With markets in turmoil, a period of quiet contemplation might not feel like the right move. But panic often gives way to tunnel vision. So reflecting on how markets fared following a similar shock, rather than succumbing to the herd instinct, could be a sensible place to start.
The aftermath of last week's vote on EU membership was reminiscent of Britain's forced exit from the Exchange Rate Mechanism (ERM) in 1992, though the political fallout is likely to endure this time around. As seemed likely, sterling has been the primary casualty of the 'out' vote, but the UK's current account deficit is much wider than it was when Norman Lamont was chancellor of the exchequer.
Brexit exposes a long-term structural weakness
The UK has managed to generate relatively high growth rates compared with most economies of continental Europe, albeit through debt. The UK's current account deficit averaged 5.2 per cent of GDP through 2015, according to the World Bank, but the industrial component of that measure is below the European average. Put another way: our deficit in non-trade income such as investment returns is now much larger than the deficit in trade items.
As a consequence, we're exposed through a disproportionate reliance on large inflows of foreign capital. This was a structural problem for the UK long before the EU vote, but it will obviously be magnified if enough overseas investors curtail capital inflows, even temporarily. The ERM debacle showed the limits of state intervention once markets smell blood, but this time around there are probably fewer levers that could be brought to bear even if policymakers opt to support economic growth.
We're also more exposed than we were back in 1992 because of the relative strength of our real estate and equity markets. The FTSE 100 had actually slumped in the run-up to our expulsion from the ERM and the property market had been largely moribund. By contrast, the UK benchmark is still 2.2 per cent in advance of its 300-day moving average at the time of writing, while both London and UK property prices are still near their highest in years, despite a fall-away in transaction volumes.
Embracing volatility and the benefits of managed decline
Of course, there could be inherent advantages to a sustained fall in the value of sterling over the long haul, assuming that it's an orderly managed decline. Last year, a range of analysts from the likes of Deutsche Bank and the International Monetary Fund warned that the pound was the most overvalued major currency. The relative strength of sterling stifles our ability to drive economic growth through exports, so investors should be on the lookout for stocks that earn a high proportion of revenues in foreign currencies but report in sterling. Ergo the periodic inflows into stocks like global liquor giant Diageo (DGE) and British American Tobacco (BATS). Both these 'sin stocks' also traditionally provide a degree of insulation during periods of recession, but it's probably expectations of sterling being lower for longer that has galvanised some investors.
Mention volatility to most investors and they'll probably think in terms of increased risk, but in essence it's how much a given security's return can be expected to vary from the market average - the standard deviation. Therefore, we should embrace volatility; markets in flux invariably throw up lucrative value plays for those who hold their nerve.
