Brexit may strike fear into the hearts of business leaders, but it has not yet exercised markets very much. No one is yet eschewing British assets on the basis that we may no longer be a springboard to Europe, while currency, equity and bond markets are apparently untroubled by the prospect of a departure from the European Union. But should they be so sanguine?
It is almost impossible to forecast the outcome. David Cameron’s election promise was to attempt a renegotiation of the terms of British membership of the EU and hold an in/out referendum by the end of 2017, but for the time being, this is one of the very few things on which investors can be certain. Until recently, Cameron has been deliberately vague on the terms of the renegotiation in order to prevent any Eurosceptic backlash should he fail to meet the exact terms. Nevertheless, on 10 November, he set out his four key objectives for the renegotiation. The first involves economic governance. Cameron wants assurances that steps to deeper financial union in Europe cannot be imposed on non-eurozone members. He also wants to ensure the UK is not compelled to offer any bailouts to eurozone countries but equally that the UK is not disadvantaged by being outside the single currency. Cameron has also demanded the reduction of red tape and “excessive” regulation.
But perhaps the most important – and contentious – are Cameron’s demands on sovereignty and immigration. It is widely thought that most UK citizens do not have a problem with economic integration with Europe, but labour mobility is particularly unpopular. The Prime Minister wants to restrict access to certain benefits to EU migrants until they have been in the UK for at least four years. He also wants to move away from the EU’s founding ambition of “ever closer union” and to give national governments greater power to block EU legislation.
He may or may not get these concessions. European leaders have been willing to negotiate, although they have balked at the idea of “discriminating” between EU citizens. If he gets these concessions, he may decide that no referendum is needed and that will be the end of that. Britain can move forward happy in the knowledge that it has Europe exactly where it wants it.
But what if that doesn’t happen? Then there will be a referendum. The timing of this is difficult to predict, particularly if it is held up by moves to lower the minimum voting age. Equally, the exact wording of the question is difficult to predict. At the moment, the frontrunner is: “Should the United Kingdom remain a member of the European Union or leave the European Union?” The responses would be “Remain a member of the European Union” or “Leave the European Union”.
Investors can then expect months of speculation about the impact of a Brexit, plus campaigning from both sides, which will be disruptive in itself. Then there is the vote. If the British public vote to stay, everything carries on as before. If they vote to leave, there are huge questions over the terms of the exit.
If the UK votes to leave then the Government would have two years to negotiate a withdrawal agreement under Article 50 of the EU Treaty. But many questions remain. Would the UK adopt a model like Norway, in which case not much would change? Or a model like Switzerland? Or a customs union, as Turkey has? Or would it just rely on World Trade Organisation rules? To what extent would the EU allow us to retain economic ties? Perhaps the only certainty is that the lawyers would be very busy.
“If you are an American, Chinese or Indian company thinking about where to put your new plant, would you put it in Sunderland or Leicester when you don’t know whether the UK is in or out of Europe?”
Given this uncertainty, should investors care at all about Brexit? After all, if it is so difficult to predict, should they not focus their attention on other, more tangible, problems? David Coombs, head of multi-asset investment at Rathbones Unit Trust Managers, is clear that Brexit matters. “We believe Brexit is the biggest macro risk affecting our strategy,” he says. “This is more important than a spike in the oil price or a US interest rate rise.
“The reason this is so important, is that while Brexit is unique to the UK, the contagion risk is high. Where the UK leads, the Poles or the Dutch may follow.
“Euroscepticism is rising across Europe and we are seeing the rise of extreme parties. Portugal, for example, has just elected a left-wing government. This may be a reaction to the migrant crisis or to austerity, but Brexit is bigger than the UK and the market is complacent about it.”
Equally, says Coombs, it is not just Brexit itself, but the threat of Brexit that may cause significant disruption. “If you are an American, Chinese or Indian company thinking about where to put your new plant, would you put it in Sunderland or Leicester when you don’t know whether the UK is in or out of Europe? As such, foreign direct investments (FDI) may pause while people wait to see what the mood is.”
The question is when to move out, though. “Given the lack of certainty, do you wait until six months before the vote? None of it is good news in the short-term. It affects all UK assets badly until there is some certainty and that may not happen for a while. There is widespread consensus that the UK being in Europe is good for business. As a result, we are underweight sterling and UK equities. We hold US treasuries and lots of non-domestic assets.”
Would an exit be bad for the economy? Again, any analysis depends on a range of questions: What would be the terms of the exit? Would Europe become protectionist? Would we find new trading partners outside the EU? It can hardly be a coincidence that Cameron has hosted Chinese and Indian leaders in recent months.
