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Implications of the Brexit referendum May 2016

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The ‘Brexit’ referendum on Britain’s European Union (EU) membership, due to take place on 23 June, represents one of the main investment risks of 2016. Within this document we focus on the economic and investment implications of the referendum, highlighting areas that we expect to be most heavily affected.

In order to predict how economies and investment markets might act in advance of and following the referendum, it is necessary to understand Brexit’s potential consequences and how uncertainty affects markets more generally. We can be fairly sure that uncertainty will continue to weigh on the UK economy and its investment markets in the period running up to the referendum, as long as its result is in question. Likewise, continental European economies and markets may feel similar effects. Furthermore, we see potential for contagion to spread through Europe.

Ultimately, a vote to leave could extend any pre-referendum uncertainty for a number of years. However, there is no precedent of any secession from the EU on this scale and it is impossible to say with confidence what the longer-term consequences of a Brexit might be. Despite this, it is clear that some areas of the economy, such as trade and financial services, will be more heavily affected than others.

Trade

The EU is by far the UK’s largest trading partner, taking almost half of its exports and providing just over half of its imports. Through its EU membership, the UK is automatically included in the European Economic Area and benefits from trade agreements with numerous other countries around the world. These cover around four fifths of its import / export business. If the UK leaves the EU, its existing trade agreements will eventually have to be renegotiated.

In summary

Brexit-related uncertainty is likely to weigh on asset prices and economic activity as long as the referendum’s result is in question.

However, the potential longer-term effects of a UK succession are much harder to quantify. A Brexit would require the renegotiation of existing trade agreements.

At a glance: European Economic Area

The European Economic Area (EEA) allows free movement of persons, goods, services and capital between its 31 member states - the members of the EU, Iceland, Liechtenstein and Norway.

It is likely that the UK will have to make certain concessions to remain within the EEA if it leaves the EU. For example, Norway has had to contribute to the EU’s budget and comply with its labour restrictions.

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Figure 1: UK trade with the EU and the rest of the world

The chart shows how important the EU is to UK trade. However, given that the UK imports far more from the EU than it exports to it, other EU member states will be reticent to abandon UK trade channels.Source: Office for National Statistics, 2014 data

Since the UK maintains a trade deficit with the EU (Figure 1), it is likely that other EU members will be keen to maintain UK trade links in the event of Brexit. This could mean current agreements being extended in the short term. However, if both parties are unable to agree to such arrangements, UK and EU trade activity could come under pressure, weighing on economic growth.

Figure 2: Composition of UK exports

Service industries make up around three quarters of UK exports, while the financial industry represents just over one fifth of the total.Source: Office for National Statistics, 2014 data

Over the longer term renegotiations of trade agreements are likely to be complicated, particularly in relation to the service industries due their heterogeneous nature. These make up around four fifths of the UK economy (Figure 2). A key area of negotiation will surround which EU rules the UK will have to comply with in order to maintain trade agreements. It is very difficult forecasting the outcome of any trade negotiations, although these will have a large bearing over the path of UK and EU trade in the future.

In the short term, it would be in the interest of both the UK and EU to maintain trade links in the event of a Brexit. Over the longer term trade agreements would have to be renegotiated, but quantifying the longer-term effect is difficult.

“The opposing views of the British Prime Minister and the Mayor of London are characteristic of the split in sentiment towards the EU across the UK.”

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Some argue that the UK would be able to establish a more favourable regulatory environment outside of the EU, but it is unlikely that the European Securities and Markets Authority (ESMA) would allow UK-based financial companies to operate in Europe without adopting equivalent regulatory structures, such as the Markets in Financial Instrument Directive (MiFiD) II. While preserving the ability to passport services would very likely require regulatory equivalence, it is possible that the added risk accompanying non-EU status would lead to some repatriation of financial activity to both Europe and the world’s other financial centres in any case.

London could clearly no longer be seen as the European financial capital, but that does not mean that it would necessarily stop being the dominant financial centre in Europe. The incumbent position and network effects provided by London’s long history as a financial centre should ensure some insulation from any major exodus of financial activity.

In summary

We have already seen Brexit uncertainty cause a weakening of the pound - it was telling that the currency’s sharpest losses of the year came in the week following Mayor Boris Johnson’s high-profile announcement supporting a UK exit (Figure 3). It could be argued that Brexit uncertainty has also weighed on the performance of the financial sector in 2016, although this is less clear given the multitude of other headwinds the sector has faced. The referendum has also caused a decline in investor sentiment (Figure 4) and a slowdown in UK economic activity (Figure 5). We see potential for activity to weaken further if Brexit uncertainty forces corporate managers to delay investment and recruitment plans in the coming months. This could lead UK domestically-focused equities and credit to underperform broader global asset markets.

EU membership provides UK-based companies with the ability to ‘passport’ their services throughout Europe. This has led to a high level of financial integration between the UK and other EU member states. It has also helped London become a gateway to Europe for the rest of the world, a fact demonstrated by the high level of global foreign direct investment in the UK financial sector. Because of this, the Brexit referendum poses a particular risk to the UK’s large financial industry.

