing? Don’t lose money. Rule number two? Don’t forget rule number one.’
The best way of avoiding losing money is to invest infrequently and only when you have serious conviction about what you are doing. Buffett calls this waiting for the ‘fat pitch’ - a baseball expression that means only swinging at the balls you are really confident of being able to hit out of the park.
In investment terms, waiting for the ‘fat pitch’ means stacking the odds in your favour by avoiding the negative asymmetric risks and playing the positive ones. Europe, not the UK, feels like the ‘fat pitch’ in investment markets today.
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This article first appeared in the Telegraph.
Tom Stevenson, Fidelity Personal Investing
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