Independent think tank Open Europe has suggested UK GDP could be 2.2 per cent lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU, or reverts into protectionism. The real risks come from a reduction in FDI. The UK is the EU’s largest recipient of FDI and Brexit could reduce the attractiveness of the UK as a gateway to Europe.
However, the Open Europe report also says: “In a best case scenario, under which the UK manages to enter into liberal trade arrangements with the EU and the rest of the world while pursuing largescale deregulation at home, Britain could be better off by 1.6 per cent of GDP in 2030. However, a far more realistic range is between a 0.8 per cent permanent loss to GDP in 2030 and a 0.6 per cent permanent gain in GDP in 2030, in scenarios where Britain mixes policy approaches.”
That is verging on suggesting that in the long run, leaving the EU may not make a lot of difference. Certainly, there are arguments countering the theory that FDI will reduce – for example, the UK may compete more aggressively for investment by undercutting the EU on taxation and the business environment.
Coombs believes the long-run outcome may be neutral. He says: “In the longer-term it might not make very much difference to the UK. Policymakers will be compelled to find an economic solution. For Scotland, the maths of an exit didn’t work, but the UK can carry on.”
However, this is not the narrative of the business community. John Cridland, CBI director general, has been strongly in favour of remaining in a reformed Europe. He says: “The CBI speaks for 190,000 firms of all sizes, in every sector and in every corner of the UK, and most of our companies want the UK to be in a reformed EU. For business the benefits of full membership outweigh the disadvantages, but the EU must work better. The single market has been the solid foundation of our economic success in recent decades, giving us direct access to eight times more consumers than in the UK alone and ensuring we can go toe-to-toe with larger economies on major trade deals, creating jobs and economic growth here in the UK.”
Amid all this debate, it is tempting to forget that the UK is an important market for many European countries, although not to the extent that Europe is for the UK. This will inform negotiations and gives the UK bargaining power in the event of an exit. Dr Gregor Irwin, chief economist at Global Counsel, said in its report, ‘Brexit: the impact on the UK and the EU’: “We conclude that the member states most exposed to Brexit are the Netherlands, Ireland and Cyprus. Each has very strong trade, investment and financial links with the UK and, in the cases of the Netherlands and Ireland, are closely aligned in policy terms.
“Among the larger member states, Germany would be affected through several channels, but perhaps most profoundly by the loss of the UK as a counterweight to France in policy debates. France may welcome the absence of the UK in policy debates but, like Spain, it has substantial direct investments in the UK. All member states would, however, regret the loss of international influence enjoyed by the EU without the UK, and the damage that Brexit would do to the esteem of the EU globally.”
Nitesh Shah, research analyst at ETF Securities, says there could be disruption along the supply chain. “European companies may have parts made in the UK and vice versa,” he says. “The whole supply chain could be extremely disrupted by an exit. This will cause reverberations not just for the UK, but for lots of European companies as well.
“If it is looking like a finely balanced vote, there will be a lot of volatility. What rules and regulations will they need to abide by? Lots will end up looking exactly like they are at the moment. In the long term, it may be business as usual, but there will be a lot of time lost in the meantime.”
For financial assets, the problem may be less about the long-term outcome and more about the short-term disruption. Brexit would be a long, complex process that, according to Global Counsel, could take up to 10 years. Coombs believes all UK assets could be impacted by the furore leading up to a referendum.
The reaction of the ratings agencies may be important. If they downgrade UK debt, it could push up the cost of government borrowing at a time when interest rates are rising. S&P has already made its feelings clear. In June, it wrote: “We revised our outlook on the long-term sovereign credit rating on the United Kingdom to negative from stable because we believe the plan to hold a referendum on EU membership indicates that economic policymaking in the UK could be at risk of being more exposed to party politics than we had previously anticipated. A potential exit of the UK from the EU poses a risk to growth prospects for the UK’s financial services and export sectors, in our view.”
Bill McQuaker, head of multi-manager at Henderson Global Investors, says: “In the event of an exit, I would worry about the global appetite for sterling assets. The UK has a significant current account deficit, which needs to be financed by global capital flows. If there is a Brexit capital flows could weaken for some time. Sterling would almost certainly weaken.”
That said, McQuaker believes the gilt market will be less susceptible. He points out that government bond markets have tended to shrug off debt downgrades for other developed markets.
Simon Gibson, director at Mattioli Woods, says: “Currency is our number one concern. It affects lots of sectors and lots of other assets for different reasons, but thinking back to the Scottish referendum, sterling fell 4 per cent in a week. Brexit could be a considerably bigger impact.”
Of course, there are sectors that would benefit from a weaker sterling, but it will have an impact for investors.
-2.2% UK GDP could be 2.2 per cent lower in 2030 if Britain leaves the EU and fails to strike a deal with the EU, or reverts into protectionism.
