Investment update - Britain votes to leave the EU
The UK has voted to leave the European Union, which will trigger two years or more of negotiations once Westminster formally notifies Brussels of its intention to secede. However, the referendum result is advisory rather than mandatory and there are significant constitutional issues that must be resolved before such notice can be given. As a result, UK and EU politics will have a significant impact on financial markets in the short to medium term.
More questions than answers
UK voters have spoken and, contrary to the guidance of most of the political class, have voted to leave the European Union. This should now trigger a formal exit process, but given the constitutional challenges, lack of precedent and relatively close result, this will not be straightforward. The government may choose to delay formal notification until the Conservative party leadership situation is resolved and until its policy ducks are in a row.
There is even a chance that the UK could remain in the EU – the referendum is not legally binding and Parliament must vote to repeal the 1972 European Communities Act. Also, despite their rhetoric in the run up to the vote, European leaders may well explore new ways to keep the UK in the EU. Either way, following initial disruption to financial markets, there will be a period of reflection as all parties come to terms with the result.
It should be remembered that until it secedes, the UK is a member of the EU and will continue to benefit from the single market – while there will be uncertainty, the full economic impact of this vote will not be felt for some time. In the meantime, political uncertainties, particularly now that David Cameron has indicated that he will resign as prime minister, will continue to impact on financial markets.
Leaving the EU
As we have said, the lasting economic implications will not be known for many years. Of the many questions, most pertinent, perhaps, is will the UK be able to negotiate continued access to the free-trade area? Further out, what will happen to the EU without the UK? Will it integrate further, dismantling the remaining barriers to trade and investment? This could mean the UK losing much of its considerable market share of European trade. Or will the entire EU project stall?
Economic integration – particularly the removal of barriers to trade – should lead to considerable improvements in productivity over the long term. If ‘Brexit’ requires the UK to forsake access to the European Single Market, it is imperative that it works hard to enact new trade deals and sign new agreements of economic integration with faster growing economies than the EU.
With an ageing workforce, productivity will be the key driver of economic growth in Western economies in the 21st century. Those economies able to capture the greatest gains in productivity are likely to generate better returns on investment, attract higher portfolio allocations and experience stronger foreign exchange rates.
The impact on the EU
Certainly, if Brexit is something of a lynchpin moment for the EU, it is wrong to assume that the UK is in any way more immune to the economic and market consequences. Trade and financial links will remain strong, many for at least another decade. Investors must be mindful here when assigning risk premia to UK investments going forward.
Market-based measures of the likelihood of eurozone disintegration did not flinch in the run-up to the referendum. This seemed at odds with the swelling tide of populist, anti-EU politics on the continent. We expect markets to start factoring in this chance of contagion now that the UK has voted to leave, which will raise borrowing costs throughout the region and curtail GDP growth via tighter financial conditions.
That said, for the majority of EU members, the case for leaving is far weaker than the UK’s. This is due to even higher levels of intra-regional trade, weak banking systems dependent on the buttresses erected by the ECB and the council of finance ministers, and the fact that most are just too small to stand a better chance of negotiating trade deals alone. Surveys suggest that the majority of citizens may want their own referendum, but that only a minority want to leave.
While the act of holding referenda could lower economic confidence throughout the region, the UK has shown that the effect on growth prior to the decision might not be very significant. The Netherlands and Sweden are arguably most likely to hold their own referenda, due to higher than average non-EU trade and prominent anti-EU/anti-immigration voices.
UK economic uncertainty
Turning back to domestic matters, we believe that uncertainty will pervade financial markets and weigh on economic growth for at least two years. Uncertainty alone is enough to delay spending, hiring and investing. And with the chancellor’s new fiscal rules, this will dictate another round of budgetary austerity in order to make up the shortfall in tax receipts from that delayed spending, hiring and investing (although the fiscal rules might be suspended if a new chancellor is appointed).
