FTSE catch down more likely on Brexit risk

Brexit fears haven’t stopped British equity market returns outperforming Europe, but now we expect them to dwindle further.

Even a week ago, startling pre-referendum market swerves were largely limited to foreign exchange. British stocks were lacklustre, but their losses since January contained: since March the FTSE 100 and FTSE 350, had ranged no wider than 3 percentage points up or down on the year.

That was before stocks, like sterling, were properly upended by a barrage of pro-Brexit polls, with a higher surprise factor for shares after several moribund months.

The dollar’s unexpected comeback last week from a spate of sketchy economic readings added weight to markets around the globe. But there were few doubts sterling’s sharp moves and wild swings were in lock step with voting sentiment (according to pollsters). And it would be remarkable if the FTSE’s slide wasn’t linked to polls too.

That raises the risk of a vicious circle for equity markets, which could make Wednesday’s bounce short-lived.

On top of higher potential for drawdowns (when whipsaws wipe out collateral) we see 3 main factors that could pile further pressure on the biggest investors to close positions, with outsize market impacts.

European banks are the region’s worst performer in 2016, sending STOXX’s sector index 27% lower. Together with this week’s ramp in euro implied volatility, it suggests some investors were cutting exposure whilst also adding protection, despite FTSE, sterling and euro options premia surging to multi-year highs.
The combination of Brexit risk, negative rates, flat yield curves and even first signs of US Election year risk aversion, certainly help explain avoidance of lenders’ shares, and will keep dragging the sector for months.
Now, with eight days to go before the Brexit vote, continued risk-aversion with a smattering of short-term hedging and speculating, will force options dealers to either close their own positions or stay exposed to whipsaws and drawdowns.

Either way brace for a rise in cross-market volatility in the days ahead which won’t spare British stocks, though a clearer swing to Remain would calm markets considerably.

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