Brexit: Is it moving markets?
March 9, 2016
With the highly anticipated public referendum on Britain’s exit (“Brexit”) from the European Union (E.U.) set for June 23, the topic has begun to percolate among bond traders and other market participants.
At the moment, it seems fair to say that markets are already pricing in a “Brexit discount,” resulting in higher currency volatility and higher interest rates. As we move toward the referendum date, it seems to us that headline risk is likely to weigh more on the pound sterling and less on the euro, largely because Britain’s economy is substantially smaller than that of the broader Union. By and large, during times of market anxiety, a smaller economy stands to see its currency affected to a higher degree than a larger economy would.
We are also keeping in mind the possibility that the Bank of England may need to provide monetary easing to reduce the risk of weaker growth and tightening credit conditions. What’s more, we recognize the possibility that a European equity-market selloff could unravel, largely due to uncertainty about economic growth and financial market stability as investors try to make sense of a potential painful fracture in the Union.
Clearly, this is not politics as usual
We believe the United Kingdom’s referendum has ramifications that stretch beyond typical policy concerns; indeed, as noted above, the referendum is casting a shadow over securities markets as well.
Here are some brief bullet points to help illustrate the interaction between political and market forces that will be on hand as the date approaches, all of which can potentially influence international bond markets.
- If polls begin trending toward Britain’s remaining in the E.U., they may reverse today’s pessimistic markets. On the other hand, should the “leave” vote lead the polls, we believe securities markets may overshoot to the downside (possibly presenting opportunities to capitalize on price weakness).
In the case of an eventual “leave” vote, the U.K. would need to unwind its integration into the Union, potentially ensnaring many administrative resources for a long time. The economic and financial interaction between the U.K. and other E.U. member states is significant. Consider that as of 2014, E.U. trade with Britain amounted to $601 billion, representing 21% of U.K. gross domestic product (GDP), while accounting for 12% of exports and 9% of imports. Direct investment into the U.K. from the E.U. was $982 billion, while $709 billion went from the U.K. to the E.U. Portfolio investment was $1.9 trillion into the U.K. and $1.5 trillion from the U.K. Population migration from the U.K. to the rest of the E.U. was 133,500 (less than 0.2% of the U.K. population), while 222,800 migrants from E.U. member countries made their way to the U.K. in 2014.
- Direct effects on the E.U.’s economic growth may be limited to a gradual downward drag of 0.2–0.3%, while also reducing inflation by 0.1% over one year. We believe the effects on the British economy could likely be more significant. In the medium term, we think the Lehman Brothers collapse in 2008 and the pound’s 1992 exit from the European Exchange Rate Mechanism make accurate reference points for possible worst-case effects on GDP. Those events had an estimated effect on Britain’s GDP of -3.2% and -2.4%, respectively. (Data for the economic relationships described above: Bloomberg.)
In the months ahead, we’ll be keeping careful watch on developments in Britain, as well as doing some advance planning to make sure our portfolio decisions are based on thoughtful evaluation of the more prescient factors. We expect to have more to say as market speculation heightens over the “Brexit” versus “Bremain” contest.
Britain’s dissatisfaction with the E.U.
British Prime Minister David Cameron has long been skeptical of the E.U. His Conservative Party has shared the sentiment, leading him to pursue changes in the official terms of the U.K.’s membership in the Union. Working with E.U. officials, Cameron finalized a set of amendments on Feb. 19. The amendments were driven largely by the party’s belief that the U.K. has a brighter future if it has a looser association with the Union. This pessimism is based in part on:
- A lack of confidence in the Union’s relevance. Britain’s political integration into the E.U. is relatively weak. Most of the recent decisions made by the European Parliament have had little to do with Britain; they have largely focused on issues such as financial rescues for weaker member states and stronger governance within the banking sector. Broader collaboration aimed at long-term growth has been limited by the E.U.’s fiscal constraints.
- The notion that Britain should limit benefits to migrant workers. Cameron’s reforms allow Britain to restrict workplace-related benefits programs for migrants from other E.U. countries.
- Concern about membership costs. The U.K. currently pays £10.4 billion a year in fees to the E.U., and the sum may increase to £13.5 billion between 2016 and 2020.
The views expressed represent the Manager’s assessment of the market environment as of March 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s views.
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IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
The European Exchange Rate Mechanism, enacted in 1979, was conceived as a way to reduce exchange rate volatility among European countries. The system was dissolved in the early 1990s, on the heels of the U.K.'s withdrawal of the pound sterling from the system.