Mike Jennings

Globe WorldWatch

Brexit – not just a binary decision

WorldWatch

We discuss four potential outcomes of the upcoming UK referendum and their implications for the global investor.    

brexit 1

Source: Wikimedia

The UK referendum on Thursday 23rd June has important ramifications for assets not just in the UK but also globally.  This is not a binary outcome, as some suggest, and instead there are potentially broad ranging consequences even in the event of a win for the Remain camp.  We discuss four potential scenarios and their implications for the global investor.    

Publishing a note on Brexit two days before the poll might seem a little foolhardy.  As I write, the polls are divided, and indeed the Financial Times “poll of polls” has the two sides neck and neck at 44:44.  Whilst it may be fun to speculate on the undecided 12%, or the effect of the wet and stormy weather forecast for polling day, the truth is that we all (including the pollsters) just do not know what the result will be, as it is entirely unprecedented. Thus it seems like an opportune moment to write an impartial piece about the potential implications on markets of various referendum outcomes.

Many have commented that, as this is a “two horse race”, there will be a binary outcome - Yes or No, Remain or Leave.  I do not believe that it is that straightforward.  Referendums are unusual in the UK and they are also not legally binding. The government is not deferring a decision to the electorate, but simply asking advice from them.  Any decision following the referendum will depend upon a parliamentary vote.  Whilst it would be highly unusual (and dangerous) for the government to go against a decisive result, it is entirely feasible that a close result is overruled by parliament.  I therefore suggest four possible scenarios:

Publishing a note on Brexit two days before the poll might seem a little foolhardy.  As I write, the polls are divided, and indeed the Financial Times “poll of polls” has the two sides neck and neck at 44:44.  Whilst it may be fun to speculate on the undecided 12%, or the effect of the wet and stormy weather forecast for polling day, the truth is that we all (including the pollsters) just do not know what the result will be, as it is entirely unprecedented. Thus it seems like an opportune moment to write an impartial piece about the potential implications on markets of various referendum outcomes.

Many have commented that, as this is a “two horse race”, there will be a binary outcome - Yes or No, Remain or Leave.  I do not believe that it is that straightforward.  Referendums are unusual in the UK and they are also not legally binding. The government is not deferring a decision to the electorate, but simply asking advice from them.  Any decision following the referendum will depend upon a parliamentary vote.  Whilst it would be highly unusual (and dangerous) for the government to go against a decisive result, it is entirely feasible that a close result is overruled by parliament.  I therefore suggest four possible scenarios:

  1.  A decisive victory for the 'Leave' camp (>55%)
  2. A moderate victory for the 'Leave' camp (50-52%)
  3. A moderate victory for the 'Remain' camp (50-52%)
  4. A decisive victory for the 'Remain' camp (>55%)

Astute readers will notice that there is a gap in my definitions above (between 52-55%) as this is a grey area that is neither ‘close’ nor ‘convincing’. Such an outcome would likely result in a hybrid of my suggestions below.

There have been entire forests of articles focusing on the implications for UK assets on Friday 24th June.  Whilst I will of course refer to the UK, what is arguably more interesting, and far less well documented, are the wider implications for global assets.

A decisive 'Leave'

The obvious immediate loser on Friday morning is sterling.  On the one hand, sterling has already been very weak – using the Bank of England’s trade weighted basket, sterling is already down 8.4% in the last 12 months1 , although since the official start of the referendum campaign (on 15th April) it is largely unchanged (+0.4%).  My assumption is that, in the event of a decisive leave vote, sterling falls sharply against the dollar, comfortably breaching its decade low of 1.37 (-6.3%2) beyond which there would appear to be very little technical support (expect -10% or more).  UK equities will probably also fall in an immediate knee-jerk reaction as foreigners sell.  The paradox, of course, is that exporters will immediately benefit from currency weakness.  Ultimately, domestic stocks, most notably banks and cyclicals, will be the losers, while non-cyclical exporters such as pharma and beverages will be the winners.

This is a bitter vote of no-confidence in the government and, in particular, the prime minister.  Cameron’s position is immediately untenable and he resigns on Friday.  This adds to the already considerable uncertainty, as the process to replace him will take many weeks and ultimately result in the probable (but not inevitable) appointment of Boris Johnson as prime minister.

