Photographer: Kenzo Tribouillard/AFP

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Brexit: Prepare for seven more months.

The U.K. voted to leave the European Union in large part because of a phenomenally successful slogan by Vote Leave campaigners: “Take Back Control.” So if there is anything on which everyone in the U.K. can agree, if not probably the entire European continent, it is that there is something absurd about the current spectacle of Germany and France arguing over how long to let the U.K. stay in their club, while the U.K. prime minister is reduced to begging to stay longer. That absurdity is capped by their choice of a new final date for the U.K.’s EU membership. Britain will now exit on October 31.

The political ramifications both on the Continent – where politicians now have to scrap their plans for a U.K.-free set of elections for the European parliament – and in the U.K. will be profound. Nobody is happy about the deal. There is no logic to the date. It allows uncertainty to drag on, without giving the fractured British body politic enough time to go back to square one and sort out a new approach. Neither the U.K., nor Germany nor France wanted it. It emerged merely as a compromise between the French – alarmed at the prospect of a badly behaved U.K. trying to act as a wrecker during a long delay – and the Germans.

There is just enough time to hold a second referendum, and there is just enough time for the Conservatives to jettison U.K. Prime Minister Theresa May and pick a new leader. But in either case it will take decisive action in the next few weeks, which are likely to be dominated by what could be farcical elections for the European parliament. Britain is good at producing joke and protest candidates. These elections, requiring the winners to serve only a four-month term that ends on Halloween, should yield a vintage crop.

None of this will deal with the central problem, which Clive Crook nailed for Bloomberg Opinion last week. The choice really is between staying or going, because no good compromise exists. “Soft” Brexits, which limit the degree of separation from Europe, also involve the U.K. giving up a say in the way in which the EU is run, while still being subject to it. As Crook put it:

The root of the Brexit crisis is not, as you might think, the failure of the hard-Brexit Tories to compromise. Rather, it’s that no good compromise exists. For three years Britain’s politicians have refused to face this, arguing endlessly and pointlessly about how to split the difference between Remain and Leave, imagining they can find a palatable soft Brexit. The underlying problem is that there’s simply no such thing.

Where does this leave investors? The can has been kicked far enough this time that the Brexit issue might leave the headlines for a while, which would be good for U.K. assets. The risk of leaving with “no deal” also seems far more limited. The U.K. can at least make a serious attempt to plan for it over the next seven months, which should reduce the perceived risk. And there is now enough time that it should be possible to avoid the dreaded “no deal by accident.” Most of the more likely compromises that could result are, as Crook pointed out, worse for the U.K. than the status quo. But in economic terms, they would leave the country on much the same footing as now, and have little impact. The chance of a second referendum and a canceling of the Brexit project altogether have also increased. On balance, it is reasonable to be more positive about the U.K. and its investments than before.

Also, rather importantly, events in the rest of the world are helping to relieve the pressure. Rightly or wrongly, investors have decided that the pick-up in Chinese economic activity will translate into a pick-up for the euro zone after a short lag. The Federal Reserve has turned dovish, reducing a serious potential source of pressure, and Mario Draghi of the European Central Bank has just given a strong hint that euro zone interest rates could be heading down again.

But down-sides have not been removed. Draghi was so dovish because he has little confidence in the European economy. The weakness of Europe’s banks continues to be a trapdoor under that European economy. And the latest word from the ECB has been enough to push German 10-year bund yields back below zero. Cheap money might be helpful, but such low rates vitiate the banks’ attempts to build profitability, and show the lack of economic confidence. The euro zone is not in a strong position to dictate terms, and another autumn dose of Brexit brinkmanship could happen with the European economy in even more parlous shape.

The U.K. now has elections to look forward to next month. If ever there was a time for a protest vote, this would be it. For most of the last three years, Remainers had greater cause to be unhappy; but at this point, Leavers are likely to be furious. A massive vote for pro-Brexit candidates, to be followed by a virulently anti-European British delegation taking its seats in the European parliament, is quite possible. Members of the European Parliament would have no direct power to change the decisions of the U.K. parliament over Brexit. But an emphatic anti-European vote next month could still change the calculus for all the country’s politicians, and revive the risk of the kind of chaotic exit that could mess up markets and economies far beyond Europe.

There are other risks from the European parliamentary elections. They look very likely to strengthen the hand of anti-Europeans in Italy, and at the same time deepen the risk of confrontation between Italy and the euro zone. That confrontation could come to a head as the new European Commission takes office on November 1 – the day after the U.K. is now due to exit. 

Any market relief after this compromise is therefore likely to be short-lived. Some sensible, far-sighted politicians in London, Rome and Brussels would be helpful. The traditional British anti-European diet will not help. 

Bright ideas about Capital Ideas.

It is time for another installment of views on the Authers’ Notes book of the month, “Capital Ideas” by Peter Bernstein. For those new to this, I have asked all of those interested to try reading Capital Ideas, an acknowledged classic on the foundations of modern finance which was written in 1992, and send me comments. Bloomberg will be hosting an online chat about the book next week.

Peter Atwater, author of Moods and Markets,  makes some interesting observations. As the title of his book implies, he has done much research on how social moods affect markets. Peaks in optimism and pessimism in society are often mirrored by market turning points. He suggests there are signs that the notions Bernstein covers, largely promulgated to little fanfare by academics in the 1950s and 1960s, came to be adopted, in large part, because of the very negative social mood of the early 1970s. The bear market back then gets less attention than the Great Crash of 1929 or the Black Monday crash of 1987, but Atwater says it led many distraught investors, reeling from big losses, to look for a new way to operate. They found it in academic finance:
 

Where others have focused on risk management and volatility, what have lingered with me from Bernstein's book are his first dozen pages.

