Investment Strategist - Europe, the Middle East and Africa
Philip Watson, EMEA Capital Markets Strategist & Head, Global Investment Lab
March 14, 2016
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The possibility that the UK might quit the European Union is already unsettling some markets – an effect that could spread if the country does actually vote to leave.
Financial markets are said to hate uncertainty. Just lately, though, they’ve had to endure rather a lot of it.
A slowdown in global growth, a tumbling oil price, and sharp exchange-rate swings have all helped cloud the investment outlook. And as if that wasn’t enough, now the UK is headed for a crucial vote on 23 June on whether to become the first-ever nation to quit the European Union (EU). For the UK and for its EU partners this means at least four months of uncertainty – and potentially several years more, depending on the outcome.
So, will the traditionally Euro-sceptic British public vote for withdrawal? We think the answer is probably not. Although many Britons have misgivings about the EU, we reckon fears over the economic fallout from quitting will likely sway voters towards staying in. But it could well be a close-run thing. While opinion polls have generally leaned against withdrawal, this could narrow as the vote approaches. Citi Research puts the likelihood of withdrawal at 30-40%.
All this uncertainty could continue to unsettle the markets in the run up to the vote. The British pound has already been rattled. It dropped recently to $1.3836, the weakest it’s been against the US dollar since the dark days of the financial crisis. In this environment, both companies and investors might think twice about investing in the UK until the result is known. But if the country votes against withdrawal, there could be a substantial relief rally in UK assets.
What might the consequences of withdrawal be for the UK economy, the second largest in the EU and the fifth largest in the world? At least to begin with, it could depress trade and economic growth. Citi Research estimates that annualized growth could fall by 1 to 1.5% from their current forecasts out to 2019. That would leave the UK economy 4% smaller than it otherwise might have been. Citi Research also estimates that the inflation rate would jump to 3-4% year-on-year in 2017-18.
Higher inflation, less trade and lower growth don’t typically go down well with investors. The British pound could be the main victim here. An outflow of foreign investment surrounding withdrawal could help drive down the pound against the US dollar to as low as US$1.16, according to Citi Research. As to UK equities, we believe that the mid-cap FTSE 250 index could underperform the large-cap FTSE 100 index. That’s because FTSE 250 has a much heavier weighting in companies that rely on the UK economy, whereas the FTSE 100 is more skewed to companies that do more business abroad.
Are the markets reflecting the potential risks of UK withdrawal, though? On 10 February, Citi Research identified the British pound/US dollar rate as likely to be one of the most heavily-affected assets should the UK vote to leave the EU, facing a potential drop of 15-20% from its then level of $1.4522. Meanwhile, the market-implied probability of a 15% drop is 17.3% and that of 20% drop is 9.3%. And, the market sees practically zero probability of UK interest rates rising by 2% in the next year. So, markets seem less convinced about this outcome.
If withdrawal risks are mispriced, it could create potential opportunities for investors in the months ahead. For example, we have identified positions that might deliver a payoff on either an ‘In’ or an ‘Out’ vote. For investors with UK exposure who are nervous about the consequences of an ‘Out’ vote, there are hedges available against rising UK inflation or interest rates.
Casting the UK economy aside, the consequences of EU referendum are more far reaching. This includes an enduring effect on the European Union and its financial markets. We’ll be getting to grips with this difficult issue in a future post.
Sources cited: Citi Research anticipated effects on markets in the event of UK withdrawal sourced from ‘Brexit – Implications for UK Equities’, as of 10 February 2016; and via ‘Brexit Risk – Implications for Economies and Markets’, as of 5 February, 2016.