Brexit bears stalk sterling again

Six weeks before June’s referendum, markets are hotting up again, but shareholders seem less excited than forex traders, and some investors are sitting prettier than others.

Whilst FX speculators have surged into ‘Brexit’ trades this year, pressuring sterling, stocks have moved far less.

The chart below compares sterling/dollar ‘implied volatility’—basically the cost of options betting on a weaker pound—with the FTSE 350 stock index.

Sterling vol. was still 50% higher for the year on Thursday, even after a sharp fall last month. The FTSE 350 hasn’t moved as much. It is just a little lower for the year, having slipped almost 10% between January and early February, before recovering.



In other words, rumours of stock market Armageddon have been greatly exaggerated so far, though that doesn’t mean there haven't been losers. Shares of retailers and banks have glaringly underperformed the wider stock market since January. We think these sectors have fared worse than average because smart investors have picked ‘defensive’ stocks and sold those perceived to be exposed to the highest Brexit risk.

Our overview raises one big obvious question: is it too late to express a view about Brexit by trading shares or FX?

Well, the answer depends partly on your appetite for risk. For traders prepared to accept some risk, we see opportunities in the fact that many of the broad trends outlined above are likely to continue, with two clear exceptions. Those exceptions, in our view, are commodity and to an extent oil shares. After sharp and even eye-watering rallies across these sectors, we think shares have now caught up with the rally in resource prices. That means investors will need to become much more selective.

Elsewhere, we think careful selection can also still weed out potential further downside in banks. RBS last week rounded off a dire first quarter for UK banks, with all of the ‘Big 3’ posting worst profits. But not all British High St. banks are the same. For those wishing to maintain exposure to the sector, it may soon be time to position for a share price recovery of the strongest, assuming Brexit doesn’t happen, which we think is the likeliest outcome. On that basis, Lloyds may offer the best opportunity of the three, especially in view of reported plans to launch a final public offering of its shares after the referendum.

We would apply a similar approach to retailers. However here, prospects seem less clear cut, especially with the sector trading only a few percentage points below the main FTSE indices, compared to a 19% drop by banks this year.

For currency traders, the main question is whether sufficient risk/reward remains on the downside for sterling against the dollar whilst GBP/USD is still 13% lower from November highs though 10% higher since March. Some of the best analysis on 'cable' this week has been written by my colleague, technical analyst Fawad Razaqzada. Read it here. Either way, we strongly advise traders to use tight stops. Polls and bookies odds suggest voters remain split, but both could turn out wrong. Sharp FX and stock moves are likely immediately before and after the vote, so it makes even more sense than usual to minimise your exposure to risk.

Conclusion

Sterling options volatility has rebounded after falling from highs in April. We interpret that as a return of bearish speculation against sterling, though we suspect the best upside in such trades has passed. We expect stock markets to retain their current defensive stance into the referendum though we also suggest it may be time to become more selective on shares of miners, oil companies and banks.