Post the Brexit vote, the U.K. Conservative Party has accelerated its anointing of a new leader and Prime Minister. Nevertheless, our central thesis from Game Theory Says STALEMATE In Brexit Negotiations remains intact. The U.K.'s future relationship with the EU, and the world, will remain shrouded in a fog of uncertainty for months at the very least. And economies and financial markets do not like such uncertainty.
This week, we will take a welcome break from the game theory of Brexit negotiations. Instead, having witnessed that seemingly unthinkable things can actually happen, it is a good time to reassess how financial markets price uncertainty, and whether the current pricing is correct.
Box1: Valuations And Long-Term Returns
There is no simple relationship that tells us where an equity market will be trading in the future. But the further into the future one looks, the clearer the prospects become. Why? Because as the investment horizon lengthens, the return becomes more and more dependent on just one factor: the valuation at purchase. The following charts illustrate this point.
Chart I-2 illustrates the very consistent relationship in recent decades between the FTSE100's price to earnings (PE) multiple and its subsequent 10-year nominal return. To be clear, very similar relationships exist for other valuation metrics like the Tobin's Q ratio (Chart I-3),2 and for other major equity markets going back more than a century (Chart I-4). So the analysis is neither specific to one valuation metric, nor to the FTSE100.