Brexit Or Bremain? Evidence From Bubble Analysis

Marco Bianchetti
Intesa Sanpaolo – Financial and Market Risk Management; University of Bologna

Davide Emilio Galli
Dipartimento di Fisica, Università degli Studi di Milano

Camilla Ricci
Intesa Sanpaolo-Financial and Market Risk Management

Angelo Salvatori
Dipartimento di Fisica, Universita degli Studi di Milano

Marco Scaringi
Dipartimento di Fisica, Universita degli Studi di Milano

June 20, 2016

Abstract:

We applied the Johansen-Ledoit-Sornette (JLS) model to detect possible bubbles and crashes related to the Brexit/Bremain referendum scheduled for 23rd June 2016. Our implementation includes an enhanced model calibration using Genetic Algorithms. We selected a few historical financial series sensitive to the Brexit/Bremain scenario, representative of multiple asset classes.

We found that equity and currency asset classes show no bubble signals, while rates, credit and real estate show super-exponential behaviour and instabilities typical of bubble regime. Our study suggests that, under the JLS model, equity and currency markets do not expect crashes or sharp rises following the referendum results. Instead, rates and credit markets consider the referendum a risky event, expecting either a Bremain scenario or a Brexit scenario edulcorated by central banks intervention. In the case of real estate, a crash is expected, but its relationship with the referendum results is unclear.

Brexit Or Bremain? Evidence From Bubble Analysis – Introduction

Brexit or Bremain?

On Dec. 17, 2015 the UK Parliament approved the European Union Referendum Act 2015 to hold a referendum on whether the United Kingdom should remain a member of the European Union (EU). The referendum will be held2 on Jun. 23, 2016, with the following Q&A:

  • Q: ”Should the United Kingdom remain a member of the European Union or leave the European Union?
  • A1: “Remain a member of the European Union”
  • A2: “Leave the European Union”

The two scenarios above were called “Bremain” and “Brexit”, respectively. In case of Brexit decision, there is no immediate withdrawal. Instead, a negotiation period begins to establish the future relationship between UK and EU. The negotiation length is two years, extendible upon agreement between the two parties. For example, the agreements between EU and Switzerland took 10 years of negotiations.

Referendum campaigning has been suspended on 16th June 2016 following the shooting of Labour MP Jo Cox. This event has had a strong impact on the public opinion, rapidly changing the opinion polls and possibly the attitude of the country.

Forecasting the results of the 23rd June 2016 referendum, given the apparent parity between Bremain and Brexit supporters and the high percentage of undecided voters observed until the week before, is clearly a very challenging task, with a high error probability. Nevertheless, there exist at least three sources of data supporting forecast analysis: opinion polls [8] [10], bookmakers betting odds [9], and market data [10]. In this paper we recur to a different forecasting approach, described in the next section.

Results

The results are reported in the following Figure 1- Figure 8. The description of the market data and the comments are included in their corresponding captions. Each chart shows, on the left hands scale, the historical series (blue line), and one representative fit with LPPL function in eq. (1) (red line) among many calibrations run with different calibration windows. The histograms reported on the right hand scale count the bubble signals (if any). In case of no bubble signals, no histograms appear.

The interpretation of the occurrence or not of the JLS bubble signal deserves some attention. The theory behind the JLS model states that if investors in some asset expect a future event (e.g. the UK Referendum) leading to a possible negative scenario for that asset (e.g. Brexit), this may trigger an asset dynamics leading to a bubble regime, possibly followed by a crash. Thus, reversing the argument, if one detects bubble signals for an asset and knows how a future event will affect the asset price, then one can state that the investors expect a negative scenario for that asset.

Translating into the Brexit context, if one detects bubble signals for an asset with a critical time ?? around June 23th, and knows that Brexit/Bremain are negative/positive scenarios for that asset, respectively, one can conclude that investors are expecting Brexit. The specular argument also holds: if one knows that Bremain/Brexit are negative/positive scenarios for that asset, respectively, one can conclude that investors are expecting Bremain.

Brexit Or Bremain

  • Source: Brexit Equity Index (Bloomberg BBRXEQT Index), basket of 10 UK stocks designed to reflect British exposure to the EU across different sectors. Data up to Friday 17th June 2016.
  • Comments: the historical series shows a decreasing trend, but no super-exponential behaviour and instabilities typical of bubble regime. In fact, the JLS model (LPPL fit) does not propose valid bubble and crash signals.
  • Interpretation: market participants are currently suspicious about UK stock market, but do not actually fear either a crash following Brexit or a sharp rise following Bremain.

Brexit Or Bremain

  • Source: gold prices (Bloomberg XAU BGN Crncy). Data up to Friday 17th June 2016.
  • Comments: the historical series shows an increasing trend, but no super-exponential behaviour and instabilities typical of bubble regime. In fact, the JLS model (LPPL fit) does not propose valid bubble and crash signals.
  • Interpretation: market participants are currently refuging into gold, but do actually fear neither a sharp rise following Brexit nor a crash following Bremain. This result is consistent with the BBRXEQT and GBPUSD FX rate observations.

Brexit Or Bremain

  • Source: GBP/USD FX rate (Bloomberg GBPUSD BGN Crncy). Data up to Friday 17th June 2016.
  • Comments: the historical series shows an erratic trend, no super-exponential behaviour and instabilities typical of bubble regime. In fact, the JLS model (LPPL fit) does not propose valid bubble and crash signals.
  • Interpretation: market participants but do not actually fear either a crash following Brexit or a sharp rise following Bremain. This result is consistent with the BBRXEQT and GBPUSD FX rate observations.

Brexit Or Bremain

  • Source: GBP/EUR FX rate (Bloomberg GBPEUR BGN Crncy). Data up to Friday 17th June 2016.
  • Comments: as for GBP/USD
  • Interpretation: as for GBP/USD.

Brexit Or Bremain

  • Source: FTSE ORB Total Return GBP Index (Bloomberg TFTSEORB Index), includes GBP fixed coupon Corporate bonds trading on LSE across different industry sectors and maturity bands. Data up to Friday 17th June 2016.
  • Comments: the historical series shows an upward trend (due to the overall lowering discount rates, driven by lowering GBPLibor w.r.t. increasing GBP credit spreads) and super-exponential growth and instabilities typical of bubble regime. In fact, the JLS model (LPPL fit) propose several valid crash signals around 23th June.
  • Interpretation: market participants consider the referendum a risky event for corporate bonds, expecting either a Bremain scenario or the BoE intervention in case of Brexit.

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