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The Brexit Referendum

20 Apr 2016

Chris Darbyshire, Chief Investment Officer

With three months to go to the EU Referendum, we highlight the impact that the uncertainty around the vote and the eventual result is having on the economy.

If it is true that capital markets abhor uncertainty, they should not like the United Kingdom European Union membership (’Brexit’) referendum. For the next three months this media-monster will ravage Britain’s reputation for stability and pragmatism and the attractions of Britain as a destination for Foreign Direct Investment. Meanwhile, political opportunism will be rife both between and within parties. Celebrities will chime in, both British and foreign. It’s going to be Big Brother on a national scale.

Current polling broadly shows an even split between voting to ‘Leave’ versus voting to ‘Remain’, there having previously been a bias towards Remain of about eight percentage points. There is a curious discrepancy between online and telephone-based polls, with online polls neck-and-neck, whereas telephone polls suggest an 11-point lead for Remain. Betting websites are more certain that Remain will win, ascribing only a 33% probability to Leave, although this too has moved higher in recent weeks. There is still a significant proportion of undecided voters (about 8-14%), but the main source of uncertainty seems to be in the degree of turnout. Of those who actually plan to vote, there is a significant bias towards Leave. This bias derives partly from demographics: younger people tend to want to Remain but are less likely to actually vote, whereas older people tend to want to Leave and are more likely to vote. The result on the day may be decided largely on the basis of who is most motivated to leave the house.

Voters are also split along party lines. Among Labour and Liberal Democrat party voters there is a decided majority in favour of Remain (about 65% in favour across both groups). Conservative party voters are the swing factor, with Brexit support currently averaging around 55%. Finally, voters are also split on the issues at stake. Those in favour of Leave see the referendum as principally about immigration into the UK, whereas those wishing to Remain see it as a matter of economic wellbeing.

Events leading up to the referendum are also going to play a role. Recently, Prime Minister David Cameron has become embroiled in the Panama scandal. This may be significant as he is widely recognised as the most influential spokesman in favour of staying in the EU. Ironically, the Prime Minister will need the support of his political enemies in the Labour Party if he is to win the vote, something that may be impossible to rely on if his adversaries feel the need to distance themselves from him. The referendum may even become politicised along party lines, becoming a referendum on Cameron and the Conservative government, at a time when the Conservative Party is likely to be engaged in very public infighting. Meanwhile, in Europe the Migrant Crisis continues to fester and risks turning Brexit into a referendum mainly on immigration. Britain’s national statistics office will release its usual quarterly data on immigration during the run-up to the vote, providing an update on the scale of the Migrant Crisis.

The Leave campaign was recently boosted by the declaration of support from Boris Johnson - Mayor of London, prime-ministerial hopeful and one of the few, senior politicians in the UK who has a claim to charisma. Sterling immediately dropped precipitously. Surveys suggest his decision influenced 25% of voters in favour of the Leave campaign. Two senior ministers within the government have also defected to the Leave camp and one can expect more defections if the Leave campaign gains a lead, making it politically opportunistic to join. Regional elections are taking place during the run-up to the referendum, and a poor performance there would encourage more of Cameron’s own party to turn against him.

The economy and capital markets are another source of unexpected events. The latest surveys suggest British business confidence is dropping as a direct consequence of the referendum. Several metrics, such as the general level of uncertainty, the desire to take risk, expectations for margins and for cash flows are down, in some cases to 2009 levels.

It is tempting to think that business decisions in Britain will simply stop dead ahead of the referendum, as is already the case with many foreign investments into Britain. Expectations for UK GDP growth in 2016 have already declined significantly over the past few months - if the economy slows further during the second quarter it could lead to additional declines in Sterling, at a time when the currency’s sensitivity to Brexit is already reaching a crescendo.

This would be as nothing compared to the potential impact on Sterling of a vote to Leave, which would prompt even stable, long-term foreign investors to reconsider their presence in Britain. Without its special position as an English-speaking stepping-stone into Europe, it is hard to see what can offset the UK’s huge trade deficit, apart from a much cheaper currency and very cheap asset prices. But this leads to inflation, suggesting that, even by the end of this year, the UK might be suffering falling growth and rising inflation – an echo of the ‘stagflation’ that persisted in the 1970s. Ironically, it was economic conditions of this kind that were partly responsible for encouraging membership of the EU in the first place.

What makes the referendum particularly difficult for investors to judge is the likelihood that extreme market conditions in anticipation of the vote would effectively scare voters towards Remain, thereby neutralising the conditions that caused market volatility and causing Sterling to snap-back even before the vote. Thus the run-up to 23 June might be difficult to manage. The day of the referendum itself brings, obviously, significant binary risk, especially in the case that the result differs materially from the advance polls. If this were the case we could see a historically large move in Sterling. That a nation should seek to leave a trading union with its biggest economic partner could appear inherently nonsensical to some, even before taking into account the years of effort - at every level of governmental, institutional and business entity - that have gone into making that partnership work.

From the British point of view, this is an existential moment. At stake is more than just Britain’s relationship with the European Union: a vote to leave on 23 June would cost the Prime Minister his job and would be likely to trigger another referendum on Scottish independence from the UK, possibly triggering substantial changes to Britain’s sovereign status. From the point of view of international investors, Brexit is a unique, and bizarre, risk. That a nation should seek to leave a trading union with its biggest economic partner could appear inherently nonsensical to some, even before taking into account the years of effort - at every level of governmental, institutional and business entity - that have gone into making that partnership work. The obvious response of foreign investors to such risks is just to avoid them, suggesting an outflow of capital from UK listed assets and, principally, Sterling. While Brexit has been a feature of British life for several months already, the implications of the referendum may not yet be fully appreciated abroad. Ahead of us lies three months of increasingly frenetic debate, media frenzy and unexpected events. Only the most extreme news stories will capture the world’s attention, no doubt throwing a sensationalist light on proceedings. No-one will want to be caught holding Sterling unnecessarily when that happens – therefore our portfolios currently have minimal weightings to Sterling in favour of US Dollars, Euros and Emerging Market currencies.

The implications for UK assets apart from Sterling are more tricky. Many listed UK companies operate globally. Among the constituents of the FTSE 100, some 75% of revenues are derived from outside the UK. These companies have relatively little exposure to the UK economy and will benefit from conversion of foreign earnings into Sterling at a favourable rate. Within the mid-cap FTSE 250 there is likely to be a performance bias in favour of exporters. We have moderately increased our allocations to FTSE 100 companies in the expectation that, in order to avoid UK economic exposure, UK-based holders of smaller UK companies may switch into larger capitalisations. In the fixed income space our concerns are mainly with the Gilt market, to the extent that foreign investors use Gilts to maintain Sterling exposure. Sterling-denominated corporate bonds are principally owned by investors based in the UK who are, effectively, neutral to currency movements.

The conventional wisdom is that the British public will vote to Remain, based on the inherent conservatism of electorates when faced with threats to their status quo. Why take a leap into the unknown? In this case I think the conventional wisdom will prove to be correct. It is difficult to see how or why life would be any better in the event of a Brexit. We might be able to undo some absurd EU regulations but we would have equally inconvenient rules put in place if we want to continue to trade with the EU on the terms we have become accustomed to. If we don’t want to trade with the EU then we had better get used to a lower standard of living, so in or out we will need to reach a viable agreement.

Chris Darbyshire
Chief Investment Officer

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The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.
The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

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