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Investment implications – before the referendum

Figure 3: The pound – US dollar exchange rate

The pound has come under significant pressure as Brexit has approached.Source: Thomson Reuters Datastream, May 2016

The pound suffered its worst losses of the year in the week after Boris Johnson announced his support for the “Out” campaign.

Financial services

EU membership provides the UK financial sector with a number of benefits… …and a UK secession could see financial service firms face new headwinds. However, the UK should be able to maintain its position as a leading global financial centre inside or out of the EU. Uncertainty surrounding the referendum has already manifested itself in asset markets... …while it is also affecting economic activity.

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Figure 4: UK economic sentiment indices

Although assessments of the current UK economic situation generally remain positive, expectations of future growth have declined. The majority of forecasters now expect a deterioration in economic growth.Source: Thomson Reuters Datastream, May 2016

Figure 5: UK manufacturing and industrial production

Measures of UK manufacturing and industrial production have been under pressure for some time as a result of the contraction in the global resource sector. However, growth has deteriorated further as the Brexit referendum approaches and activity in both sectors is now contracting in terms of value added.Source: Thomson Reuters Datastream, May 2016

A vote to remain within the EU would improve clarity on the economic and political outlook. As such, it could lead to a reversal of the effects of uncertainty seen prior to the referendum, i.e. the pound, equities and credit may rally. Over time, any pent up demand that had built up as a result of delays to investment programmes should flow through, potentially boosting UK economic growth in the second half of 2016. From this perspective, any Brexit-related weakness in asset prices may ultimately prove to be a buying opportunity.

Some have speculated that the referendum could catalyse a capital-outflow driven selloff in UK gilts, while others have voiced concerns that there could be an impact on the supply of wholesale funding to UK financial institutions. However, any policy action would be likely to support bond markets in general, while bouts of risk aversion should support UK gilt demand. Furthermore, we note that the Bank of England has already drawn up contingency plans to combat any liquidity shortage. Outside of the UK, there is also potential for the Brexit referendum to have similar negative effects on other European economies and asset markets, although this has so far been limited.

We are cognisant that the Bank of England is likely to react to weakness in the economy by shifting to a more accommodative policy stance, potentially leading the pound to weaken further. If this happened, it would boost the earnings of UK-based multinationals and also improve the global competitiveness of the UK export sector.

Investment implications after the referendum

Through these channels, the referendum could lead the Bank of England to respond with policy measures… …particularly if financial stability is called into question. If the UK votes to remain in the EU, we would expect asset price movements to reverse.

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In the event that the UK decides to leave the EU, the economy is likely to undergo a period of significant uncertainty. Exit negotiations should last for at least two years (as per the terms of Article 50 of the Lisbon Treaty) and uncertainty surrounding the UK’s economic outlook is likely to be elevated during this period. It is somewhat unclear how markets would act in this time, although we could see an intensification of the effects evident in the build up to the event, in particular the pound may weaken further. Volatility would likely last for some time and news surrounding exit negotiations would likely become a key driver of asset markets and economic sentiment.

By leaving, the UK may call the EU’s longer-term sustainability into question, if other countries choose to follow. However, the EU could also see itself strengthened if the UK is perceived to have weakened its own position by leaving. Furthermore, the event may lead to further questions over what Scotland will do in terms of its own relationship with the UK. In either case, the political fallout is likely to reverberate for some time.

The Brexit referendum is likely to continue to provide a headwind to both the economy and asset prices as long as its result is in question, as uncertainty will weigh on investment activity, job creation and investor sentiment. Through this mechanism, it could potentially lead the Bank of England to respond with more accommodative policy.

In summary

The longer-term investment implications of the UK leaving the EU are likely to be bad for London and the City, but good for exporters. This divergence adds further weight to our argument that we are currently in a stock-picking environment. The wider economic and political implications also mean that this situation deserves significant consideration from a global asset allocation perspective, in particular the wider European impact. However, it is hard to say what the longer-term implications of a UK secession are with confidence, given that they will largely be determined by events that will take place after it occurs.

Conclusion

However, if the UK votes to leave the EU, the effects seen prior to the referendum could intensify in the short term... …and we could see an intensification of the political issues that have plagued the eurozone since the Global Financial Crisis. In the short term, the Brexit uncertainty is likely to continue to have negative economic consequences Over the longer term, a secession is likely to have positive and negative repercussions for different parts of the economy.

If you would like to know more about any of the topics discussed within this publication, please contact your Brooks Macdonald representative.

Contact information

72 Welbeck Street, London, W1G 0AY T: 020 7499 6424 F: 020 7499 5718 E: info@brooksmacdonald.com www.brooksmacdonald.com

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A UK secession would put the eurozone’s longer-term sustainability back into the spotlight.

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Important information

The performance indicated for each sector should not be taken as an expectation of the future performance. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a guide to the future. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets.

The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others.

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