Caution creeps into markets as Brexit saga drags on

London — Investor hopes for either clarity or closure on Brexit have lifted British stocks, credit and the pound in recent weeks. But with neither scenario materialising, a few nerves are starting to show.

Optimism remains and so do most of the gains, but in several assets there are signs of traders protecting against losses. The prospect of the UK crashing out of the EU receded further as Prime Minister Boris Johnson’s exit deal received backing in principle on Tuesday, but the uncertainty over what comes next was stoked as parliament rejected his timetable for making it law.

With an extension now likely, the odds of an election rising and some politicians still seeking a fresh referendum, caution is creeping back into markets.

Here’s a look at what key assets are saying:

Sterling has gained more than 5% against the dollar in the past two weeks, and traders seem to think that’s enough for now. The options market has shown an uptick in demand for contracts that protect against pound declines in recent days. One-week pound-dollar risk reversals flipped in favour of selling sterling and remain well in bearish territory.

The caution may be temporary. Longer-term forecasts from banks including NatWest Markets and Goldman Sachs Group see a potential pound rally to $1.35 on a Brexit deal being approved. Sterling was at $1.2851 as of 10:47am in London.

In the lead-up to this week, Brexit optimism was translating into flows for the Vanguard FTSE 250 UCITS exchange-traded fund (ETF), which tracks mid-cap British companies that are more sensitive to domestic growth and show more resilience to sterling strength.

The fund took in £133.7m in the week ended October 18, the most on record, and has attracted more cash in the past two days. Before last week, the £1.4bn fund had barely seen any inflows since June.

But elsewhere in ETF land, investors are showing their cautious side, with short sellers returning to BlackRock’s US-listed fund of large-cap UK stocks. On Monday the amount of shares in the hands of shorts climbed to about 4% of the ETF, according to data compiled by IHS Markit.

Bearish sentiment in the $2.3bn product had cooled over the past two weeks as optimism mounted for a breakthrough. Some of that hope was scuppered at the weekend as parliament forced Johnson to request a further Brexit delay rather than approve his deal there and then.

For all the recent hope, local shares in the UK — companies that get more than 70% of their revenue from the domestic market — still lag their more internationally orientated peers.

While they’ve been playing catch-up, having jumped about 10% since October 9 vs about 1% for the FTSE 100 and 5% for the FTSE 250, they still languish below their level at the time of the referendum three years ago.

CoCo bonds — otherwise known as callable contingent convertible bonds — from British banks have proven a reliable sentiment indicator during Brexit. That’s because the asset class is designed to help transfer the risk of bank rescues to bondholders instead of taxpayers, and fears over the fate of the financial services industry have run high throughout the tortuous process.

This £750m issue from Lloyds Banking Group had been on a tear all year, but as of Wednesday morning in London its rally stalled as investors await the next twist in the Brexit saga.

Bloomberg