Next Friday, June 24 potentially will be the highest volume trading day of this year as it is not only the day after the UK vote on whether to leave the European Union but also the date of the annual rebalancing of the FTSE Russell indices.
The UK is holding a referendum on whether to leave the EU, or “Brexit”, on June 23 but the results will not be known until the morning of June 24. The vote holds implications for markets globally, with Europe as the epicenter.
OTAS Technologies, a provider of market analytics, said in a blog that back in April there was no evidence of Brexit-related volatility in equity markets as its analysis of three-month single stock options covered the post-referendum period. Since April the probability of Brexit has increased as opinion polls show ties between remain and leave, although bookmakers’ odds still favour a majority voting to remain.
“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,” added OTAS. “This is +/- 1.5% more uncertainty than in April.”
David Zahn, Franklin Templeton
OTAS continued that the current level of volatility is still far below the peak in February this year and previous peaks in 2011 and 2008.
“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 to judge how far the Brexit hysteria spreads,” added OTAS.
Viktor Nossek, director of research at exchange-traded fund issuer WisdomTree Europe, said in a note that uncertainty surrounding the referendum is starting to test traders’ nerves. “Implied volatility of the GBP/USD spiking to 22% – a level approaching the extreme highs seen in the 2008 financial crisis – and 10 year gilt yielding less than 1.3% to reach new historic lows means risk-off positioning is now starting to build up,” he added.
However he continued that equity markets in Europe have resisted succumbing to significant downward pressure even in weeks leading up to the referendum, when compared to the referendum in Greece last year.
“The upbeat sentiment in European equities in the run up to June 23 may yet reverse in these final days,” warned Nossek. “Investors should be prepared for the potential eventuality that uncertainty building up in the pound may spread to rising volatility in European equities. Hedging long European equity exposures and long dollar strategies may regain appeal.”
David Zahn, head of European fixed income at Franklin Templeton Fixed Income Group, warned in a note that investors hoping the result of the referendum will bring an end to the uncertainty and volatility are likely to be disappointed.
Zahn said: “The one thing we can say with some certainty is that the ramifications, whatever the result, will likely be felt for some time to come—and not only in the United Kingdom.” He expects volatility in the UK equity, bond markets, and sterling to continue until the day of the vote.
“But we also suspect there could be further volatility in mainland European markets, as more European political leaders make public their opinions in the run-up to the vote,” added Zahn. “There are some indications that if the United Kingdom were to vote to leave the EU, calls for referendums in other countries could intensify as well.”
He continued that European bonds, and in particular peripheral government bonds, do not appear to adequately reflect the risk of Brexit in their pricing so if there is a vote to leave spreads could widen in the short-term.
“Let’s not forget that on June 26, three days after the UK’s Brexit referendum, the re-run of the inconclusive Spanish general election is scheduled to take place,” said Zahn. “So, there are two relatively large political events happening in the course of three days, suggesting that across Europe, investor interest in the political machinations is likely to remain high.”
Fund manager Pimco has said three sectors of the UK corporate bond universe are most at risk from a vote to leave the European Union – financials, utilities and non-food retailers.
Pimco said: “We believe UK bank debt currently provides good compensation for risk, and outside of this, there are other sectors and companies – food retailers where investors are rewarded by wider spreads (both investment grade and near investment grade issuers), or certain exporters – for which Brexit could have positive effects. However, it does suggest a differentiated approach, overweighting sectors and issuers where the compensation for risk seems appropriate.”
Marino Valensise, head of multi-asset and income at Baring Asset Management, said in an email that a vote to leave would cause sterling to weaken by 25% to 30% in order to continue to attract capital flows, slow imports and boost exports for the UK economy. He added that short and intermediate UK government bonds will be most vulnerable to uncertainty.
“Observing periods of stress in the past, Barings would quantify the risk premium required as an additional 150 basis points – a significant correction,” added Valensise. “In terms of equities, the prospect of a depreciation in sterling would be likely to favour UK-listed multinational companies, such as those in the FTSE 100 Index, able to benefit from international revenues.”
Nicholas Colas, chief market strategist at Convergex, a global brokerage company based in New York, said in a note that the Russell indices reconstitution will affect an estimated 398 stocks with a turnover of $46bn (€41bn). He said the US stock market shrank by almost 5% over the past year but the Russell 1000 large cap index is down 1.9%, and the Russell 2000 is down 9.1% from a year ago. In order to keep the indices synced with the market, FTSE Russell recalibrates them once a year.
“This is why money managers and investors use broader indices like the FTSE Russell measure of total equity market performance,” added Colas. “The Russell 3000 (the sum of the 1000 and 2000, naturally) represents about 98% of the investable US stock market – essentially any security that might make it into an institutionally managed portfolio.”
He continued that the Russell rebalance is often the single most active trading day of the year as hedge funds and other opportunistic traders buy/short the names to be added/reduced/removed ahead of the actual reconstitution event and then close out their positions on the close of the final day of this process. “By the estimates of our program trading desk, there is some $850bn tied up in tracking just the Russell 1000 and 2000,” added Colas.
Convergex emailed the client service group at FTSE Russell to ask if there is a plan for June 24 if the market is very volatile. “The bottom line here seems to be that, as long as markets are functioning normally, the rebalance will occur as scheduled regardless of market volatility,” added Colas. “There is a chance they choose to delay – the policy we cited makes it clear they can – but for now we assume everything will go ahead as planned.”
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