Brexit & Gravity
Topic: Pearls of Wisdom
June 30, 2016
Image used with permission: iStock/altamira83
Brexit & Gravity
As stock markets reacted strongly to last week’s surprising result in the U.K.’s “Brexit” referendum, lots of metaphorical ink has been spilled in myriad analyses of what this means for the U.K., Europe, the economy, financial markets and investors. There seem to be as many possible outcomes following the vote to leave the European Union as there are commentators willing to venture an opinion. That there is such an extraordinary range of possible paths from here argues against assigning a high probability to any particular possible future state at this early stage. So, if the future is suddenly so much more uncertain, why would financial – chiefly stock – markets decline so sharply? That reminded me of an interesting, “shorthand” way to think about the time value of money that I read about years ago.
But first some background.
In economics and finance it is a truism that a dollar today is worth more than a dollar in the future. Simplistically, that’s because we could invest the “today dollar”, earn a return on it, and have it grow in value into a “future dollar” – $1 invested today at a rate of 1% would be worth $1.01 in a year. Expressed differently, a dollar a year from now is worth only $0.99 in “today dollars”. That difference is often referred to as the discount, and the assumed rate of return is called the discount rate. Of course, a today dollar can grow more in 5 years than in one year. So we “discount” a dollar due in 5 years more heavily than one due in one year. (At a discount rate of 1% annually, it’s only worth about $0.95 – $0.9515 to be strictly accurate mathematically.)
But not all future dollars are the same. Some are a sure thing – like an interest or principal payment on a Government of Canada bond. Others are quite a bit less certain – like the value of a dollar invested in the stock market. Naturally, a bigger discount – a higher discount rate – applies to those less-certain future dollars than to the “sure thing” future dollars. Leaving aside which particular future dollars (or cash flows) are being discounted for any given investment, suffice it to say that an investment like a stock or a bond is simply a bundle of future dollars, some that we expect to receive periodically (like interest and dividends) and some that aren’t expected till some unknown date in the indefinite future.
Of course, discount rates, like interest rates, aren’t static. They’re constantly changing. Whereas the discount rate for a very high-quality government bond moves in lockstep with interest rates, that for an investment with less-certain future cash flows will move with changing views on the size and predictability of those future cash flows. When discount rates rise, a future dollar is worth less in today’s dollars than before, so an investment falls in value.
With that as background, here’s the shorthand.
Discount rates act on the value of financial instruments in a way that is analogous to the way gravity acts on physical bodies. When gravity is greater – as on Jupiter – physical bodies are heavier and stay closer to the ground. But when it’s weaker – as on the moon – physical bodies rise more easily. So, too, with discount rates and financial instruments. When discount rates rise, they act as a form of “financial gravity”, pulling down the value of investments. And when discount rates fall, investments can seem to levitate at very high values.
What does this all have to do with Brexit? The market isn’t necessarily predicting any particular economic consequence of Brexit. It’s just suddenly much less confident of what the future will look like. In other words, the near-instantaneous surge in uncertainty triggered by the referendum result is increasing the downward pull of financial gravity on the value of investments with cash flows that are less than a sure thing.