While HM Treasury’s estimate of the short-term impact of Brexit (GDP 3.6% to 6% lower than would have otherwise been the case over two years) suffers from some rather extreme assumptions and uses some economic sensitivities notably out of line with the general consensus among academics, we believe growth will be 1-2% lower over the next two years largely from uncertainty alone. Numerous independent forecasters share this view. Investors should be mindful of sectors most correlated with GDP growth, such as certain cohorts within banking, insurance and consumer goods.
Trade and investment
Although we believe that GDP growth will suffer in the first few years, we have never agreed with the hyperbole from the ‘remain’ campaign that trade and investment will collapse. Although we know from survey data that access to the single market is an important factor contributing to the UK’s attractiveness as an investment destination, it is far from the only reason.
The UK ranks as one of the easiest places to do business in Europe (taking into account red tape, tax regimes, etc.), while it also excels as a centre of agglomeration – an economics term to sum up the benefits gained when companies locate near each other.
Moreover, the threat of Brexit did not seem to have a deleterious effect on investment over the last 18 months. Investment intentions surveys did not soften as much as expected, while data compiled by EY show that 2015 was another record year for inward foreign direct investment. Britain even attracted more manufacturing projects than Germany for a second year in a row, despite the threat of tariffs on international trade if the UK leaves the free-trade area.
Moving on to trade, the UK will retain access to the single market until negotiations conclude. Even if the UK must in the end give up its access, goods exports to the EU would be subject to tariffs equivalent to just 3.3% of their value on a weighted average basis. Given that the business models of most UK exporters are not predicated on being the lowest cost producer, and that sterling has already depreciated by 12%* since its November peak (thereby already more than offsetting the imposition of tariffs), this is hardly likely to lead to a collapse in trade.
That said, investors should be mindful that some goods exporters will be subject to more punitive tariffs under this ‘hard Brexit’ scenario – such as automobiles, clothing and agriculture – and the supply chains of these sectors should be studied. Beyond the first two years, the larger threat to trade stems from potential non-tariff costs – more costly burdens of proof for regulatory compliance and customs legislation – particularly in the financial services sector. These could be severe.
On what terms might we exit?
We do not believe that retaining access to the single market on beneficial terms will be easy to negotiate. The Norwegian model should be unpalatable to those who voted for Brexit: Norway must make a sizeable contribution to the EU budget and pass EU laws on to their own statute books without any representation in the bodies which draft them.
The Albanian/Balkan model referred to by Michael Gove is not realistic either. Albania wants to become a full member of the EU, but the EU does not wish to lift visa restrictions. Its deal is arguably a matter of international aid and not something that will be offered to a large, developed nation – and certainly not one that has just bid them adieu.
This leaves us with a complex series of bilateral directives à la Switzerland. However, Switzerland does not offer a replicable model either, not least because most of its directives were agreed before 2006, when becoming a member of the EU was still a ‘strategic goal’ of the Swiss government.
The risk to financial services
Importantly, the Swiss have never managed to negotiate a deal on financial services access, and most large Swiss financial firms conduct cross-border business in Europe by obtaining a regulatory passport from their UK subsidiaries. Now, the EU exports more goods to the UK than it imports, so it is likely that some variety of deal will be reached here. But the UK has an enormous trade surplus in financial services with Europe.
Given that various EU institutions have tried to repatriate with new legislation a number of financial activities over the last five years (both successfully and unsuccessfully, due to the UK’s recourse to the European Court of Justice – which it will now lose), the likelihood of a deal on financial services – a sector on which the UK’s economy is still heavily dependent – is decidedly uncertain.
How will equity markets react?
UK- and EU-focused financial stocks have already underperformed their more globally diversified peers this year, although how much of that is due to Brexit and how much to subsiding fears of a China-led emerging market recession (thereby benefiting the global financial plays) is difficult to say. Still, given the threat to UK firms from an EU clampdown on financial services activity undertaken outside EU jurisdictions, we expect the recent underperformance to become more pervasive.
Similarly, the loss of a ‘regulatory passport’ will undoubtedly make doing business on the continent from outside of its jurisdiction much more costly for banks, asset managers and insurers. At the time of writing, bank stocks look set for double digit losses on day one.
