James Bevan: Pricing the risk of Brexit
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James Bevan
As we know, the long anticipated UK referendum on UK membership of the European Union will take place on 23rd June and we’ve long assumed that on balance, the most likely scenario is that Britain votes to stay in the EU.
But given there’s a risk that the vote is to leave, perhaps the critical question for us and our clients is whether ‘Brexit’ be bad for the assets held in the client portfolios and funds.
“Neverendum”
We need to begin by distinguishing between how markets will react to the risk of a Brexit, and to the actual reality of Brexit – if it happens.
Until 23rd June there will be considerable volatility, and, sterling, in particular, could suffer (it has already fallen by 5.5% vs the dollar and by 7% against the euro this year) as markets, preferring stability, wish the UK to stay in the EU.
The stock market effect has not yet been noticeable. The FTSE share index is overwhelmingly weighted towards multinationals with little reliance on the UK economy – and this will likely remain the case even in the event of a Brexit as the fortunes of companies like Unilever, GlaxoSmithKline, Diageo, HSBC and Royal Dutch Shell are unlikely to be affected much by UK membership of the EU.
It is the longer-term implications, however, that are far more complicated and difficult to predict. In particular, we cannot discount the risk of a ‘Neverendum’.
This latter sobriquet refers to the possibility of a Quebec-like situation resulting from a very close vote to stay.
Under such a scenario, politics become ugly as the ‘ins’ and ‘outs’ continue to skirmish and a further referendum gets called at a later date (as in Quebec). And, in the meantime, the country loses ground economically as investment is discouraged.
Interestingly, this has been the consequence of 2014’s referendum on Scottish independence. The Scots voted to stay in the UK by a margin of 10%, but the chief protagonists of departure from the Union, the Scottish Nationalist Party, have continued to campaign tirelessly for independence – despite describing the referendum as a ‘once in a generation’ vote beforehand.
Surplus services
The arguments presented by the ‘ins’ and ‘outs’ are well rehearsed.
- The ‘outs’ argue that Britain would benefit from being free of some £10bn p.a. of EU dues; the myriad of social, employment and environmental regulations; the impact of open borders to EU migrants – not to mention the Common Agricultural Policy and the Common Fisheries Policy. In addition, Britain would be free to sign up to free trade deals with the US, China and others, whilst retaining fairly full access to the EU single market.
- The ‘ins’ counter that the UK has benefited considerably from the single market. Tariffs have fallen and the EU now accounts for 45% of the UK’s exports of goods and services (whilst only 6.6% of the EU’s goods and services are exported to the UK). They argue that Britain is actually very lowly regulated according to the OECD, and the UK is by far the least regulated country in the EU. They also claim that Britain has actually benefited from migration with young skilled and semi-skilled migrants from Eastern Europe making the UK economy more dynamic and competitive.
Perhaps surprisingly, the UK is the largest exporter of services in the world after the US and – on a per capita basis – greatly outstrips the US.
According to John Kay, writing in the Financial Times, Britain has a trade surplus in almost every service except tourism.
In areas such as financial services, transport, communications, education, entertainment, publishing, information services, public relations, engineering consultancy, law and accountancy, Britain generates strong net service exports.
Indeed, these exceed Britain’s largest manufacturing exports (of cars and pharmaceuticals) by over 50% in each case.
The single market in such services is, for now, less developed than in manufactured goods but the UK has secured a commitment to open up the market in this area too in future. If it were to leave the EU, therefore, this potential long-term benefit to the UK services sector would be lost.
Institutional brake
The true economic effects of a Brexit are unlikely to be known for a number of years and are, in any case, hard to predict.
Some have tried – thus, for example, a highly regarded think tank, Open Europe, has modelled the impact on UK GDP in 2030, assuming that if the vote is to leave, Brexit takes place on 1st January 2018.
Their best case scenario is a free trade deal with the EU, open borders to global trade and deregulation of the UK economy, and this adds 1.6% to GDP.
Their worst case scenario is failure to agree a trade deal with the EU and no free trade policy and has GDP falling by 2.2%. Open Europe’s central base case scenario is for a permanent effect on GDP in a modest range of +0.6% to -0.8% a year to 2030.
One of the big risk factors in a Brexit, which is rarely mentioned, is the higher degree of dependence it puts on the British electorate to make the right choices in general elections over the years ahead.
The current relatively business-friendly Conservative government will inevitably be replaced one day by a more left-wing government that is at least in relative terms, anti-business, anti-free market, high spending and interventionist, similar to what we had in the 1970s.
At that point, the stability and discipline provided by the EU membership would not be there. The value of this institutional brake was evident last year when a radical, socialist government in Greece was quickly made more moderate.
Another benefit of the EU over the last 25 years has been the stability provided by a common economic framework.
The competitive devaluations and higher spending of the 1980s – that led to high inflation – have been replaced by fairly co-ordinated economic policies.
Whilst monetary union has not been a success and the structural deficiencies are self-evident, we have not had a return to the more extreme policies pursued by various European governments in the 1970s and 1980s.
Equally, the benefits of the Thatcher period in the 1980s in the UK, that created the foundation for a more dynamic economy have become entrenched. Without the discipline and competitive pressure created by EU membership, these could, at some stage, be put at risk by an independently-minded government tempted to use devaluation and public spending to ‘rescue’ the UK from an economic downturn.
Impact
In terms of stock market impact, the performance of the share market in dollars since the referendum was called (in line with other European markets) suggests that large-cap UK equities are a natural hedge.
Mid-cap equities are more at risk, given that they are more exposed to the UK economy and have more limited or no foreign earnings.
So, the likes of retailers, housebuilders, leisure, property and certain financials, would suffer from a weaker economy and the impact of a weaker currency in the event of a Brexit, but such companies represent a small part of client portfolios relative to some peers.
The implication for European equities overall could be negative, not least because of the size of the UK market in the European index (30%), but also because of the disruptive effect on the European economy and the knock-on effect of Brexit on politics in other European countries where plebiscites may also be encouraged.
This could also increase the risk premium for European equities. Another risk factor for the UK is the high probability of another Scottish referendum in the event of a Brexit as the ruling Scottish Nationalists want to remain within the EU, a stance that opinion polls suggest a clear majority of Scots support.
In summary, our base case is that a Brexit will not occur, but a lot of the above risks are likely, at some stage, to be at least partially priced into currencies and markets over the coming months.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
