On June 23rd, the UK will vote on whether or not to remain in the European Union (EU). For investors, it is a complex issue. At first glance, it is complex because of the interplay between the numerous issues and stakeholders. In fact, there is more uncertainty than risk. Whereas risk can be quantified, there are so many uncertainties that modelling the plausible Brexit scenarios is impossible. In the near term, a Leave vote would entail no immediate change, but would nevertheless have some impact. A Brexit would increase uncertainty, which would weigh heavily on the UK economy and prompt a fall in sterling. In the longer term, most studies predict a negative impact on the UK’s economy, and a limited one on the Eurozone. Whilst economics argue in favour of Remain, the vote could hinge on other issues. That said, the latest polls put the Remain campaign ahead. Against this backdrop, the markets may sit on the sidelines in the run-up to the referendum. If the UK votes in favour of Brexit, risk aversion will certainly increase in the short term, but the real question lies in the medium-term impact on businesses’ capacity to generate profits and on equilibrium rate levels.
The official campaign began on April 15th and caused a fracture within the Conservative party. Heavyweights supporting a Remain vote are David Cameron, the Prime Minister, George Osborne, the Chancellor of the Exchequer, and Theresa May, the Home Secretary. On the Leave side, the main campaigner is the former Mayor of London, Boris Johnson, followed by Ministers and former Ministers such as Michael Gove and Iain Duncan Smith. In the Labour Party, while Jeremy Corbyn officially supports Remain, his perceived lack of enthusiasm in the debate leaves former Prime Ministers Tony Blair and Gordon Brown active on the frontline. The campaign will come to a head with a great debate organised by the BBC on June 21st.
Politics aside, many studies have been published on the cost the UK leaving the EU and the Bank of England’s Governor recently insisted that a Brexit carries the risk of technical recession. Similarly, several former intelligence officials have said that the UK’s security could be undermined outside of the EU. However, the impact of these arguments on public opinion remains to be seen.
If we were to summarise the arguments raised so far by both sides, they could be condensed down to economic logic on the Remain side and sovereignty on the Leave side. Bremainers insist on the economic costs of leaving, backed by numerous studies. For Brexiteers, the emphasis is on controlling immigration and breaking free from what is seen as a bureaucratic institution that is crippling the UK economy.
A general note of caution applies to opinion polls after poor calls on recent UK elections. They largely underestimated the Conservative party’s score at the May 2015 General Elections and overestimated the score in favour of Scottish independence at the September 2014 referendum. Taken as a whole, polls show no clear majority for either side, but telephone surveys, which are considered to be the most reliable because they are based on more representative samples with higher response rates, put the Remain campaign seven points ahead. Bookmakers’ odds are another source of information and they suggest there is a two-thirds chance that the Remain campaign will win. One of the key issues will be voter turnout, particularly amongst younger cohorts who are more favourable to Remain.
Firstly, it should be kept in mind that the withdrawal procedure would take time and that the UK would not actually quit the EU for several years. If the Leave vote won, the Government would invoke Article 50 of the Treaty on European Union and notify the European Council of its intention. In practice, nothing would change in terms of relations between the UK and the EU, but a period of negotiation would open with a view to reaching a withdrawal agreement. Secondly, it is only once an agreement had been found and ratified by the qualified majority that the UK would leave. The parties would have two years to reach an agreement. If, after two years, no agreement was reached, membership would automatically end, unless the parties concerned decided jointly to extend this period.
History has proved that negotiations would take several years. When Greenland secured independence from Denmark, the country held a referendum on European Economic Community (EEC) membership in February 1982. It took three years for the exit to take effect, and with the creation of the single market by the Single Act of 1986, today’s EU is far more complex than the EEC at that time. When the Swiss rejected EU membership in 1992, the negotiation of bilateral agreements on seven issues including freedom of movement, agriculture and technical barriers to trade began in 1994 and came into force in 2002. According to a white paper by HM Government, “It is therefore probable that it would take an extended period to negotiate first our exit from the EU, secondly our future arrangements with the EU, and thirdly our trade deals”. Meanwhile, in an interview with the Financial Times, the Director of the World Trade Organisation (WTO) suggested that the UK should renegotiate the terms of its membership. This could take several years, and longer than a possible exit from the EU, leaving the UK in a period of prolonged uncertainty.
The long-term impact on UK growth depends on several factors. Firstly, how will the UK’s international trade framework evolve, especially with the EU countries? Supporters of Leave have always maintained that the UK could keep its access to the single market at no cost but this is very unlikely. Norway, despite not being a member of the EU, has to comply with many European regulations and pays a non-negligible contribution to various EU budgets. In any case, there would clearly be a rise in import and UK export prices Secondly, how would the UK’s potential growth be affected? If a Brexit caused a decline in immigration, this would mean slower workforce growth. Moreover, productivity growth could be adversely affected by an increase in the cost of capital. Indeed, the UK has benefited from a steady flow of direct investment that could dry up.
One of the arguments of the Leave campaign is that UK growth toils under EU regulations imposed by Brussels but OECD data show that it already has one of the least regulated economies in terms of both labour and product markets. There is little chance, therefore, that a “big bang” deregulation would result in improved productivity.