The volatility of the FTSE 100 has not diverged from other global large cap indices and there has been little evidence of a potential Brexit impacting the relative performance of the FTSE 100. After all, it is far more an index of global giants that happen to be domiciled in London than a barometer of the domestic, or even the European, economy.
The 25 companies in the index most exposed to domestic revenue streams have underperformed, but half of that can be explained by the substantial rally in oil and gas and mining stocks – again, a global trend extraneous to Brexit. Much of the remaining underperformance can be explained by the UK-focused financials, as discussed above.
However, in the last few weeks overseas investors have lowered their allocations to UK and European equities. If this trend intensifies, the FTSE 100 could be affected by such broad-brush asset allocation calls. We also expect this to weigh on continental bourses. Early indications suggest significant volatility in all European markets.
We have identified a much stronger relationship between domestic economic uncertainty and the equity risk premium of the FTSE 250 and small cap indices, which would mean lower stock market valuations as uncertainty increases. However, one should note that a substantial valuation cushion has already been priced in: the relative price/earnings ratio between the 250 and the 100 is at its lowest in over six years. This seems to already suggest a sharp divergence between the UK and global business cycles.
How will the Bank of England react?
Although a spike in the equity risk premium would dominate price movements, the effects would be partially mitigated if the Bank of England cuts base rates. Governor Mark Carney has made his fears well known. And given the rare unanimity among academic economists that Brexit will weigh on growth for at least the first two years, it is likely that his colleagues on the Monetary Policy Committee (MPC) will also feel the need to cut rates.
However, after markets reacted poorly to interest rate cuts into negative territory at the start of 2016, we believe that the policy rate will not be cut below zero. If further monetary stimulus is deemed necessary, extraordinary measures will be redeployed.
Some pundits have speculated that the MPC would be forced to raise rates if sterling fell further on Brexit in order to stem rising inflation. This seems highly unlikely. Firstly, our analysis suggests that the rate of inflation rises by about 0.4% for every 10% fall in the value of the pound; sterling would have to fall a very long way before it caused the inflation rate to become problematic.
Secondly, policymakers are more concerned about inflation expectations, rather than inflation itself, and expectations are somewhat less sensitive. Thirdly, such a response would run contrary to previous actions: sterling lost 30% of its value between 2007 and 2009, yet the MPC continued to cut rates by a cumulative 5%; similarly, in 1998-99 the pound fell by 10% and again the MPC did not abandon its path, with interest rates settling 2% lower.
How will gilt yields react?
We dissect gilt yields into three components: expectations for the path of real Bank of England rates, inflation expectations and the term premium (driven by the compensation demanded by investors for uncertainty as well as changing supply/demand balances). We expect real rate expectations to move lower, although they already moved a long way in the run up to voting day. Inflation expectations should move up to reflect higher import costs, while the term premium may move higher too, potentially offsetting any downward shift in yields due to interest rate expectations.
Foreign investors (who hold about a third of gilts outstanding) have been marked net sellers in 2016. That said, UK pension scheme deficits have moved back to near all-time highs and the trend towards more liability matching investment strategies continues apace. This could potentially provide new sources of domestic demand to pick up the slack.
How will sterling react?
Our modelling suggests that the pound is likely to settle between 7.5% and 12.5% lower after the results once the initial volatility subsides. The 7% fall in the pound over the six months prior has been attributable largely to changes in interest rate expectations, with the direct contribution from general Brexit uncertainty much more limited.
However, changes in market interest rate expectations this year have been extreme (the expected date of the first rate rise moved from late 2016 to late 2020!), especially for an economy nearing full employment, leading us to suspect that interest rate expectations are reflecting a significant probability of Brexit since February. This will limit the extent of further depreciation.
The result of the referendum leaves a lot of uncertainty. This will weigh heavily on both economic growth and financial markets. As long-term investors we encourage clients not to worry unduly – the politicised hyperbole of the campaign should not be taken seriously. Nonetheless, we face bouts of volatility for at least two years until we know how the UK will interact with Europe economically and financially. We will continue to update clients as events unfold.
* Against a trade-weighted basket of currencies as of the morning of 24 June.