All posts tagged Brexit

“Because as any coup-launcher or Fed-fighter or volatility-embracer knows, if you’re wrong on timing … you’re just wrong” – Ben Hunt, Epsilon Theory July 26, 2016

The number of short bets on sterling through the futures market is at a multi-year high ahead of next week’s expected cut in interest rates in the UK. While these may be the speculations of the same hedge funds that lost money on the UK referendum, there is a strong consensus that the pound is headed lower. As recent events have shown, this is putting UK companies in the shop window, but can OTAS provide a way of figuring out who is next to be taken over?

There have been strong suspicions and some academic research suggesting option market activity pre-empts M&A announcements. What the research cannot determine is whether trading was due to inside information or informed opinion. Typically it is out-of-the-money call option activity that is more informative than at-the-money or put options.

Before we look at the evidence from OTAS, will the Bank of England cut rates next week? This is a different discussion to whether it should. Jeremy Warner argues in the Telegraph that the sledgehammer-to-crack-a-nut response to a knee jerk, post Brexit survey of disappointed corporate Remainers is not the right way to run an economy. He points out that the acquisition of ARM Holdings funds the current account deficit for three months. Speculators may not be “fighting the Fed”, but they are battling investment flows.

The post referendum narrative is that the economically disadvantaged swung the result and new Prime Minister Theresa May has aimed her pitch squarely at where she believes this constituency lies. Politicians still fail to appreciate that many of those who feel left behind are middle class savers whose retirement plans are decimated by central bank group-think. Unfortunately, the prospects for this small-c conservative demographic are very poor, as explained by Ben Hunt in his latest Epsilon Theory.

If Ben is right and that nothing will stop the central banks from flooding markets with cash, as Brexit, data dependence and such-like are just excuses for more of the only thing the authorities want to do, then stocks should rise and the pound fall. Typically bull markets take place over longer periods than bear markets, and are associated with lower implied volatility as the direction of travel becomes more certain.

UK Large Cap Implied Volatility

UK Large Cap Implied Volatility

Implied volatility for UK large cap stocks is back in the average range of the past two years, but five points above the stable state of the first half of 2015 that saw UK stocks rising steadily. The two recent peaks reflect Brexit worries immediately before and after the referendum. The one before, which was a bigger shock regardless of what the media may tell you, was the global recession fears of February, now long forgotten in large part thanks to desperate/determined[1] action by the ECB.

The US market appears to be leading the UK, which is worth bearing in mind as the Brexit furore subsides and the Trump-panic-hype really takes off.

US Large Cap Implied Volatility

US Large Cap Implied Volatility

M&A activity may mean stock specific rises in implied volatility. OTAS shows that among UK large caps only BHP Billiton has seen such a rise over a month, while Anglo American and GlaxoSmithKline have risen over a week. This is based on at-the-money options, but OTAS users with desktop access may dig deeper to see at what level recent trading has taken place. The bulk of the activity for Anglo American, for example, has been out-of-the-money puts (no take-over expected here).

AAL 1-Week Exchange Traded Option Activity

AAL 1-Week Exchange Traded Option Activity

The chart for ARM Holdings shows that the take-over by Softbank was a surprise. The subsequent sharp fall in implied volatility reflects a done deal at a fixed price, while any continuing option activity is by arbitrage specialists using leverage to magnify small price movements.

ARM Holdings Implied Volatility

ARM Holdings Implied Volatility

There is much more to the option market than M&A. Specialist take-over investors will have lists of potential acquirers and targets and stay on top of many more factors than market signals. For the part-time speculator it is worth creating your own list of sectors and stocks that you believe could be vulnerable to approach were the pound to fall further. Putting these in a portfolio in OTAS will allow easy filtering for unusual activity, whether that is in the options market, dealings by directors, or idiosyncratic price performance.

For those interested in potential acquirers, checking the CDS of the companies may be a means of investigating which managements are planning leveraged take-overs. There are, however, other reasons why credit costs can jump, such as a shortage of cash from operations. For this reason, while OTAS provides an initial view on the world of potential M&A that goes further than press speculation, it is only suggesting stocks on which the user will need to do additional research.