Overall, most models predict GDP to suffer between 2.5% and 9% by 2030 as compared to expected levels if the UK remains in the EU.
Quite apart from the impact on the UK, the exit of a member country would be a real test for the European Union. Would it lead the other members, especially those in the Eurozone, towards further integration, or trigger the beginning of a fragmentation? There again, plausible scenarios in both directions can be built. Although pro-Europe feeling is not particularly widespread, the sight of the UK economy in recession or near-recession because of its choice would pull the rug from under the feet of the most Eurosceptic parties. Furthermore, some of the investment currently destined for the UK to build factories to supply the European market could be diverted to the continent, which would be positive for Eurozone growth.
Although changes would take time to materialise, there would be no shortage of economic impact with market participants reacting to sharp increases in uncertainty. In addition, a political crisis may be difficult to avoid, with David Cameron’s ability to retain the leadership of the Conservative party being severely challenged. Furthermore, Scotland, which is more pro-EU, would surely seek to hold a new referendum on leaving the UK. Increased uncertainty has already had an impact on growth in recent months as shown by the NIESR’s growth nowcasts (see Figure 2).
But the most sensitive variable to a Brexit will undoubtedly be the pound. According to some estimates, it could fall by 20%. What would cause such a precipitous fall? The UK runs one of the largest current account deficits in the developed world and it increased in recent quarters, due to the impact of the decline in commodity prices on profits in the energy and mining sectors. What’s for sure is that the deficit is now higher than it was both in 1974, before the 1976 IMF intervention, and in the early 1990s, before sterling left the EMS. A current account deficit has to be financed by attracting foreign capital. A Brexit would reduce the UK’s attractiveness, and a substantial fall in the pound may be necessary to redress the balance of payments (see Figure 3). That said, even if Remain wins, this current account deficit shall weigh on the pound sterling.
In the short run, rising uncertainty and the decline of the pound will have several consequences. Investment is expected to fall, inflation accelerate and consumption slow because of the higher import costs. According to UK Treasury estimates, GDP could contract by an annualised 0.4% over four quarters in the case of a benign Brexit and by 2.0% if the shock was severe.
Meanwhile, the impact on the rest of the EU is expected to be fairly limited. Whilst UK exports to the EU represent 13% of UK GDP, exports towards the UK represent only 3% of the Eurozone’s GDP.
In the worst-case scenario, Eurozone growth loss could be in the region of 0.3%-0.4%, weighing against an expected growth trend in the region of 1.6%-2.0% over the next twelve months. However, it seems unlikely that heightened uncertainty in the UK would have an impact on investment on the continent.
The referendum on Scottish independence saw the markets pricing-in risk relatively late and only to a limited extent. It took until the beginning of September, three weeks before the vote, for UK CDS spreads to react (see Figure 4). Other asset classes hardly priced-in any risk at all before the referendum. If the evolution of different asset classes since the beginning of the year is anything to go by, parallels may be drawn with the present situation.
In the aftermath of the vote, a knee-jerk reaction to reduce risk is likely if the Brexit wins and vice versa if the Remain campaign wins. We believe fine-tuning exposure to be delicate during events like these, especially if the risk is not priced in by the markets. Aside from market volatility in the days following the referendum result, the real question for investors is to what extent this change would upset the medium-term outlook for assets. Would the profit-generating capacity of companies be permanently damaged? Would equilibrium levels change?
What would happen in the interest rate markets? The initial reaction of the bond markets would undoubtedly be a flight to quality. Rates would fall in anticipation of monetary easing. A sharp rise in rates is unlikely on government bonds for a country with its own central bank and debt issued in its own currency. Moreover, only 25% of British treasury notes are held by international investors, compared to 50% for Italy and Spain before the Eurozone crisis, and 60% for Germany or France currently. Although there is no available data on who these investors are, it can be assumed that given sterling’s reserve currency status, several central banks are among the holders, and they are unlikely to suddenly sell their assets. However, in the medium term this reserve currency status could wane.
In the longer run, UK growth potential would probably decline, but the risk is that the surge in inflation linked to the decline of the currency may trigger a subsequent rise in rates.
In mainland Europe, the Bund would probably be buoyed by the rise in risk aversion should Brexit happen. As for peripheral countries, during the Scottish independence referendum, the rise in UK CDS spreads was not mimicked in Spain, the country most likely to be subject to separatist risk over Catalonia. In other words, it seems unlikely that the market will price-in an additional risk premium.
In the case of a Brexit, aside from risk aversion, a fall in sterling could boost the results of UK companies that generate only 30% of their sales in the UK. As shown by our Chart of the Week dated February 29th, 2016, after the exit from the European Monetary System (EMS) in 1992, the UK strongly outperformed other developed markets on the back of currency devaluation. That said, today’s UK market is hardly cheap, with the forward 12-month price-to-earnings ratio standing at 15.8x compared with 14.1x for Eurozone shares, whereas the price-to-earnings ratios of the two markets are historically very similar.
In the longer-term, the backdrop of prolonged uncertainty and lower growth could lead investors to demand an additional risk premium.
Conclusion
As things stand, the most likely scenario is that of a Remain vote. However, as the saying goes, in referendums voters tend to answer questions other than those on the ballot paper. Clearly, the spotlight will remain on the debate during the countdown to June 23rd.
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