In any negotiation, fear of being blamed for the alternative often prevents breakdown. But the more players in the game, the less likely it is that any one player will be blamed, and the more likely players are to push forward with their threat strategies. That is what's happening with Brexit.
Revisiting the Game Theory of Brexit
Game theory helps us translate geopolitical dynamics into a form that has investment implications, and Brexit has been a fascinating example.
Brexit has been on the table for almost three years and, for most of that time, it could be thought of as a two-player game, with the United Kingdom (UK) and the European Union (EU) battling for dominance. Both have objectives, and those objectives don't completely align. And both have varying degrees of power (right now, the EU holds most of the cards).
Until late 2018, this situation didn't really imply anything from an investment perspective. With plenty of time on the clock to strike a deal, inertia resulted. With no progress, there wasn't much risk. We were happy to respond to the attractive fundamental valuations of the pound and UK equities, keeping long exposures to both in our portfolios.
More recently, however, as deadlines have approached, passed, and been extended, near-term risk has elevated then dissipated, and we've reconsidered our positioning twice now in the past few weeks.
A New Game Theater in Town
Notably, there's a new game theater in town. The UK doesn't have a singular objective; it's a multi-player theater in and of itself, and the players cannot agree on a way forward.
When different factions in a game theater confront each other, each has what is called a threat strategy— the alternative outcome if bargaining fails. And the threat strategy coming from all sides within the UK is the default outcome referred to as “no deal”—an exit from the EU that preserves no favorable trading relationships.
Players don't generally want their threat strategies to be the outcome, and it's easy to see why that's true in this case—a “no deal” Brexit would hurt UK growth and create significant geopolitical uncertainty.
But in a negotiation, what often stops a breakdown from happening is that no player wants to be blamed for the alternative—in this case, a “no deal” Brexit coming to pass. Each player wants another player to take the blame. And if players are afraid they'll be blamed, that keeps them at the table and usually produces some kind of compromise.
If there are only two players at the table, each has a 50% chance of being blamed. But the more players there are in a showdown, the less likely any one of them needs to fear that they'll get blamed for a failure. And that's what is happening in the UK game theatre. Most players think the prime minister will get most of the blame if “no deal” happens.
Investment Implications
So, with the advent of the UK game theater, the risk of a “no deal” (hard) Brexit had, for a short time, risen, and the negative implications for the UK had grown.
Our base expectation has always remained that there will eventually be compromise that resembles a soft exit from the EU and preserves many existing trade agreements. But, as risks increased, we scaled back our notable long exposures to UK equities and currencies.
Most recently, however, we have stepped back in at a moderate level in both the pound and the equity market. The date for leaving the EU has now been extended (by a unanimous EU-member vote) to October 31, 2019. This provides more time for the UK to ratify an agreement, which is our base case.
Therefore, we conclude that the near-term risks previously identified have dissipated for now. Consequently, we do not think it is appropriate to fully suppress the valuation opportunity and have now unwound the trade from a few weeks ago that eliminated exposure to both the pound and the equity market.
Tom Clarke
Portfolio Manager
William Blair Investment Management
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