Right now there is little unusual option market activity among UK large cap stocks. This may be because, as the quote at the top of the blog indicates, timing is everything. Or it may be because so few people seem to have been able to contemplate that the UK would have a corporate future outside the EU, any M&A activity comes as a complete surprise.

[1] Delete as per your preferred narrative

The rapid rebound in stock markets since the UK’s vote for Brexit is witness to two things. The option market, which is easily and effectively tracked using OTAS, expected little disruption through the vote and this is what has happened. Equally, investors anticipate another injection of liquidity from central banks to prop up asset prices, as the likely reaction to further shocks and as we discussed in April.

The debate about the efficacy of further central bank support was well underway before the UK referendum, as the protagonists knew the result was unlikely to change their opinions. A summary of the arguments is provided here, courtesy of Evergreen Gavekal’s weekly newsletter. At a time when the machinations of party politics are dominating the UK headlines and there is great gnashing of teeth at the absence of leadership, it is well to remember that central banks and not politicians have determined economic outcomes for many years, and it is their policies on which we must focus.

The optimistic case is put by Niall Ferguson, distinguished economic historian, who argues that the world’s central banks have coordinated their actions to stymie the rise in the dollar and end the currency wars that some believe will be the trigger for the next global downturn. If so, then the Bank of England Governor Mark Carney may have helped trigger a final competitive devaluation for the pound through his otherwise unseemly haste to declare his Brexit warnings as fact.  Sterling could be argued to have been held up by fumes, Brexit or no Brexit, given the UK’s gaping trade deficit and short-term financing requirements and the economy may benefit from the recent depreciation.

The pessimistic case, put by successful fund manager John Burbank, does not doubt that central banks desire to pour more fuel on the fire of monetary easing, but sees the policy as self-defeating. Where optimists cite Reinhart and Rogoff’s study of recoveries and the average eight years from financial peak to eventual recovery, the pessimists assume that the dollar will resume its rise and draw liquidity from much of the rest of the world in the process. Time will tell, but both camps appear sanguine short-term, which brings us to the three month predictions of the option market as deciphered through OTAS.


UK large stock implied volatility, a measure of risk or uncertainty, is at the top of its normal two year range. The post Brexit peak was lower than previous highs, including when Brexit first headed the polls and well below the February level, when global economic slowdown was the issue. While it is tempting to conclude that Brexit is no big economic deal, it is just as likely that investors expect evermore intervention by central banks. Thus the correct investment strategy remains to buy-the-dips, as it has been throughout the post-crisis years.

It is worth noting the frequency with which volatility tops out close to the two standard deviation level, marked by the upper solid blue line on the chart. While risk is not a normal distribution, the two standard deviation level remains highly instructive and statistical analysis provides a superior guide to upcoming investor behaviour than market commentary. The turning point normally comes when the noise level advising otherwise is at its zenith.

UK Stoxx IV

The recent disruption to the blanket volatility suppression undertaken by central banks does have a British flavour.  A week before the referendum, the relative volatility in the UK compared with the STOXX 600 matched the February peak and, again, was at a two standard deviation level measured over the previous two years. The post plebiscite peak did not reach this high, as it becomes increasingly apparent that uncertainty remains greater in Italy and Spain than in the UK (OTAS will show you this). Overall, UK large caps are barely more risky than Europe’s largest stocks and current relative risk is only a couple of percentage points above the average level.


Turning to Europe and a longer timeframe, implied volatility in the STOXX 600 remains safely mid-range over the past ten years, a result of continuing central bank activity and the insignificance of the likely long-term economic effects of Brexit on the UK or Europe. There is uncertainty, as many are determined to repeat, but the range of expected outcomes appears to be narrow. Note from the chart above how over this time period the one standard deviation levels, marked by the dotted lines, prove to be the normal resistance and hold in all but the most extreme trading environments.