The immediate implications for global markets are substantial. The sheer uncertainty will cause a sharp fall in risk assets across the globe, and be met with major central bankers opening the liquidity taps even further. The first issue to contend with will be the reaction from the European Union and whether it will be rational from an economic point of view or biased by politics. The rational economic reaction is to be pragmatic and claim to the world that Britain’s decision to leave will have no immediate impact on trade until a renegotiation has been completed.  After all, as a buyer of 13% of the Eurozone’s exports, why would a rational participant put that in jeopardy? 

However, politicians are not always rational!  Many, including Germany’s finance minister Wolfgang Schäuble, have warned that as soon as a ‘leave’ vote is declared Britain should not expect any favours from the EU.  Similarly, in a meeting we had last week with French Economy Minister Emmanuel Macron, he made it very clear that ‘passporting’ – the ability for banks to provide their services across the EU – would also be removed quickly following a ‘leave’ vote. 

From a political perspective the first interesting test will be the effect on Spain’s general election on June 26th.  Other EU nations such as Denmark and Sweden would find their already significant anti-EU voice substantially bolstered and undoubtedly also call for a referendum. Even in the ‘core’ of France and Germany, both incumbent presidents are unpopular, both face growing popularity of the extreme right, and both hold elections in 2017.

Such issues will increasingly pressurise economic activity in the region and precipitate a simultaneous sharp weakening of the euro.  It would also seem logical that, with pressure on the fringes, credit spreads between the core and the periphery would widen, possibly testing the highs of 2010/11 in some cases.  In this scenario, the dollar would be a clear safe haven as would the yen – bullish for US Treasuries, and bearish for equity markets and global growth.      

A moderate ‘Leave’

A small win for the leave camp causes a great deal of uncertainty.  The government is under no obligation to take heed of the decision, and my assumption is that David Cameron would try to integrate members of the leave camp more closely into his government while heading back to Brussels to try to resolve the electorate’s big concern – immigration.  Given that free movement of its citizens is a key tenet of the EU, Cameron will struggle to secure any significant reform on immigration and the UK electorate are unlikely to accept his efforts.  This scenario would also start with a collapse in sterling but its fall may be moderated by hope that a ‘3rd way’ can be found.  Ultimately this could be the worst case scenario for the UK, as a split between the popular vote and the elected members of parliament may become evident, causing political paralysis.

It would certainly embolden the non-EU camps and anti-establishment parties elsewhere in the European Union, paving the way for turmoil within Europe and a sharply weaker euro.  

A moderate ‘Remain’

Whilst this vote would be hailed as a victory for the incumbent government, to have nearly half of the electorate voting to leave the EU would be highly embarrassing and a stark warning to UK and EU leaders.  Eurosceptics across Europe would feel that an exit from the EU is within their grasp and would feel emboldened as a result.  EU leaders would try to become more liberal and cohesive whilst grappling with temporary methods to control the flow of migrants.  At home, Cameron’s credibility will have been dealt a severe blow and, after limping on – perhaps for a year or so – he would resign earlier than expected, leading to much acrimony within the Conservative Party and a battle for leadership.

For UK assets this scenario is met with a sharp bounce in sterling and equity markets, which peters out within a matter of days as political infighting becomes a drag on confidence.  Within the EU, politicians will studiously avoid the tough issues and stumble on with one eye fixed on their approval ratings at home.  European equities regain some ground lost in recent weeks, but the enthusiasm again peters out after a few days.      

A decisive 'Remain'

This is a huge relief for markets, risk assets, the European Union, and the UK government.  It is positive for UK and European equities which, after 19 weeks of consecutive outflows, see a sharp re-allocation and catch up relative to the US market.  Sterling rallies 5-7% against both the dollar and the euro, taking it back to levels seen in December and January.  This is also unequivocally bad news for eurosceptic groups across the EU, and emboldens the European leaders to become closer and more integrated going forward.  Cameron has secured a clear victory and he shuffles the key ‘leave’ architects in his party to the sidelines.     

Notes:

1)     Data is as at the close on 17/6/16

2)     As at mid-day on 20/6/16


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