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United Kingdom: last straight line before a decisive vote

At the referendum on 23 June, British voters will be consulted about keeping the United Kingdom (UK) in the European Union (EU). Recent polls have reversed and are now giving a slight edge to the Brexit side. Even though the gap is not significant, given the high proportion of undecideds (~10%)1, the financial markets reacted strongly this week, giving a foretaste of the financial turbulence that is likely to occur if the Brexit happens.

In practice, the procedure for leaving the EU (governed by Article 50 of the Treaty of Lisbon) stipulates a period of two years during which the UK remains a full member of the EU. However, the decision to exit the EU would have immediate economic and political consequences in both the UK and the EU.

1. Politically speaking, the Brexit would weaken both the UK and the EU:

  • In the UK, David Cameron would probably resign and this would cause uncertainty as there is no clear political agenda for the next PM. Moreover, Scotland, favourable to staying in the EU, would seek to organise a new referendum on its independence,2 putting the country's unity at risk.
  • In the EU, while it would not benefit any eurozone (EZ) country to leave the single currency, some EU (non-EZ) countries may demand benefits comparable to those given to the UK. The "Europe à la carte" theme would be potentially destabilising for the EU and could provoke mistrust in investors.

2. Economically, though, the Brexit shock would be asymmetrical:

  • The Consensusestimates that ‎in 2017 GDP growth would be lowered by 1.4 %pt in the UK and by 0.3 %pt in the EZ. In the longer term, all studies are pointing to the asymmetric nature of the economic impact.
  • In the UK, the Brexit would open a period of great uncertainty which would seriously hamper domestic consumption and investment in the short term (precautionary savings set aside by households and greater conservatism by businesses in their investment and hiring). The British economy could fall into a recession.
  • In the EZ, the confidence shock would have no reason to derail the recovery which is underway; growth is driven by domestic demand, and the UK weighs too little in the EZ's exports to change the game.

3. A long negotiation phase, bringing uncertainties for the UK:

  • A Brexit would open up a long period of negotiation between the UK and the EU to draw up new free trade agreements, a crucial step for the UK. Negotiating new agreements will be very slow going: on average, this takes between 4 to 10 years to achieve.
  • Negotiations promise to be tough, particularly on the financial services component, which is strategic for the UK and the EU alike. The UK is the EU’s largest financial centre: it accounts for about 25% of all EU financial services and 40% of its financial services exports. Financial services account for 8% of Britain’s GDP. The loss of a “European passport” for UK banks is likely to lead to the relocation of certain business segments (to Ireland or certain EU markets).

4. What will the consequences for the market be?

  • Recent market trends are giving us a taste: (1) a weakening pound, (2) declining equity markets in Europe, (3) rising volatility, (4) widening credit spreads, (5) rising government bond yields in the EZ peripheral countries, and (6) a flight to "safe havens" (German government bonds, US Treasuries, US dollars, gold or Swiss franc).

5. The authorities have the means to stabilise the markets and "reassure" investors:

  • On the central banks' side, the ECB and the BoE have already made it known that they would increase their cooperation to guarantee the banks access to liquidity in both currencies. In case of very significant turbulence, coordinated interventions with other major central banks (specifically the Fed) are likely. The ECB could temporarily accelerate its securities buying programme. For the BoE, all options would be on the table if financial stability were threatened.
  • Politically, EU governments can reassure investors, for example by showing their cohesion or by guaranteeing that they will offer the UK the time it needs to negotiate new trade agreements. Up until now, EU countries have always managed to benefit from periods of stress to consolidate their institutions. Still, this is a significant challenge, and its difficulty must not be underestimated.

Conclusion: A challenge for Europe that may offer opportunities for investors

  • Economic and political uncertainty is conducive to overreactions on the markets in the very short term, amplifying recent movements and sending asset prices to levels that have no connection to their fundamentals. Thus we must not sink into excessive pessimism, especially concerning the EZ. Even if conservatism is the watchword in the short term, the markets could, paradoxically, soon offer very interesting tactical investment opportunities (for instance, we would expect to see the equity markets rebound quickly after an "excessive loss"); the reasoning being all the more valuable if the UK stays in the EU. Nevertheless, whatever happens, Europe will come out of this referendum weaker, and investors must be prepared to suffer some setbacks on the markets.
  • In an environment where growth is resilient and interest rates promise to stay very low for a long period of time, strategies in search of yield will very quickly return to the fore after the vote. From a tactical viewpoint, discounted assets in Europe could benefit. From a strategic viewpoint, the weakening of the European continent will support the diversification of portfolios toward the emerging markets: these contain sources of securities that have attractive risk/return profiles and are, by their nature, less sensitive to Europe's political vagaries.

 

1 The emotion stirred up by the tragic assasination of an MP who was in favour of staying in the EU (Thursday afternoon) is likely to affect the vote of those who report they are undecided 

2 In case of independence, Scotland would nonetheless have to apply to join the EU, because the referendum's outcome is binding on the entire United Kingdom.

 

 

2016-06-17-focus
BOROWSKI Didier , Head of Macroeconomic Research
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United Kingdom: last straight line before a decisive vote
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