The final chart compares current volatility in Europe to that in the US. Risk reduction is a global policy, but the biggest Brexit shock, which came before the vote, was enough to cause a spike in this measure from which markets have not fully recovered. By keeping a careful eye on the relative positioning of option investors in different markets around the world, OTAS users have a ready-made guide to what is most likely to unfold in equity markets. This should be of use as the news flow shifts to the potential for political uncertainty in the US later in the year.

With little over a day to go before the UK referendum, we present a last look at the state of play across equity markets using the multi-asset analysis within OTAS.

The pattern for the valuation of the STOXX 600 is established. At above 16.5x 12 months forward earnings the market is stretched beyond its normal range and has reverted in fairly short order. Much below 15x and the index attracts buyers, especially around 14x.

STOXX Jun 2016

This narrow range of values has persisted for many months and means that the Brexit vote in the UK is having little impact on investors’ views on the prospects for European equities. Rather investors should focus on 12 month EPS Momentum and the stocks being upgraded. A two-step filter within OTAS reveals nine shares in the STOXX 600 where upgrades were at least 5% in the last month and 10% in the past three months. Eight of these nine companies have EPS Momentum in the top decile across their respective sectors. Contact us for details.

STOXX CDS Jun 2016

The average cost of credit for European companies has been rising since March of last year, most likely to be when economic growth momentum was at its best. This is in spite of the ECB announcing and now launching purchases of corporate debt. Unless the cost of credit falls there is unlikely to be any change in productive investment across the continent’s listed sector, although recycling new debt into buybacks is one probable consequence of ECB action.

STOXX IV Jun 2016

Risk, as measured by three month implied volatility in the shares of Europe’s largest companies, has been rising gradually since September 2014. Even if we allow that the most recent spike to over 30 was Brexit related, the peak was no higher than the August 2015 move that took far longer to dissipate, and was well below the February 2016 period. At this time investors were focused on the risks of a global slowdown, so for all the publicity surrounding the potential damage Brexit could do to growth across Europe, equity option investors are dismissive of the risks.

The prevailing trends in European equities are a declining valuation, punctuated by central bank induced temporary recovery, mirrored by rising risk recorded in both credit default swap and equity option markets. This speaks to a gathering economic slowdown as a far more important trend than anything Brexit could cook up for European shares.

This is of course what the calm voices have been saying throughout the fractious UK debate, but calm voices don’t sell in the media and hence are easily drowned out by the ranting and raving of those using economic and market predictions for other ends.

One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute – William Feather

The media is alive with lurid stories of volatility back at seven year highs. This refers to foreign exchange volatility and it is hardly surprising, as central banks have done their level best to dampen volatility for seven years, but everyone knew that this would last only as long as market participants chose to believe. If Brexit is indeed the reason why currency markets are aquiver, then this should be no surprise as the campaign for the UK to leave the EU has risen in defiance of central bank warnings, along with those of the rest of the establishment.

Back in April we published a post arguing that there was no evidence of Brexit related volatility in equity markets. OTAS implied volatility (risk) analysis centres on three-month single stock options and so April was already discounting expectations for the post referendum period. The prevailing consensus, however, may well have been that there was no way that the UK would vote to leave, and it is this consensus that is being shaken with reports of nine out of ten recent bets placed with bookmakers anticipating Brexit.

UK Shares Average Implied Volatility - Short Term

UK volatility, whereby options investors expect a +/- 16% move in share prices in three months, is at the top end of its two year range. This is +/- 1.5% more uncertainty than in April. Today’s level, however, remains below the peak in February, when it is worth remembering that the prevailing panic was about global growth, not politics. Last night US bond spreads were at nine year lows, which is a recession warning, and it would be a stretch to blame Brexit for concerns over domestic US economic growth.

UK Shares Average Implied Volaility - Long Term

It is also worth viewing UK equity volatility in a longer historical context. Compared with previous peaks in 2011 and 2008, the recent increase in uncertainty barely registers and remains well within normal bounds. Even during February’s market fall, when the prevailing wisdom was that there would be a recession this year and not one triggered by UK voters, uncertainty did not rise beyond the normal range. Investors should keep an eye on this measure over the next eight days to judge how far the Brexit hysteria spreads.

