The Brexit question: Mixed signals, mixed messages, and mixed emotions
June 9, 2016
The United Kingdom is home to a diverse and highly functional economy, supported by a strong market structure and shareholder-friendly corporations. But British voters are inching closer to the possibility of handing the system a big shock, as they prepare to decide whether to stay in the European Union (EU).
The upcoming referendum on Britain’s fate, slated for June 23, could have wide ramifications. While many economists have released estimates about the effects that leaving the EU would have on the U.K. economy, these forecasts tend to differ. The Organization for Economic Cooperation and Development, for example, projects negative near-term effects that amount to a detraction from gross domestic product (GDP) of 0.8% per year and culminate in a long-term total shock of -5.1%.
Taking a more optimistic view, a group of economists known as the Economists for Brexit has estimated near-term economic gains of 0.4% per year and an overall long-term contribution of 4.0%. Proponents on both sides of the debate are sifting through multiple factors, which complicate any answer to this basic question: Is a British exit a good idea or not?
An inventory of the issues at hand
On the pro-Brexit side, supporters argue that Britain can handle itself quite well without the EU. They contend that Britain could quickly establish new trade pacts with Union members, perhaps following the model enacted by other nations around the world. Canada, for instance, has formed a binding free-trade relationship with the EU, one of the most ambitious among all trade deals the Union has conducted outside of the bloc. The agreement puts a big emphasis on reducing trade barriers, gradually eliminating tariffs on industrial and agricultural products.
On the other side of the fence, serious economists and professional analysts seem less sanguine. They point out that a British departure would come with deeply rooted drawbacks that include:
- increased volatility in the pound sterling, with the potential to embark on a prolonged run of depreciation
- a slowdown in Britain’s economic growth, which is already happening at the mere prospect of a Brexit; GDP growth for the first quarter of 2016 came in lower than the prior quarter, partly because companies are tamping down spending ahead of the referendum
- a possible economic knock to the City of London, one of the world’s leading financial centers1, as competing financial hubs could siphon away business
- risk of a long-term period of uncertainty about the fundamental underpinnings of Britain’s economy
- the potential to weaken the nation’s financial stability, which is already hampered by a current account deficit of 4.2% of GDP, a budget deficit of 3.6% of GDP, and slowing economic growth.
Clearly, the specter of a British exit has introduced a measure of uncertainty for investors. Below, some of our portfolio managers and investment analysts offer individual views and put some perspective on the types of fallout that could accompany the referendum.
Interpreting the referendum, possible complications, and market implications
Global Strategist — Macquarie Bank International Limited
Any assessment of the potential effects of a Brexit, for the U.K. as well as Europe, requires a lot of guesswork. One hard fact that we can draw on, however, is that 44% of the U.K.’s exports are to the EU but only 8% of mainland EU exports go to the U.K. (data: Office for National Statistics, United Kingdom*). Thus, from a trade perspective, a Brexit would have a disproportionately larger impact on the U.K. than the EU. This invites the question as to what will happen with trade should Brexit succeed. How soon could Britain re-establish trade agreements with Europe? Some argue this would happen quickly (between 6 and 12 months) while others argue that the process could take 5 or more years. We have yet to see estimates that are backed by rigorous justification, and investors should probably assume that these timelines are derived with a large measure of subjectivity.
Most analysts agree that a Brexit would likely result in extreme pressure on the British pound. This in itself implies higher volatility across asset markets, which is unlikely to be limited solely to the U.K. With global growth closer to 2% compared to approximately 4% before the global financial crisis, an external shock like a Brexit could have a larger-than-expected negative effect. (Data for global growth rates: Organization for Economic Cooperation and Development.)
One significant drawback that I am discussing with my team is the possible effect on sentiment within other EU countries. There has been speculation that a Brexit could prompt countries like Greece, Denmark, or the Netherlands to reconsider their membership. Others speculate that a Brexit would make countries like France vulnerable, particularly if Marine Le Pen, leader of France’s far-right National Front party, manages to put a referendum on the political agenda.
Interestingly, demographics could play an important part in the result of the referendum. The older generation (who have a higher propensity to vote) are nostalgic about life in the U.K. before it joined the EU in 1973. At that time, Britain had full sovereign control over all things British. A second notable demographic group includes (1) those whose jobs might be threatened by new migrant workers, and (2) the unemployed. This group tends to support Brexit. However, the younger generation with a higher education (and a lower propensity to vote) only knows life under the EU, and therefore tends to support Bremain.
Neither camp really knows what will happen if the U.K. leaves, and there doesn’t appear to be a coherent plan in place to coordinate the departure. Even those campaigning to leave admit that there will be economic pain for the U.K. in the short term. The market clearly believes that the pound and the euro will fare poorly in the aftermath; this is one sentiment that runs consistently throughout the debate.
* Data are effective as of Dec. 31, 2014.
Portfolio Manager — International Debt
During the past two months, we’ve seen the political environment within the EU become increasingly anti-immigration, anti-austerity, and ultimately, anti-Union. In early April, for instance, Dutch voters rejected a treaty between the EU and Ukraine, with “no” votes prevailing by a margin of two to one. In Spain, meanwhile, newly elected parliaments missed their deadline to form a coalition government as negotiations were blocked by the anti-austerity parties PSOE and Podemos. (Spanish voters are therefore heading to another election on June 26, three days after the Brexit referendum vote.) Elsewhere, the rise of far-right parties, such as Alternative fur Deutschland (AfD) in Germany and the National Front in France, has pushed the Union’s political orientation further to the right. I believe this shift could play a role in raising the odds of an eventual exit vote.