What comes across so clearly is how much of today's modern financialized world is essentially the backlash to the last cycle.  Out of money managers' failure to successfully navigate gyrating equity markets (1966 to 1974) and skyrocketing interest rates arose an extraordinary list of new tools, instruments and thinking.  From the ashes, as it were, came a financialized Phoenix that we now take for granted.

Looking back over the past 40 years, it is hard not to see a clear evolution from invention to innovation to expansion to excess.  Vanguard, for example, has gone from revolutionary to near-monopolist just as stock buybacks, which were once banned outright, have gone from an extreme response to activist investors like Ivan Boesky to a daily tool for corporate CFOs.  Across instruments, tools and thinking, tentativeness has been replaced by a full-embrace.

All of which begs the question whether our relentless pursuit of 1970s defined risk management now leaves us vulnerable to yet another cycle change.  Does deflation, rather than 1980s-esque inflation, become the unforeseen and therefore unhedged-against risk?

This has much validity. I also found myself doing a lot of underlining and margin notes in the first few pages. Most of the book is about the ideas themselves and how they came about, but it is at the beginning and end that Bernstein told us why people started to apply them. As Atwater said, this was in large part due to the humbling they had suffered in the early 1970s:

Had it not been for the crisis of 1974, few financial practitioners would have paid attention to the ideas that had been stirring in the ivory towers for some twenty years. But when it turned out that improvised strategies to beat the market served only to jeopardize their clients’ interests, practitioners realized that they had to change their ways. Reluctantly, they begat to show interest in converting the abstract ideas of the academics into methods to control risk and to staunch the losses their clients were suffering. This was the motivating force of the revolution that shaped the new Wall Street. 

There is another big factor that is underappreciated, but Bernstein which does touch on briefly in his introduction: scale. Even by the 1970s, investment managers were finding themselves too big to operate the way they had in the past. They were yearning for a model that would give them some economies of scale. 

“The merry game of just picking the best stocks and tucking them into a client’s portfolio had worked well enough when portfolio management organizations were small. My firm, with less than $100m under management when were were acquired, had no trouble running portfolios with less than 20 positions. 

As organizations grew in size, that scale of operations was no longer practical… Many of the go-go managers of the 1960s ignored that reality, and continued to act as though they were still managing small portfolios. Their innocent disregard of change helps explain what happened when stormy economic weather overwhelmed the optimistic markets of 1971 and 1972.”

Continuing Atwater’s point, we now have a model of investment which encourages and, indeed, requires gigantism. Our money is tied up in enormous funds run by leviathan entities, and until recently this has gone largely unquestioned. But now, the beginnings of a backlash against the enormous power accumulated by the big three passive investment groups in the U.S. – Vanguard, BlackRock and State Street – seems to be well under way. Maybe our embrace of scale, like our embrace of academic ideas, was a reaction to the last cycle. It was just part of the process.  

Risk: Bend it to your advantage.

The issue of risk does not go away. This contribution ob ‘Capital Ideas” comes from Phil Deane, an options trader:

Volatility means 2 things to options traders;

1. The actual measured historical volatility of an asset
2. The “implied volatility” calculated by taking the price an asset is trading at and imputing the volatility that the market expects.

I would add a third volatility risk and that relates to the inter-market risks between assets. Most of the models assume that this can be measured by correlation coefficients, but as one of your readers pointed out, these can and do change drastically.  I have always assumed that WTSHTF (when the s***….), these correlations all go to 1 and that so-called diversification among non-correlated assets is of limited value as a defense.  As traders say in these circumstances, you sell what you can, not what you want to.  Indeed, this seemed to me (in advance) to be the major issue in the sub-prime crisis which built AAA-rated CDOs on the basis that not all of them would go bad at the same time.  History proves that point to be correct.

 So I would assert that you can measure volatility in 2 ways (historical and statistical) and that both are required to understand markets.  You have the “fat tails” that cannot be measured in advance, but “common sense” is needed to avoid them or make money from them.

Meanwhile, Yuval Taylor of Portfolio123 in Chicago suggests in this article that risk can be defined two different ways, and that it is impossible to guard against either of them:

If we define it as the failure to meet expectations, the essential component of risk is unpredictability. Logically, then, no measure of risk will exhibit any persistence, since persistence is the opposite of unpredictability. Therefore, a measurement of ex-post risk will have no correlation with ex-ante risk. On the other hand, if we define risk as the permanent loss of capital, then there's no logical way to adjust returns for risk, since positive returns are the sole guarantee against the permanent loss of capital, and negative returns are the sole guarantee of the permanent loss of capital. The concept of risk-adjusted returns is a chimera.

In a separate article, also available on SeekingAlpha, he goes on to attack the notion that higher rewards require greater risk. He suggests instead a different version in which risk and reward are related to each other, but the relationship is not linear. Instead, after a certain point, the relationship bends, like Beckham:

With no risk at all, there is no reward. As risk increases, reward increases, to a certain point. After that point is reached, as risk increases further, reward decreases.

The recognition that at a certain point lowering risk can increase returns should make a big difference in how we look at investing. It helps justify low-beta approaches, low-volatility approaches, and increased carefulness in how thoroughly we examine our investment opportunities. The idea that higher risk will lead to higher returns has been used to justify a lot of very risky investments without due consideration of their merits.

Can he prove this beyond mathematical doubt? I am not sure, but there is a decent argument that he should not have to, and that we should try to work in line with common sense. And his version of the relationship between risk and reward does accord with common sense, even if it is not a Capital Idea. 

To contact the author of this story:
John Authers at jauthers@bloomberg.net

To contact the editor responsible for this story:
Robert Burgess at bburgess@bloomberg.net