In any negotiation, fear of being blamed for the alternative often prevents breakdown. But the more players in the game, the less likely it is that any one player will be blamed, and the more likely players are to push forward with their threat strategies. That is what’s happening with Brexit.

Revisiting the Game Theory of Brexit

Game theory helps us translate geopolitical dynamics into a form that has investment implications, and Brexit has been a fascinating example.

Brexit has been on the table for almost three years and, for most of that time, it could be thought of as a two-player game, with the United Kingdom (UK) and the European Union (EU) battling for dominance. Both have objectives, and those objectives don’t completely align. And both have varying degrees of power (right now, the EU holds most of the cards).

Until late 2018, this situation didn’t really imply anything from an investment perspective. With plenty of time on the clock to strike a deal, inertia resulted. With no progress, there wasn’t much risk. We were happy to respond to the attractive fundamental valuations of the pound and UK equities, keeping long exposures to both in our portfolios.

More recently, however, as deadlines have approached, passed, and been extended, near-term risk has elevated then dissipated, and we’ve reconsidered our positioning twice now in the past few weeks.

A New Game Theater in Town

Notably, there’s a new game theater in town. The UK doesn’t have a singular objective; it’s a multi-player theater in and of itself, and the players cannot agree on a way forward.

When different factions in a game theater confront each other, each has what is called a threat strategy— the alternative outcome if bargaining fails. And the threat strategy coming from all sides within the UK is the default outcome referred to as “no deal”—an exit from the EU that preserves no favorable trading relationships.

In a negotiation, what often stops a breakdown from happening is that no player wants to be blamed for the alternative.

Players don’t generally want their threat strategies to be the outcome, and it’s easy to see why that’s true in this case—a “no deal” Brexit would hurt UK growth and create significant geopolitical uncertainty.

But in a negotiation, what often stops a breakdown from happening is that no player wants to be blamed for the alternative—in this case, a “no deal” Brexit coming to pass. Each player wants another player to take the blame. And if players are afraid they’ll be blamed, that keeps them at the table and usually produces some kind of compromise.

If there are only two players at the table, each has a 50% chance of being blamed. But the more players there are in a showdown, the less likely any one of them needs to fear that they’ll get blamed for a failure. And that’s what is happening in the UK game theatre. Most players think the prime minister will get most of the blame if “no deal” happens.

Investment Implications

So, with the advent of the UK game theater, the risk of a “no deal” (hard) Brexit had, for a short time, risen, and the negative implications for the UK had grown.

Our base expectation has always remained that there will eventually be compromise that resembles a soft exit from the EU and preserves many existing trade agreements. But, as risks increased, we scaled back our notable long exposures to UK equities and currencies.

Most recently, however, we have stepped back in at a moderate level in both the pound and the equity market. The date for leaving the EU has now been extended (by a unanimous EU-member vote) to October 31, 2019. This provides more time for the UK to ratify an agreement, which is our base case.

Therefore, we conclude that the near-term risks previously identified have dissipated for now. Consequently, we do not think it is appropriate to fully suppress the valuation opportunity and have now unwound the trade from a few weeks ago that eliminated exposure to both the pound and the equity market.

Thomas Clarke, partner, is a portfolio manager on William Blair’s Dynamic Allocation Strategies team.

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Please carefully consider the Funds’ investment objective, risks, charges, and expenses before investing. This and other information is contained in the Funds’ prospectus and summary prospectus, which you may obtain by calling +1 800 742 7272. Read the prospectus and summary prospectus carefully before investing. Investing includes the risk of loss.

Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.

This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions.

Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Investments are subject to market risk. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Distributed by William Blair & Company, L.L.C., member FINRA/SIPC.

Copyright © 2019 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

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Please carefully consider the Funds’ investment objective, risks, charges, and expenses before investing. This and other information is contained in the Funds’ prospectus and summary prospectus, which you may obtain by calling +1 800 742 7272. Read the prospectus and summary prospectus carefully before investing. Investing includes the risk of loss.

Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.

This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions.

Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Investments are subject to market risk. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Distributed by William Blair & Company, L.L.C., member FINRA/SIPC.

Copyright © 2019 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

Statement of Financial Condition | NMS Rule 605 & 606 | Business Continuity Plan | UK Stewardship Code
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