The past two months also have delivered sobering news about the British economy, as indicators have generally trended weaker. This is important because a softer economy generally provides fodder for Brexiters, and they have seized on several red flags that appeared during the first quarter of 2016. First among these was a GDP growth reading of 0.4% (quarter-over-quarter), down from 0.6% in the fourth quarter of 2015.
Whether the referendum passes or fails, there’s a strong argument to be made that it would be more important for European officials to focus on alleviating the structural imbalances and debt levels that currently work against the European economy. Even the slightest improvement in these areas will enhance the growth potential of the Union and its member countries. However, I am realistic about sources of friction, including (1) long-term fiscal imbalances in the U.K., (2) structural debt issues in certain EU countries, and (3) ineffective political decision making within the Union.
Margaret MacCarthy Bacon
Investment Specialist — Global / International Value Equity
Within the International Value Equity team, we are cautiously optimistic that the U.K. will vote to remain in the Union. However, if voters choose to leave, we believe the effect will be negative for the U.K. economy in the short term. Membership in the EU offers the advantage of being part of one of the largest unified markets, which allows people, capital, products, and services to move without restraint. Being part of a larger whole offers each member better bargaining power, especially with regard to trade and military agreements.
Although the euro zone economy has slowly improved since the debt crisis, the recovery has been somewhat fragile and equity markets do not like uncertainty. A Brexit may worry U.K. investors, which might delay future investments, slow the rate of hiring, and jeopardize economic growth. This in turn could further weaken the British pound as well as the euro.
Brexit proponents contend that the EU has diminished Britain’s authority as a world power. They believe that the EU has had too much control over legislation that has adversely affected the U.K.’s taxes and national finances, and has facilitated excessively high levels of immigration. They have argued that once outside the Union, poorly written laws can be rewritten and trade agreements can be renegotiated to better benefit the U.K. But our investment team is concerned that all of these revised agreements and legislation will take time to negotiate and vote on — probably carrying on for several years. In the meantime, capital inflows may be reduced, supply chains may be disrupted, and tariffs could be levied. It’s also feasible that the EU may not treat the U.K. favorably during renegotiations, in order to discourage other countries from trying to exit the Union.
Lower loan growth for U.K. banks and reduced investment in real estate may occur as investors postpone decisions due to uncertainty about the consequences of the referendum. An exit could also cause rating agencies to lower the U.K.’s sovereign debt ratings.
It’s worth remembering that the U.K. has survived financial uncertainty before; it has persevered through the aftermath of two world wars, the 1973 oil crisis, several depressions, and several recessions, including the so-called Great Recession and the European debt crisis. We believe the U.K. can survive a Brexit as well — but we expect markets would be volatile for quite some time.
Senior Portfolio Manager — Global Ex-U.S. Equity
My teammates on the Global Ex-U.S. Equity team and I believe that if Britain leaves, it will produce a wave of uncertainty that European markets have not experienced since the Great Recession. Investors will be left to wrestle with questions about how disruptive Britain’s disentanglement from the Union could be. Markets will also be challenged to make sense of what the U.K. would truly look like going forward, and just how much animosity it would encounter from the EU.
Overall, economic forecasts look bleak under a “leave” scenario. A long list of respected research organizations have issued reports concluding that a Brexit would weaken the U.K. economy. We think the negative economic effects could be felt for years.
In asset markets, foreign exchange is among the biggest areas of concern, and investors are understandably preoccupied with the possibility of currency volatility. Again, uncertainty is the biggest pain point, and the British pound is not immune from it. At first glance, a weaker currency might seem like a plus for British exporters, but we think the global nature of the supply chain would probably temper the positive effect. Equities are already feeling the pressure as well. We think a formidable list of industry groups could see some further softening, including homebuilders, utilities, banks, and retailers.
Another potential negative outcome involves a high probability that inertia will spread throughout the economic landscape. This would inhibit decision making across the board, leading to slowdowns in consumer spending, business spending, and capital expenditures. Already, industrial businesses are feeling the results of uncertainty as customers delay orders until there is better clarity about what lies in store.
With most aspects of the Brexit question, the things we know are overshadowed by the things we don’t. Speculation is the order of the day as analysts attempt to keep track of many moving parts. Matters are complicated by the fact that the issues are not limited to matters of economics; they are also ensnared in the political realm. Campaigners in favor of leaving the Union are appealing to a base that views the EU as an overbearing bureaucracy that stifles the country’s sense of political identity. This brings yet another source of uncertainty into the mix, as investors wait to see if other European nations pursue similar referendums. (Other countries are currently grappling with the increasing influence of opposition parties, making this threat more and more credible.)
Bringing it all together: Our collective outlook is for delicate conditions ahead
In the event that British voters choose to leave the EU, we believe negative consequences will ripple through financial markets for some time. Perhaps most damaging of all, from an investment perspective, would be a long period of market uncertainty, with little or no guarantee that Britain could quickly negotiate new trade agreements and maintain a healthy flow of commerce with trade partners.2 Broader effects at the macroeconomic level would likely unfold even more slowly, as lawmakers and government officials make difficult decisions about new administrative relationships — and new implications for trade — within the European Union.
1 London is by far the most important financial market in the EU. It is the largest net exporter of financial services in the world, with a strong presence in markets for foreign exchange, bonds, derivatives, and fund management. The city accounts for 41% of global foreign exchange turnover, more than double the value processed in New York, the next-largest competitor.
2 Headwinds include the sheer number of trade pacts that would need to be replaced: 53. Some negotiators would be extremely tough — South Korea and Mexico stand out — and on the whole, it’s unrealistic to assume that agreements will fall into place very easily. Overall, when it comes to the possibility of restoring trade relationships, the "unknowns" trump the "knowns."
The views expressed represent the Manager's assessment of the market environment as of June 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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