1.6% Britain could be better off by 1.6 per cent of GDP in 2030, although a more realistic range is between a 0.8 per cent permanent loss to GDP and a 0.6 per cent permanent gain if Britain mixes policy approaches.
Certain industries will be more vulnerable than others. Insurance group Atradius has looked at the industries likely to see most disruption from a Brexit. It found manufacturing the most vulnerable. It says: “In the chemicals, mineral fuels and manufactured goods industries, over half of its exports go the EU. With such large volumes of trade, any disruption will have an immediate impact. This would be felt especially strongly for oil and gas companies, part of the chemicals sector, which on average send over 77 per cent of their exports to Europe.”
It also highlighted the automotive industry, which would lose benefits from EU funds for manufacturing research and development. That said, the service sector is far more important to the economy as a whole. On this, Atradius says: “About one third of insurance and financial services exported from the UK are sent to the EU, and the UK has a trade surplus with the EU of £19.8bn. Trade negotiations for the services sector will be much more difficult than for goods. Therefore the sector is extremely vulnerable to changes in trade and more at risk of not having similar access to the single market. EU regulations would especially be an obstacle for retail banking and euro traders.”
However, it adds that while some services may relocate, it would be almost impossible to replicate such a large network of financial and professional services elsewhere.
City Financial investment director Peter Toogood is sceptical about the impact on the financial services industry. “Would a Brexit challenge the financial services industry? I’m not sure,” he says. “The Germans make cars and we do finance. Are asset managers going to up sticks and move to Frankfurt just because we are not part of the EU? There are concerns: a common thread of law and legislation is an advantage, though much of this is coming from the US in the first place. The Europeans may make it difficult, but there is still the Free Trade Area. It is difficult to see that the UK has received any special favours as a result of our membership of the EU. There are issues over access to a talent pool, but I believe aspects such as natural law, free trade and the lack of barriers and red tape for business are far more important in that respect. Overall, we will probably just become a bit less relevant.”
Toogood believes the financial services sector is already global in nature and, as such, the impact of a Brexit would be limited.
McQuaker says larger multinationals would be barely affected, while the FTSE 250 or more cyclical stocks may be vulnerable. He says: “The large companies such as pharmaceuticals and tobacco would be largely immune to some of these effects. The majority of their business is outside the UK and, in fact, a drop in sterling may be good news. Those areas that are more reliant on access to the European single market will inevitably suffer. These may be the more cyclical parts of the economy, perhaps the FTSE 250.”
Political disruption is a known unknown. There remains a danger that Brexit will unseat the incumbent government and this could cause problems. Eric Moore, manager of the Miton Income fund, says: “Over the past 20 to 30 years, whoever has been in Number 10 hasn’t disturbed the aims and movement of multinational capital. Trade barriers have gone down and shareholder democracy has gone up. We may have become a bit blasé about that.
“A bigger risk than the UK in Europe is whether a long-term pro-business environment remains. We are seeing an increasing amount of extreme right-wing and extreme left-wing politics in Europe. We believe the risks to the European project are high.”
What will galvanise investment managers into caring about Brexit? McQuaker believes that the date of any referendum will be important. At the moment, it is abstract, but once the countdown has started it will focus investors’ attention. Equally, he says, events matter. The atrocities in Paris, for example, will shape public thinking on border controls and may influence David Cameron’s position in the EU negotiations. To date, the debate on Brexit has been largely economic, but the mood of the nation could be quickly changed by events.
The long-term economic impact of Brexit is hard to discern and may be negligible, but the short term disruption while the UK negotiates and renegotiates is only likely to be bad news for sterling assets. It might provide a relative fillip for the beleaguered multinationals of the FTSE 100 and in the long term, some industries may benefit from being out of the EU, but it is difficult to see many winners while the UK redefines its relationship with Europe.
Should politics inform investment analysis?
David Coombs, Rathbones: “Politics matters. For example, the consensus is that Jeremy Corbyn is unelectable, but that, to me is hugely complacent. If he does well in the Welsh or Scottish elections, or with the 35 per cent of people who didn’t vote last time, it could have a massive impact. Politicians set fiscal policy. The trouble is, it is very hard to predict.”
Eric Moore, Miton: “Political impact is hard to quantify. We have to run our fund for a central case, but with a mind to the extreme cases. Our central case is that the UK will muddle through, but we are keeping an eye on the alternative scenario.”
Simon Gibson, Mattioli Woods: “We do a lot of strategic long-term thinking, but also aim to be mindful of more tactical considerations, such as political change. Prior to the General Election in May we took off half of our UK exposure. That said, we believe assets will only start to move closer to the referendum. At the moment, it is part of our discussions, but not reflected in our portfolio.”