UK Company Aveage P/E - Short Term

UK average P/E valuation has fallen back into the normal two-year range, having reached a peak in mid-April. The valuation has moved, swung would be too aggressive a description, between 14x and 17x over the last two years and could fall another 8% before reaching that lower valuation. The drop since mid-April has been 10%.

A look at earnings also suggests that there is little to be overly concerned about in the world of equities. Analysts have been downgrading UK shares more often than upgrading for the last six months, but the ratio of downgrades to upgrades has fallen recently.

 Average UK Share

Upgrades over 1%

Downgrades more than 1%

Last 6 months



Last 3 months



Last 1 month



Source: OTAS

While it would be convenient to blame economic uncertainty caused by potential Brexit for the downgrades to earnings expectations, if this were the main reason for changes, then the downgrades would surely intensify as a leave vote became more probable. The opposite is true. We do well to remember that analysts almost always start a year more positively than they finish it, as reality bites into bonus-period optimism. Analysts are also notorious for not changing their estimates until guided to do so, thus there is a reasonable chance that company executives would use the cover of a leave vote to downgrade their outlook, whatever the underlying reason for caution.

With even Mark Carney admitting that the Chinese debt mountain is a greater concern than Brexit, there are plenty of excuses for corporate chieftains to cut themselves a little slack. Keep an eye on the OTAS measure of implied volatility for an early steer as to when this becomes a cliff edge issue, rather than the gentle undulation that it is at present.

The striking thing about European equity markets is how stable they are right now. EPS Momentum is mildly negative in most major markets, valuations are very similar and implied volatility is as expected, with Switzerland deemed least risky and Spain the most. More importantly, the country markets are trading relative to each other precisely as you would expect.

So where is the Brexit risk, the great fear that the UK will dive off a cliff should the population defy the European elites and vote to quit the European Union (note to editors, the UK would not be leaving Europe, which is not possible geographically). Equally, where is the fear that a UK exit after the June 23rd vote will lead to a tailspin for European markets. Answer; there isn’t any.

In OTAS we track three month implied volatility more than any other duration. We do this because there is plenty of liquidity at this point relative to at other times. As of April 11, we are less than three months from the UK vote and hence today’s numbers reflect perceptions about where markets will trade on the other side of the decision.

The strongest evidence of a Brexit effect

The strongest evidence of a Brexit effect

The chart above represents the strongest evidence of a Brexit effect, in that implied volatility (read uncertainty) for leading UK shares is slightly above the average range over the past two years relative to France. This, however, is a relative rating, and the implied volatility of the two markets is very similar. Option traders expect UK stocks to be +/-14% by July 8 and French ones to be +/-14.5%. So uncertainty is marginally greater in France.

Over the same time, traders expect Spanish stocks will be +/-18%, Italian +/-17%, German +/-13% and Swiss +/-11%. This is how these markets line up next to one another most of the time, except when there are perceived problems on the horizon. What is more, the current level of volatility is in the average range of the last two years, having been much higher in February, before the date of the UK vote was announced.

Uncertainty in France is in the normal range

Uncertainty in France is in the normal range

Stock market valuations are normal as well, safely in the average range, where you would expect relative to one another and at very similar levels. France, Italy and Spain trade on 15x 12 months’ forward earnings, the UK on 16x alongside Switzerland, and Germany on its typical slightly lower rating of 14x due to the composition of its more cyclical stock market. The UK has re-rated relative to Europe so far this year and not because EPS Momentum has fallen relative to elsewhere. If anything, the UK market is looking toppy.

The inverse Brexit effect

The inverse Brexit effect

What is behind the complete absence of Brexit panic in stock markets? One answer is concerted and coordinated central bank action to crush volatility. Another is that the world has bigger problems, in terms of an economic slowdown precipitated by nearly two years of falling global trade volumes, than the possible changes in an inward-looking Europe. A third is that those people who put money on these matters, day-in, day-out, do not think that anything very much will change whether the UK is in the EU, or votes to leave.